Note to Readers from Larry: Despite the rollercoaster feel of the last 5-7 trading sessions, we are simply back to level after the late Feb selloff. We’re still in consolidation mode until new macro data releases. Looking out longer-term, the probability of a structural downturn is increasing. Any rallies, however large, are counter-trend in nature and need to be treated as such.
We believe investors should take extra precaution to protect themselves as both the real economy and stock markets will soon confirm the bond market’s warning. Planning ahead today will pay dividends down the line. Our Substack/Patreon community will help you get prepared.
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Strategist Larry uses Interactive Brokers as his core brokerage. Feel free to check out IB. I currently park excess cash (yielding 4%) at Interactive Brokers.
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BofA’s annual Global Wealth & Investment Management Survey found that respondents had the most bearish near-term (3-month) outlook since 2017 while also having the most bullish 12-month outlook in survey history. Meanwhile, 70% of respondents either expect the market to bottom in 1H ‘23 or think it has bottomed already…
Macro Chart In Focus
Analyst Team Note:
Inflation has been surging for two years and that could have lasting effects. It means a return of more normal inflation risk premiums. In addition, the global backdrop is shifting from disinflationary to inflationary as globalization reverses. It is plausible to expect inflation on average to modestly overshoot rather than undershoot the target.
Fiscal irresponsibility could also impact the market.
“Bond vigilantes seem to have disappeared in recent years and neither budget brinkmanship nor huge deficit seems to be impacting funding costs. However, challenges to the full faith and credit of US debt will continue and a large structural deficit remains an upside risk to funding costs.” - BofA
What is the new equilibrium? One simple approach is to throw out the 2010-19 aberration and focus on the prior decade of 2000-09. As the chart above shows, over that decade 10-year yields averaged 4.5% and real yields averaged 2.0%. That seems like a reasonable “new normal.”
In February’s press conference, JPow mentioned ‘disinflation’ 13 times, but made no mention of tight labor markets and avoided saying that a return to 2% inflation would require softness in the labor market. However, in yesterday’s remarks in front of congress, Jerome Powell noted that “Restoring price stability [would likely require] some softening in labor market conditions”.
Powell also noted the importance of “two or three” data releases to analyze before the time of the March FOMC meeting, stating that “Those are going to be very important in the assessment we have of this relatively recent data”. My guess is that he is referring to the February payroll numbers this Friday, and a CPI and retail sales report next week.
The market sure took notice of this hawkish tone. The odds of a 50 bps hike at the March FOMC meeting before JPow’s remarks were just 31%. At the time of writing, the odds are now 76.4%.
This segment was adapted from my (Tim’s) new FREE newsletter. Check it out!
The table above estimates how each 1% increase in interest rate costs the economy as a percentage of GDP. Note that most of the debt is fixed and would take time to reset at higher levels.
“We use the five-year Treasury as a proxy for interest rates to approximate how higher interest rates will dampen the economy over time. The five-year note currently yields 4.25%, about 2.50% above its 1.75% average of the last 12 years. Most maturing debt was added when interest rates were below 2%.” - RealInvestmentAdvice
If only 20% of debt matures this year and is rolled over, the additional interest cost could be equivalent to 1.38% of GDP. This percentage will continue to increase as more debt matures and gets reissued at higher rates.
