What’s the Bond Market Signaling?

0:09What's the bond market signaling? Welcome to Real Vision Daily Briefing. It's Thursday, September 21, 2023. I'm Ash Bennington. I'm joined today by Darius Dale, CEO and founder of 42 Macro. Darius, it's been too long since we've done this, man. It's been way too long. I miss you, brother. How are you doing? I'm doing great, man. Keep me busy here. Absolutely. Well, I appreciate being back on the program. Let's step right into it. So let's talk about what we signaled at the top of the show, what's happening in the bond market. Obviously, big day. Yesterday, the so-called hawkish hold. I love that term.

0:40I get a real kick out of it, how holds can be hawkish. But what do you make of what's happening right now in terms of monetary policy, in terms of the business cycle, and in terms of what the bond market seems to be telling us? We've obviously seen a bit of an updraft today on yields on the 10-year. Yeah, absolutely. So we've been in the bear steepening camp for quite a while in conjunction with our resilient U.S. economy theme. And as I say that, I'm feeling mortified and embarrassed because I didn't bring my list of 10 key factors contributing to the theme that I bring every time I'm on the program.

1:12So, you know, so Maggie and I have been kind of having this conversation really for over a year now, about 13 months now, in terms of the resiliency of the U.S. economy that we should be expecting. And we think the Fed and the bond market are really just now truly catching up to that in terms of pricing out, you know, steep rate cut expectations, not just out of 2024, but really out of 2025 and ultimately to the floor policy rate. So, you know, we can just quickly list those factors and ultimately, you know, kind of talk about why we think they're likely to persist for a little bit longer in terms of perpetuating the bear steepening in the bond market.

1:46So number one, we got household balance sheets are flush with cash. Number two, we have corporate balance sheets are flush with cash. Number three, we have ample liquidity in the private sector and it's made us, us, the private sector participants impervious to rate hikes. Number four, we have longer, long and variable lags in this particular cycle. Number five, we have limited credit cycle vulnerabilities in terms of capital misallocation in the economy. Number six, we have limited exposure to the more volatile manufacturing sector, which tends to account for 98 % of the net job loss we experience in recessions.

2:15Number seven, we have a perfect storm for new housing development, although it's getting less perfect by the day. Number eight, biodynamics. Number nine, immigration. And number 10, labor hoarding. So all those factors, Ash, have contributed to the resilience of the economy that has become the headline story this year. It should have been going back to last summer, but eventually the Fed has caught up, consensus has caught up, and now the bond market's catching up. So the resilience of the economy and also potentially, I guess, on the flip side of that is the acceleration in prices. Yeah, absolutely.

2:42So we are also seeing a budding acceleration in inflation. So we've had this transitory Goldilocks view really since going back to January. And half of the view has been obviously the resilient U.S. economy contributing to the growth aspect of that theme. But the inflation aspect of the theme, the immaculate disinflation that we've observed across a variety of inflation metrics throughout the year is something that, A, has persisted and has been one of the reasons we've been allowed, the risk assets have been allowed to appreciate this year. That's now starting to come unglued at the margins. You go back to the last CPI report, we're now starting to see stasis around 3 % in terms of the trim mean CPI on an annualized basis, on a three-month annualized basis.

3:21That's about 100 basis points north of what it trended at pre-COVID. So we're kind of getting stuck at an uncomfortable level of median inflation there. We're also now starting to see producer price inflation tick up. If you look at core PPI X trade services, we pop back up to 3.3 % on a three-month annualized basis in the month of August. So sort of the vanguard, the leading edge of inflation is now starting to show stickiness. And ultimately, we do believe that we're going to have to transition from immaculate disinflation as a market narrative to sticky inflation as a market narrative. And that likely will contribute to more bear steepening and volatility in the bond market.

3:58So one of the memes that we've seen coming out of this, this kind of trilemma, a hard landing, soft landing, or no landing. Do you put yourself in one of those camps or does that not give it enough nuance? Yeah, no, no. That's plenty of nuance, in my opinion. I think we're very much no landing for another three to five months here, probably six, seven, eight, nine months from now, will start the process of hard landing, in my opinion, at least according to our analysis. Go back to last fall when we initially put out a recession forecast, not necessarily that the recession would happen, specifically the forecast of when we thought it might start.

4:30We've been back and did a long-term study of the three-month, 10-year Treasury yield curve. And what we found from that study is that the 13-18-month forward interval has the highest probability of seeing a real GDP contraction and a rise in unemployment rate. When you go back to October of last year when the yield government birded October 26, 13-18 months forward from that was November of 2023 through April of 2024. So since last fall, we've had the expectation that we weren't going to see a recession in the U.S. economy in conjunction with this Brazilian U.S. economy theme until we got into perhaps middle, the latter part of Q4, or more likely Q1 of this year.

5:07If you put a banana in my head now, I'd have to say that it's probably more likely the latter end of that forecast range. Yeah, talking of which, I'm just looking right now at two tens. It looks like coming in somewhat here, 66 basis points today. Yeah, absolutely. So this is the bear steepening we're talking about. And there's another factor, by the way. So we got resilient U.S. economy, number one. We got the transition from immaculate disinflation to sticky inflation is number two, why we're seeing a bear steepening in the bond market. And number three, which I don't think many investors are talking about, but they will potentially be by this time tomorrow, is the BOJ.

5:40is highly likely to continue tightening monetary policy and infusing incremental bond market volatility into global sovereign debt markets. And the reason I say that is because when you go back and you look at what we track on a daily basis at 42 Macro, our global liquidity model, which looks at deltas and trends and levels across a variety of key metrics to try to identify and front run big inflections in liquidity cycle, not just globally, but also domestically across key geographies. And when we analyze that table, we can very clearly and visibly see that Japan is the only major economy right now in the world that has above-trend real GDP growth and above-trend level for its composite PMI.

6:17So its leading indicator is still showing robustness as well. We have an above-trend level of headline CPI and an above-trend level of core CPI. It's the only major economy in the world with those conditions. And so it's our belief that the BOJ, which is very much lag, the rest of the global central banks in terms of the tightening policy, will have to step on the brakes incrementally this fall to sort of prevent, you know, sort of cost push inflation from further kind of restraining purchasing power in Japan. Obviously, the yen being in free fall is really contributed to that. Well, what can you say other than, man, that's a big shift from the narrative we've had for the last 20 years?

6:50For most of my career. Yeah, my whole career. It's been more and more. Actually, one of the biggest calls I ever made in my career was in November 2012 when the LDP took the election. We said, you have to short the yen and buy Japanese stocks. You have to lever up and do both because it became very clear to us that sort of monetization and ultimately large-scale asset purchases was going to be a key factor of that program. And that's obviously how we got Haruhiko Kuroda. That's why he's so famous. And that trade worked for a really long time for a lot of folks. It's one of the best trades in my career.

7:22Yeah. So one of the things I've been joking about is with our tendency to sort of navel gaze and reflect on our own reflections is this idea of a hawkish hold. But the serious point here is the summary of economic projections, the dot plot. It looks like the consensus now is for higher for longer. I remember not that long ago on this show talking about lower for longer. Now we're talking about higher for longer. Talk a little bit about that and how you see that projection. Yeah, absolutely. So, Gabriel, if you can pull up chart one, I put together a series of charts to help investors better contextualize what the heck just happened in that FOMC meeting.

7:55That's sort of leaving the bond market in its wake. So chart one, we just show the dot plot, the current year dot plot estimate, then the one year forward, two year forward, and ultimately the longer run projection. And we see that the Fed effectively hiked its median 2024 and 2025 dots by 50 basis points apiece. And so now if you look at chart two, Gabriella, we're now we look at chart two, we're now effectively only pricing in two rate of cuts in 2024 and seven cuts by year in 2025. So that's up from four and nine respectively. So that's a big deal in terms of investors understanding now that the incrementally that the Fed truly means business when it comes to its policy.

8:37If you think about the Fed's policy, just kind of summarizing yesterday what happened. And you can, Gabrielle, if you just sort of fly through charts three, four, and five, just for the audience to kind of view, that'd be great. Because what charts three, four, and five really just summarized, which is the Fed took up its GDP forecast, that's chart three. The Fed took down its unemployment rate forecast, chart four. But then they also took down their core PCE forecast and then put a 2 % number out there as far out as 2026 is concerned. So effectively, the Fed is saying we're going to get more economic growth.

9:09We're going to get better labor market conditions, but we're still going to have this magic soft landing in inflation, which is historically extremely inconsistent with how inflation has developed in the U.S. economy. We've done a tremendous amount of work on that. Inflation is a very lagging indicator with respect to the business cycle. It tends to break down below trend around six to eight months into a recession. So a lot of the disinflation that we've observed thus far in this process, A, is going to include, in our opinion, soon, and B, it's going to leave us at a higher level of inflation that is inconsistent with the Fed's 2 % price stability mandate unless we go through a recession.

9:42And so when you think about this kind of Goldilocks, Pollyannish summary of economic projections that the Fed has put out there, I think you have to take it to chart six and chart seven, Gabriela, because chart six, in my opinion, is sort of, you know, Jay Powell reiterated yesterday that the Fed wants a soft land. Well, if you think about the path to a soft landing can only come from one path and one path only, which is that job openings continue to bear the brunt of labor market rebalancing. So right now, if you look at labor demand relative to labor supply, that's the third panel in this particular chart here on slide six.

10:14We are about 2.5 million in excess of demand relative to supply. And the reason that matters is because that spread between labor demand and labor supply has historically been very correlated to the year-over-year rate of change of the private sector employment cost index, which is the broadest measure of wages and salaries and benefits that we have here in the states. And so what's caused the imbalance between labor supply and labor demand to decline in recent months and recent quarters, really, has been all through the lens of declining job openings. And it's taken some pressure off of the wage component.

10:45Now, that may continue, and this is how you get to a soft landing. And there's another way to get to a soft landing as well is on side seven, which is the U.S. economy experiences a productivity boom, Ash. I don't think that's going to happen. We've been very consistently averaging around 1.5 percent productivity for the last 5, 10, 20, and 40 years. So I think it's going to be around 1.5 until further notice. We had this big thing called the Internet kind of jump in there in the time series, and it didn't really change. So what I'm showing in this chart here, and I'll shut up, is the blue line represents the spread between the year-over-year rate of change of private sector average hourly earnings minus their non-farm productivity.

11:23So private sector average hourly earnings year-over-year subtract non-farm productivity year-over-year from that. And the reason we track that is because historically, when you've seen these big spikes in inflation, they've historically been in response to the widespread in what companies were having to pay their employees at the margins, which is, by the way, it's the largest line item in terms of costs relative to what those employees were incrementally producing in goods and services. And so we saw it throughout the 60s and 70s. We're seeing it right now. And so ultimately, the only way to get this line down is obviously through taking down earnings.

11:53And the only way you can take down earnings is either firing people and creating excess supply of labor relative to labor demand. Or you have this productivity miracle, which I assume the Fed is effectively forecasting, that takes productivity up high enough to take the pressure off of corporate margins. And so, again, this is a very Pollyannish Fed. We still don't think the soft landing is the highest probability. We do believe a hard landing is the highest probability, if only because history shows that's the only way we're truly going to get rid of this inflation. Have you ever wanted to trade Bitcoin but haven't dared try?

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13:00Experience the fast, accessible futures trading you've been waiting for with Plus500. With over 20 years of experience, Plus500 is your gateway to the markets. Visit us.plus500.com to learn more. Trading in futures involves the risk of loss and is not suitable for everyone. Not all applicants will qualify. Plus500. It's trading with a plus. Yeah, Darius, I always enjoy these conversations with you because you're so good at untangling all of these intertwined macroeconomic variables and talking about where they intersect with markets. You mentioned 1.5 % productivity growth is a longer term trend.

13:34I think trend growth right now on a real basis is about 1.8%. So it's predominantly productivity growth. I guess one of the questions that lots of folks are talking, we were actually talking about it before the show began, is AI and the potential role that AI may have in productivity growth. But the flip side of that, I guess, is the risk to labor markets, right, that these technologies are tremendously labor saving. So that's kind of a weird, you know, we talk about how quickly, for example, monetary policy has changed. How many times since I've been at Real Vision, you and I have been having these conversations.

14:05How many inversions we've had. We've seen fiscal intervention. We've seen totally unprecedented things happen with the COVID pandemic. Gosh, we could go back another decade and talk about the totally unprecedented things that we saw happen around the global financial crisis. And yet, the rate of trend growth and the rate of productivity growth, man, they stay in a very, very, very narrow band. Absolutely. Unless you're changing total factor productivity, which we don't really know how to tinker with as economists and as economic agents, you're going to be stuck with that level of trend growth.

14:40I mean, demographics is destiny in that regard. Again, you could have a productivity miracle, and productivity miracles typically don't come from new technology unless that new technology finds a way to better transform energy and make energy less expensive. That's typically when you get these big step-ups in productivity. It's not going to come from just having, well, we have the Internet, now we have AI. You're not going to get a productivity miracle on top of the Internet relative to AI in terms of the boom that we could have potentially saw on the Internet and obviously did not. So in my opinion, this is a very typical mundane business cycle.

15:13The Fed is treating it as it's not a mundane business cycle, and it's ultimately causing bond market volatility because every time they go forward in time, they're getting information that says this is a normal mundane business cycle. You're getting back to this concept of a resilient U.S. economy, and it's unlikely we have this sort of stasis in inflation without a resilient U.S. economy. So again, as I mentioned, they're just now catching up to where we've been for the better part of 13 months. The other thing I wanted to talk about, I'm looking right now on my Bloomberg terminal. I'm looking at the warp function, the world interest rate probability tracker.

15:47And for folks who haven't seen this, who don't have Bloomberg terminals, it's probably an important visual for you to get. I know if you're listening to this, I'm going to draw this with my finger in the air. If you're listening to this, I'll try and describe it on audio. But basically what you see is this very slow roll up to an implied interest rate delta in the, I guess, looking out to mid 2024 of a change of about one hike being priced in. And then you see this drop coming down from that peak into 2025, where we're looking at an implied rate delta of 75 basis points minus 75 basis points, meaning three additional cuts, I guess, four from the peak if you price it from the peak of that peak to trough.

16:27This is something that I think for non-economists is always a little bit tricky to understand because it's like, okay, we're talking about hiking here, and then we're talking about cutting after that. So talk a little bit about that, particularly for people who just struggle to understand the basic framework of what's happening. Yeah, 100%, Ash. I'm really glad you brought that up because, again, there is money to be made in the fixed income market. In our opinion, it's just not now. We think we still have to traverse kind of this bearish trifecta of curve steepening, of bear steepening in terms of, you know, we still have a resilience economy that may persist for another quarter or two.

16:59We still have this trend. We have this transition from immaculate disinflation to sticky inflation that may be very much underway now and could accelerate in the coming months. And then also we have the specter of BOJ tightening. So, Gabrielle, if you throw up slide eight, where we show in the top panel that the median of the current year projections, the next year projection in red, the two year projection in black, and ultimately the longer run projection in the purple line there. And what we see is from the terminal rate, or at least what the Fed expects the terminal rate to be, which is 5.75 basis, 575 basis points, the Fed sees 325 basis points of cuts from that to its longer term projection.

17:36Well, if you go to slide nine, Gabriella, when we look out and we look at the OIS market, the overnight index stock market, so these are money market rates similar to Fed fund futures or euro dollar futures. We prefer OIS because it's calendar agnostic. And what we try to find is that, okay, what's the spread between what's currently priced in the swaps market for the terminal rate relative to what's currently priced in the swaps market for the floor rate. So just taking the max value out two years and subtracting the min value out two years from that number. And we find that minus 152 basis points is the number.

18:06So markets are effectively calling for six rate cuts at some point in the next two years from the Fed. Well, the Fed is telling you, going back to slide eight, they're going to cut 325 basis points. So there is money to be made on the long side of fixed income, particularly duration, once we get into the hard landing part of the process. But we're not in that part of the process. We are still in the resilient U.S. economy part of the process. And we have a litany of high-frequency indicators that we track on a daily, weekly, monthly basis at 42 macro that give us indication of how close we are to that recessionary process.

18:38And those high-frequency indicators are saying we're not close yet. And so it behooves us as investors to constantly be Bayesian about these things, these thoughts. Everyone has this recession, inflation. There's all these big buzzwords. that cause retail investors in particular to do things with their portfolio that could be hazardous to their financial health. The reality is if you are Bayesian about these things, you can watch these things evolve in real time and actually get out with enough time in terms of protecting your family or your client's wealth. But the reality is a lot of folks don't do that because it's more sexy to hear a talking head like myself say something really sexy on a podcast and do a bunch of stuff in your portfolio as a function of that.

19:17But that's typically how you lose money. by the way talking about the bond market talking about exposure and asset allocation i want you to take a look at a conversation uh between andreas steno larson and bob elliott recently on this platform i think it came out today actually i hosted this uh they all bleed together after a while this is uh air date september 21 2023 a part 11 is recession priced in let's take a look at this because it has some bearing on the points that you were just making most investors have some version of 60-40, whether they like to admit it or not, right? That's essentially what their exposures are.

19:53And what is 60-40 particularly good at? When does it outperform? It outperforms in an environment where there's disinflationary strong growth. And instead, what we're sort of seeing here is an environment of inflationary weak growth, right? Look at the UK, unemployment is starting to rise. Growth is zero or a little bit worse, but core inflation, 6%. Look at the US, it's clearly moderating, but inflation remains elevated. Europe, basically the same story. And so if you're in that environment where you're holding 60-40 or something related to it, it's not a great environment. And particularly what we've all learned over the last few decades is that bonds are a good diversifier to stocks.

20:43And that's exactly the opposite of what's happening. So Bob Elliott talking about the decline of some version of the 60-40 portfolio. I think it's really interesting, his point, because this touches on what you were talking about before. This idea that essentially that we're seeing an environment that's inflationary with weak growth rather than disinflationary with strong growth. So talk a little bit about that perspective. And I think you've got a chart here. Yeah, absolutely. So even before we put the chart, the key takeaways, one, I agree with Bob, does a tremendous amount of work. I'm a huge fan of his in terms of the insights that he's bringing to our global investment community.

21:20He's very much right in terms of the lack of diversification that investors are getting from the fixed income market in terms of their equity exposure. And the reason that is the case is because we have high inflation. We went back and looked at data going back to the 1800s in terms of the stock bond correlation. And what we found is through quantiles of levels of inflation, what we find is that 2-ish percent inflation is kind of where that correlation stops being negative. The deeper you go in terms of deflation or disinflation beyond that, it gets more negative in terms of stock-bond correlation.

21:51But once you get to around 3 percent inflation, the correlation between stocks and bonds turns modestly positive. And once you get beyond 5 percent inflation, it's very positive. And so we are obviously still in a regime where inflation is still running north of that kind of 2-ish percent threshold. We're currently tracking a 3.9 % on a three-month annualized basis in terms of headline CPI. We're a little bit north of 4 % in terms of core PCE. And speaking of core PCE, Gabrielle, if you throw up slide 10, this is a chart. I probably featured it on this program throughout the last kind of 18 months or so because we built this model at the beginning of last year, which is our secular inflation model.

22:29And the buzz line, the headline of the model is that the model is saying we're going to have 50 to 100 percent more trend core PCE inflation in this decade relative to the prior decade. Now, that sounds like a lot. It's obviously a buzzword or headline to get people's ears excited. But what I'm effectively saying is that when you interpolate the normalized change of this litany of indicators that all been academically proven to be correlated or co-integrated with the underlying trend of inflation, which is stuff we back-tested ourselves, what we find is that on an unweighted basis, core PCE inflation, the underlying trend, not the level, but the trend between that level, is 1.6 % headed to 2.5 % in this particular decade.