Stay Captive
The impossible could not have happened, therefore the impossible must be possible in spite of appearances – Agatha Christie
There are times when the unimaginable occurs. This holds not only in life but also in financial markets. Certain events from the past influence the positioning and expectations of investors in the future. Typically, these assumptions prove to be accurate. One might say that the investor has gleaned insights from past experiences, whether personal or observed in others, and shapes their future actions accordingly.
However, at times, precisely these expectations lead people into deep trouble. After all, nothing is as uncertain as the future, and circumstances can unfold quite differently than they did in the past. This doesn't negate the argument that it's different this time but acknowledges that sometimes, situations can take an unexpected turn.
Throughout history, market events have caught market participants off guard due to the unforeseeable. Recall the early years of this century. Many investors believed that real estate, primarily residential property, was a safe and secure investment during that period.
Significant sums were poured into the housing market, driving up demand and, consequently, prices. Banks bundled mortgage loans into Mortgage-Backed Securities and traded portions of their loan portfolios among themselves. Low-risk mortgages were mixed with riskier ones, resulting in higher yields. Rating agencies bestowed triple-A ratings upon them because, to paraphrase Lewis Ranieri, the innovator of MBS's, in The Big Short: Risk? What risk? The only risk is getting paid back too soon!
Furthermore, banks used these bonds as collateral when lending or borrowing money from each other. After all, the credit rating indicated that MBSs were as secure as bonds issued by the United States Treasury Department. What could possibly go wrong? As investors soon discovered, a lot. Sometimes, assets considered safe bets are anything but safe.
Another example occurred about a decade later in a country known for its collectivist economic policies and financial turmoil: Argentina. Argentina had a lengthy history of financial instability, including multiple government debt defaults. However, in the years leading up to 2018, Argentina pursued a strategy that ultimately proved disastrous. The government issued a substantial debt denominated in dollars to cover budget deficits and service existing debt.
The issued bonds offered an extraordinarily high yield compared to safer assets. Because these bonds were denominated in dollars, investors were enticed, believing they offered protection against currency risk. Then, in 2018, circumstances took an abrupt turn for the worse.
A severe drought adversely affected Argentina's crucial agricultural exports, inflation rates soared, and the peso experienced a rapid and substantial depreciation. This raised concerns among investors about whether the Argentinian government could still meet its mounting debt obligations.
As the crisis unfolded, it became clear that these dollar-denominated bonds were far from safe. The value of the bonds plummeted, and investors faced substantial losses. Between 2018 and September 2019, stocks denominated in US dollars dropped by 75 %, and dollar-denominated bonds plummeted by 65 %. It turned out that these bonds were not the secure haven investors had believed them to be.
The bottom line is that no matter how confident you are, always consider what could go wrong. Even if your historical analysis supports your strategy, remember that people are not particles, and economics and finance are not natural sciences like physics. Just because it worked yesterday does not guarantee it will work tomorrow.
There has been much debate about whether things will return to normal (pre-2020) after the pandemic or if there has been a structural change in the economy. The most noticeable change affecting businesses is the ability for people to work from home, something that was once considered unimaginable.
However, there are significant differences across continents. While Europeans and Asians have seen office occupancy rates reach about 75 % of pre-pandemic levels, the occupancy rate remains 50 % lower in the US. One driving factor behind this could be that labor markets are still tight despite a global economic slowdown. This situation gives employees some bargaining power to continue remote work arrangements.
As I've mentioned before, I want to emphasize once more that an increase in remote work leads to changes in consumption patterns. A shift away from city centers, with fewer people working there, results in lower revenue for restaurants and stores in those areas.
This shift also has implications for the value of US commercial property. Commercial real estate was highly profitable before the pandemic, but the landscape is changing. With more people working from home, businesses no longer require as much office space as they did before 2020. According to a McKinsey study, office-heavy areas in New York and San Francisco have experienced a significant decline in real estate demand. The consultancy estimates that in a moderate scenario, approximately $800 billion could be wiped from the value of office buildings in nine major cities and up to $1.3 trillion in a worst-case scenario.
Furthermore, rising interest rates have altered consumption patterns. With inflation persistently above 2 %, interest rates have increased significantly since 2021. This has made it more challenging for many people to purchase a home, which is often the most significant expenditure in their lifetime. Consequently, fewer individuals believe they can afford a home, and instead of saving for a down payment, they are spending like there’s no tomorrow.
This could be one of the reasons why travel and leisure stocks rallied during the summer, with flights and hotels fully booked, while the housing market displayed some weaknesses. Nonetheless, even though fewer people opt to buy homes, the supply is also slowing down. New home sales are at levels comparable to those during the Global Financial Crisis (GFC), and existing home sales have not shown a robust recovery. This contributes to the fact that home prices are still at all-time highs despite the increase in interest rates.
The reduced housing supply is another consequence of the rapid increase in interest rates. Many individuals secured ultra-low mortgages during the pandemic and are now reluctant to obtain another one. This has counterbalanced the challenges of rising rates, such as credit card debt, and has allowed those who are financially comfortable to continue spending. The only group that appears to benefit from this situation clearly are those who are downsizing and purchasing smaller homes for retirement.
As a result, the proportion of total household debt tied to market interest rates is currently at a record low of 11 %. To provide some perspective, this figure was approximately 40 % at the beginning of the 1990s and 25 % before the Global Financial Crisis hit. Furthermore, households with savings can place them in relatively low-risk money market funds and earn over 5 %. This has led to an even greater divide between the haves and the have-nots, with the latter still attempting to recover from their real wage losses in previous years.
The shift in consumption patterns exacerbates a trend that was already noticeable before the pandemic. When interest rates remained at record lows, people lowered their time preference, choosing to consume now rather than save for future consumption.
What's truly intriguing, however, is that the further decrease in people's time preference coincides with rising interest rates, which, at least in theory, should reduce consumption and increase savings. The question of how long this trend can persist is one that investors should contemplate. It's essential to factor in the accumulation of excess savings due to government spending during the pandemic. It's still uncertain whether these savings have been exhausted or if there are still reserves.
Currently, I am inclined to believe that things could take a turn for the worse rather swiftly, and we may experience a significant downturn later in this quarter. However, some compelling arguments suggest it might occur a bit later or that the US economy could continue to grow. However, even if one assumes that the US economy can endure current interest rate levels, a transitional phase that disrupts the status quo is still probable, potentially resulting in negative growth for a brief period, perhaps a single quarter.
I lean towards the possibility of a hard landing, leading to significant disinflation in 2024, because of the negative rate of change in the broad money supply. We are aware that the growth of the US and Eurozone broad money supply is negative compared to the previous year. However, central banks maintain that broad money supply has a lesser impact on consumer price inflation than interest rates. This is why they utilize interest rates to target inflation, even though central bankers, such as those at the BIS or Isabel Schnabel, have recently acknowledged that money supply still plays a role in inflation.
If one agrees with this theory, I would encourage you to examine Turkey. Like most central banks, the Central Bank of Turkey has raised interest rates to combat consumer price inflation, but consumer prices have continued to rise. While proponents of Modern Monetary Theory, like Warren Mosler, may argue that this results from the rate hikes, the answer might be more straightforward—namely, that the increase in the money supply is driving up inflation. Hence, one could argue that the Fed and the ECB have, in fact, tightened monetary policy too much due to their fixation on interest rates.
Typically, the belief prevails in the financial markets that if the Fed has tightened monetary policy excessively, it should result in a stock sell-off and increased demand for bonds. This is a widely held notion among financial market participants. If we consider that bond prices tend to rise in such scenarios, it follows that bonds with longer durations offer more attractive returns. This is why there has been a rush into bonds whenever the economy has faced turbulence in recent years.
But what if we also witness a change in behavior within financial markets, akin to the shifts we observe in the real economy due to remote work and higher interest rates? There has been much discussion about the underperformance of many individual stocks listed in the S&P 500 recently, even though the index has gained approximately 23 % since October 2022.
Most traders and investors continue to draw comparisons to the bursting of the dot-com bubble and the Global Financial Crisis (GFC). However, there is a significant difference in what we are witnessing today. Whether it was the dot-com recession, the GFC, or the Covid crash, bond prices exhibited an upward trend in all these cases before the stock market reached its peak.
In 2000, bonds hit their low point in January, starting a rally, while the S&P 500 did not drop until September. 2007 US bond prices bottomed in July, and the S&P 500 declined in October. When Covid struck in 2020, bond prices had already bottomed a year before, consolidated, and then began to rise at the beginning of 2020. Conversely, the stock market (S&P 500) peaked in February 2020, two months later.
Another analogy that some have recently drawn is with the 1987 crash, where bonds also experienced a sharp drop before Black Monday. Indeed, the recent rise in yields resembles 1987, but comparing the stock market's behavior back then aligns with the other downturns mentioned earlier. Bonds reversed sharply and rallied, while stocks were on an upward trajectory before subsequently declining.
Since the Fed commenced raising interest rates, the S&P 500 declined alongside bonds but hit a low point in June 2022, rebounding until August of this year, while bonds consolidated. Then, bonds continued to decline despite investors flocking to long bonds in anticipation of an impending bond rally, contributing to the stock downturn.
However, despite an increasing number of investors seeking refuge in long bonds, bond prices have continued to decline. Since August of this year, bonds have proven less lucrative than the S&P 500. While TLT has seen an 11 % decline, the S&P 500 has only dropped by 5 %, primarily propped up by the Magnificent 7. Perhaps bonds are on the verge of losing their status as a safe haven to assets like gold (and Bitcoin?) and the Magnificent 7.
To clarify, this does not imply that bonds couldn't witness a significant rally when the economic downturn eventually strikes. In fact, the likelihood of bonds responding with a substantial rally at that time is relatively high. However, I would contend that this initial surge is merely a countermove within a more extensive and enduring downturn—a continuation of the air escaping from the immense bond bubble that central banks inflated following the Great Financial Crisis.
However, it's challenging to overlook the persistent claims that long-duration bonds are a buy at these levels. According to the latest BofA fund manager survey, long bonds remain the most popular trade despite the ongoing decline in bond prices. Trader Jason Shapiro aptly captured the current sentiment when he remarked that buying TLT (the 20-year Treasury Bond ETF) is the new shorting NVIDIA.
Despite the significant influx of funds into bonds, yields have continued to climb. This week, the German 10-year yield reached 3 %, and US Treasuries have surpassed 4.75 %. Long-time readers know I have held a bearish outlook on bonds for quite some time. Although I wouldn't be surprised if yields were to increase further, it is likely prudent to consider taking profits in such positions.
I tend to agree, at least in part, with the perspective that the recent sell-off in bonds was accelerated by the Fed's pause at their last FOMC meeting. Market participants began factoring in the looming supply surge in long-duration treasuries. Whether the next move entails a consolidation phase or a brief rally remains to be seen. However, one thing that appears certain, in my opinion, is that volatility will remain elevated in the bond market.
Another reason we might be poised for a pullback or consolidation is the catalyst behind the recent rise in yields: the surge in oil prices and the strengthening of the US dollar. It's been a correlated trade since oil prices hit their low point in June and the dollar bottomed in July.
The Fed adopted a hawkish tone, pushing the dollar higher and simultaneously prompting foreign holders to sell off Treasury bonds to buy oil. Both oil and the dollar have reached levels where a pullback can be anticipated, which suggests that the ascent in bond yields should either stall or retreat at current levels.
A pause in the upward trajectory of yields and stable long-term inflation expectations should also support the gold price. This suggests that the correction I predicted in early September might have ended, and we are likely in the process of finding a bottom. This could potentially present a buying opportunity, mainly if one entertains the possibility that central banks could be on the verge of stepping in again to provide support.
The key takeaway here is that investors should explore alternatives to the conventional 60/40 portfolio firstly because it's becoming increasingly uncertain whether bonds will continue to provide the same level of safety they have offered for over four decades. Secondly, real bond returns are lackluster compared to hard assets like gold or commodities in the current economic environment.
We might very well witness shifts in consumption and investment behavior that the markets haven't fully grasped yet. While it's evident that the declining time preference of consumers can't indefinitely sustain the economy, it's also clear that governments can't persist in their spending spree with interest rates at these levels. Such a scenario would send their interest rate expenses skyrocketing.
The pressing question is whether the Fed will eventually backtrack and return to its low-interest policy of the 2010s, accompanied by massive quantitative easing, to rescue investors again. Alternatively, they might stand aside and let the free market operate, allowing the growing interest rate burdens for governments and heavily indebted businesses to take their course. I'm still not entirely convinced the latter will happen. Still, I also believe that the Fed and other central banks might implement specific support measures to prevent a financial system crash, something akin to BTFP forever.
However, even in such a scenario, it's probable that central banks will lower interest rates somewhat when they realize they've tightened too aggressively in response to inflation concerns rather than letting the money supply work. But such a move carries a significant risk: the potential for long-term inflation expectations to become unmoored. This holds true for a return to an ultra-expansionary monetary policy as well.
While the initial response I anticipate might involve a brief, robust rally in government bonds, this trend could swiftly reverse, causing the long end of the yield curve to surge. Regardless of how you analyze it, the assumption that human actions, whether in the real economy or financial markets, have remained unchanged since COVID-19 doesn't hold water. Believing in such a notion could lead to a rude awakening.
Until someone moves or cares
Stay captive, keep yourself there before love
Until someone moves or cares
Stay captive, keep yourself there, wait for loveStill Remains – Stay Captive
I wish you a splendid weekend!
Fabian Wintersberger
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(All posts are my personal opinion only and do not represent those of people, institutions, or organizations that the owner may or may not be associated with in a professional or personal capacity and are no investment advice. I may change my view the next day if the facts change.)