Shock and Ahh

For the record, I feel nothing but empathy for fixed-income investors now that they suddenly find themselves managing the world's riskiest asset class. As a long-time stock jockey, I say 'welcome to my world'. If it doesn't kill you, it will make you strong.

But what can I now say about the bond market that I haven't said before? When you don't own anything but a promise, you shouldn't expect a risk-free lunch. And when you don't have any say in the management of the enterprise that offers you that promise, you can't complain. The Fed is your master, telling you to jump, and you can only ask "how high"?

And how high indeed! The Fed doesn't have clue, based on reviewing their previous, and now denigrated projections. And investors also don't have a clue either, based on the meltdown that has just played out in the Treasury and Credit markets. It seems Bondies finally have given up the notion of Fed supremacy when it comes to managing the economy.

As I have repeatedly said, the Fed's narrowly focussed domestic mandate is totally incongruent with the setting of what is de facto global monetary policy. Extrajurisictional forces beyond their control such as oil prices and imported goods supplies are exposing that fatal flaw.

Let's look at the recent volatility of interest rates. It ain't a pretty picture.

The 3 -month rate of change of the 10-year bond yield is just short of 60%. That historically high rate move is only slightly less than the 2021 rate rally off the pandemic lows. Notice the pattern of higher highs and lower lows since the Fed got in the QE game. Admittedly has been exaggerated by the low starting level of nominal rates, but the pace of the move has been destabilizing. Bonds are trading like penny stocks as compared to the '80s and '90s.

10 Yr U.S. Treasury Yield (LHS)

The effect on stock prices of the rate shock is shown in the chart below. The S&P 500 has been limited to high single-digit declines, - a run-of-the-mill correction. Last week, I postulated that the equity risk premium could compress as investors tried to inflation-proof their financial assets. In a still-growing economy, with rising earnings, stocks are seen as a good hedge against inflation - hence the resiliency of stock prices.

S&P 500 12 Wk ROC (LHS)

On a price basis, the 12% decline in longer-dated Treasuries, ostensibly the lower-risk asset, is instructive if not alarming. There is suddenly more price risk in fixed income than in equities. This is not what Professor Fabozzi promised us.

TLT 12 Week ROC (LHS)

This morning, we have seen a positive reaction to the CPI report. After the "Shock", we are getting an "Ahh" moment. This is a typical reaction to the well-telegraphed inflation data. And as fans of calculus will know, it is the second derivative that is more important in expectation setting. The lighter than expected 'core' inflation print, combined with the recent decline in gasoline prices in early April, has generated this change in expectations. This could potentially be the high water mark for inflation phobia, if not for actual inflation.

Also, the 'Goods' vs 'Services' inflation data show a transition to the latter as a source of price pressure. Early cycle indicators such as lumber and used cars have declined recently. The stickier issue is food, given the disproportionate effect of war on soft commodities. A pure-play stock on farmland values, Gladstone, shown below, shows that there are winners amidst the recent market gloom. But as we saw in lumber last year, don't underestimate the supply response to high grain prices. I seem to recall, that lumber stocks peaked about this time last year.

Gladstone Land Corp

So as we start to lap the 'hot' inflation data of last year's Q2, and with the natural deceleration from the Covid reopening effect, we may get a reprieve on the interest rate front for a while. The removal of excess stimulus from the economy will take time, and that will provide investors with trading opportunities, as we are seeing this morning. Unfortunately, it will be a case of 'good news is bad news' this year. If there is any hint of a strong economic expansion after the recent softness, the 'inflationists' will be back on the streets calling for further rate hikes.

My working hypothesis this year of an economy that does better than the stock market still holds for now. It's a bit like arm wrestling, a bit back and forth at first, but ultimately a winner will emerge. I'm still a believer in equities for the long run, even if the path forward might be choppy.

Risk Model: 3/5 - Risk On

With the sigh of relief rally this morning, the Model has stayed the course after last week's gyrations. After going positive early last week, it suddenly flashed a negative reversal on the back of the rate shock in the fixed income market. That appears to be reversing yet again today on the "Ahh" rally.

The governing factor for risk-taking has been the CBOE VXV 3-month Implied Volatility. Shown below, it is in a disconcerting uptrend since the halcyon days of the post-pandemic rally of 2021.

I would wait for this pattern to break down before fully committing to a full risk-on stance. A declining 100-day moving average is also a prerequisite, in my opinion.

CBOE 3-Month Volatility Index

As for sentiment, the AAII readings have been dismal and were partly to blame for the Model's reversal on their disclosure last Thursday. They seem to be bottoming in a fashion not unlike the 2020 period but there could be more work to do yet. Just assuming a contrarian position is not prudent here. Unless I get confirmation from the VXV, and Copper/Gold, I won't be comfortable going for anything more than a trade here or there. Gold is outdoing Copper today as the China shutdown worries persist and Europe heads for a home-grown recession. Goldman's call for an upside breakout in the red metal seems a stretch.

AAII Bull/Bear Ratio