Getting Real

I love it when somebody says "Get real". It's both uncomfortable to hear but ultimately refreshing. But we often need a much-needed dose of tough love. Investors are finding this out the hard way.

The Bond prices are saying what I have been thinking for years. They are getting to the point of providing an inflation-adjusted return with a positive term premium. They are finally shedding the effects of manipulation by central bankers and overinvestment by the 60/40 crowd. They are getting real.

The chart below shows how long it has been since investments in fixed income actually earned a level of profit after inflation. The downward slope demonstrates the degree of that decline. Real rates of 4% or more were the norm when yours truly was cutting his now-worn investment teeth. For over twenty years bond investors have been under-compensated for the loss of purchasing power due to inflation. Perhaps the systemic demands for perceived 'low risk' investments were also to blame after a series of highly existential volatility events like the Tech Wreck and GFC, and lately Covid. But a primary reason was that rates were suppressed in the name of 'innovative' monetary policy by Mssrs Greenspan, Bernanke, and now their dutiful acolyte Jay Powell.

Now we are reaping what they have sown.

10 Yr Real Rates

The inflection point we are witnessing will slowly dawn on Bondies over the next few years. Maybe the three consecutive years of negative returns to fixed income should help in their reassessment. But fear not, The path forward is a long one, and being bearish of fixed income is second only to AI in the level of hype being demonstrated by those in the negative camp. Chief among them is a famous hedgie Bill Ackman. He has been crowing all year about his short position in the bond market to anybody who will listen. The trouble is, he's been right for the wrong reason.

His position was premised on an uncontrolled and persistent level of inflation that the Fed's monetary policy is not equipped to handle. Now that U.S. rents are deflating, the final nail in the coffin for reported inflation is about to drop. Given this, some commentators are expressing a degree of perplexed confusion about why bonds sold off so abruptly on the higher for longer views expressed by the FOMC last week. They obviously haven't been reading Tuesat11. Re-read last week's offering to understand the implications of the Fed's last policy revelation. The Dot Plot really did thicken!

The second derivative of reported inflation went positive last month. Yes, core inflation has declined but the bounce in oil prices rained on that parade. The Fed, dutifully adhering to their data-dependant Pavlovian mantra signaled a higher terminal rate for Fed Funds than the 'market' had expected. My contention that this could happen and yields could rise sharply, suddenly became a cold reality for the complacent stock market. That resulted in a quick reversal of the Risk Model and a hardening of the soft landing thesis (more on that below).

But I contend that bond prices have more to do with supply and demand than inflation expectations now. With the reversal of QE into QT, the U.S. Treasury's huge calendar, and the negative sentiment about recent fixed-income performance, there is a classic sentiment-driven bear market for bonds that we haven't seen since the late 70s. No surprise then when this week saw record outflows from fixed-income ETFs.

But fear not, this period of bond volatility, exacerbated by the government Kabuki theater surrounding the debt ceiling in Washington, will soon pass. That is the message of real rates. Now that bonds are offering competitive real returns, the supply/demand balance should begin to shift away from the recent FOMO-driven narrow-leadership stock bet towards a more diversified and balanced environment. But first, the fixed-income pain trade must steady itself. Rising rates and the consequent poor trailing returns are self-reinforcing - a spiral that is hard to escape. However, escape from the downdraft is axiomatic given the pervasive weakness in risk assets and the rush to safety. October 1987 taught me that.

My recent postulation for an extended period of soft landing is now nothing more than hope. And you know what that does for strategists. They soon find themselves hoping for a new job. Now that bonds have shown how quickly they respond to any economic or inflation strength, the threat to risk assets of a soft landing is greater than the benefit of a strong economy.

I have been steadfast in my belief in the risks of an inverted yield curve. I downplayed those risks this year due to the Covid-related stimulus. That card has been played now. There is likely more downside for growth and employment now that the sticker shock of 5-7% is being talked about. I still contend that a process of 'normalization' would generate market pain no matter which way it occurs. This bear flattening is only slightly less painful than the alternative of a weaker economy and Fed easing.

Bonds are a clear and present danger now. Their message to the soft landing crowd is also clear - get real.

Risk Model: 1/5 - Risk Off

What a faceplant last week was! Any thoughts of an immaculate, soft ending to the 18-month-long period of yield curve inversion can be shelved for now. Any doubts that the economy is strengthening have been dismissed by a lower copper/gold ratio. Any signs of complacency have been erased by the spike in the VXV and a sharp reversal of the AAII Bull/Bear ratio. I had hoped for one last rotation trade before it was done. Hope was not a good strategy apparently.

But I do hope for a 'bad-news is good-news' reversal soon. I just want to see it before betting on it. I'm moving on from the soft-landing theory. I believe it was created to explain the unusually long lag to the tight money policy and the persistently positive economic surprise this year. But the sudden tightening of the long end of the bond market combined with a 'risk-off' shock should soon begin to wear that argument down.

My hard-landing countdown clock has officially begun ticking.