The Ignorance of Crowds

“I do not believe in the collective wisdom of individual ignorance.” Thomas Carlyle, Scottish philosopher and historian

My hopes, expressed last week in calling the "Dimon Bottom" turned out to be prescient. Treasury bond yields 'topped out' in a dramatic fashion, rallying in the face of a sea of pessimism. I believe this will turn out to be the true inflection point that cements a lasting high for Treasury yields.

But why? Was it the slightly weaker data? Was it a smaller bond auction than expected? Was it the drop in oil prices? Did Taylor Swift stop touring?

None of the above by itself explains why there were more buyers than sellers of long bonds last week. I remember once back when I was 'somebody' on Bay St ("instead of a bum which is what I am" - Marlon Brando, 'On the Waterfront') I got a call from a 680 News reporter after a strong rally asking me why the market went up. I told him "More buyers than sellers" and hung up. Even though I was right, he never called me again.

But maybe this is all we need to get the call right. The chart shows the record level of short positions in the bond market. Quite a crowd, eh? Wisdom of crowds or groupthink? You decide.

Treasury Market Treasury Positioning

"Faced With the Choice Between Changing One’s Mind and Proving That There Is No Need To Do So, Almost Everyone Gets Busy On the Proof". - Sir John Kenneth Galbraith

Besides being an economist of redoubtable notoriety, Galbraith was also a keen student of behavior when it came to markets. Remember he also gave me the mantra of 'anticipate the anticipations of others' that I have held as my investment touchstone. Market 'narratives' are simply anticipations given form. They drive markets. Narratives are a consensus of thinking, a shared expectation about the future, be it ill-informed or completely prescient. In this quote, Sir John is describing confirmation bias, only in a more poetic fashion.

And reason Jamie Dimon was wrong about 7% yields comes from being too close to the forest to see the trees. Of course, a banker who has seen his net worth shrink and his business dwindle would be the wrong person to ask about the markets. He saw bond yields as an existential threat and couldn't look away. He only looked for proof that he was right, never considering what could make him wrong.

The strong Q3 data, supercharged by Bidenomic spending and an immune consumer, benefitted from high savings and locked-in low mortgages, was an unsustainable construct. The 'Higher for longer" consensus built its case on that now fading impulse. Signs of economic weakness in recent data have buoyed bond investors and, voilá, a 40-beep rally in 10s. Even September's soft landing talk seems vulnerable to downward revision now. The crowd was dead wrong.

Now that 'Higher for longer' is over as a driver of negative sentiment towards the bond market, I believe it will soon be replaced with a dot plot make-over. The Fed is done hiking. But they aren't saying it just yet. They have painted themselves into a corner with their hawkishly tilted narrative. As usual, they are firmly staring into the rearview mirror of economic data as they fight the last war. That 'last war' was based on the mistaken 'inflation is transitory' and underestimation of the post-Covid rebound. That now-defunct argument - an example of the wisdom of crowds at the time - damaged their credibility. Faced with another crowd-funded narrative that drove bond yields higher recently, it's no wonder they intend to err hawkishly, as Neel Kashkari of the Minnesota Fed as much as said this morning,

The bond bear crowd was driven to a frenzy by a 'stronger for longer' economy and persistent inflation narrative. Added to that was some nitrous oxide in the form of a bond vigilante resurrection that seemed mostly hype. Evidence recently is throwing a bit of cold water on that heated argument.

The Atlanta Fed's GDPNow model, which got the summer strength so right, has now picked up on a dramatic reversal in economic behaviour. It has completely negated the readings of strength seen in September. Short of a blow-out Christmas season, the economy is set to decelerate now, as the high interest-rate chickens finally come home to roost. Just ask the huge cohort of student-debt-laden parents and younger employees how 'immune' the consumer is to higher rates now that the deferral period has ended. And housing affordability has spiked, leaving a wide swath of younger consumers to reduce spending in favour of saving, further depressing aggregate demand.

Atlanta Fed GDP Now

The unemployment rate has finally ticked up above the basing pattern of the last two years. If the chart below represented a stock price, a chartist would rate it a screaming buy.

U.S. Unemployment Rate

And the average small businessman is more pessimistic about their prospects than during the Covid shock. Small companies are ground zero for the higher interest rate bomb dropped by the Fed this year. They don't have the luxury of the pristine balance sheet of the likes of Apple and Berkshire Hathaway. They also are facing the brunt of higher wages, being more labour-intensive than the tech titans.

NFIB Optimism

But the market wants desperately to buy the recovery from a recession that hasn't happened yet. Bonds are sniffing out a second derivative move toward a weaker economic backdrop that the bond bears hadn't expected. But rising stocks are acting like a rotation to stronger growth is imminent. There was broad participation by banks, cyclicals, and resource stocks in last week's rally.

I'm calling "Head Fake" on that.

We will need to see the yield curve dis-invert before there can be a sustainable recovery in those sectors. That's not what we got, as long yields have dropped faster than short and are now 35 basis points apart. Call me back at zero and I might get interested in anything but non-cyclical, bond-like equities. For now, I'm sticking with Utes and High-quality bonds.

Treasury Yields Spread: 10s vs 2s

So with three-month annualized core inflation at 2.5% and still set to drop further, and signs of recessionary conditions multiplying globally, what is the Fed waiting for?

They are waiting for a consensus to form around a new narrative that will allow them to climb down from their soft landing perch. Burned by bad forecasts, they are finding it impossible to proactively shift their stridently hawkish stance to a more supportive one. They will be unable to generate a 'normal yield curve without a surprisingly bearish data point or financial upset to back a reversal of their narrative.

They are staying data-dependant. Kashkari even said that they suck at forecasting. I guess they are waiting for the crowd to move first. And we just saw a prime example of how ignorant that can be.

Risk Model: 3/5 - Risk On

The twin price variables - 200dma and RSI - have been positively reversed by last week's sharp short-covering rally. The 3-mo VXV indicator is also comfortable with more risk.

That leaves the lagging AAII sentiment number due Thursday morning and the more important Cu/Au ratio. Copper is recovering from the China-led sell-off of the past month and there are many commentaries from industry players that it will eventually be in a shortage. Any sign of an easier Fed could cause a sharp reversal on speculation but the timing of that move is unknowable.

AAII may bounce on the euphoria of last week but it has a long way to go to signal a positive level.

AAII Bull/Bear Ratio

Copper is under more pressure this morning on weak trade data, so that jives with the hard-landing tilt to my views given the global nature of the metal. This indicator was also supportive of the bond market 'buy' recommendation I made last week. The only strength that I see left is in the U.S. and, as usual, they see themselves as 'exceptional'. It's sort of how they see the weather too!