If a picture speaks more than a thousand words, we can see today’s CNBC headlines demonstrate everything we need to know about the US economy right now. We have the potential threat of interest rates rising by 0.75% within the next two weeks, and that is causing a rippling effect throughout the markets. The very top of the page shows that the NASDAQ has now traded down in 7 straight days, and the bottom headline shows that home prices have stopped appreciating, and in some cases home prices have starting declining. The strong dollar, which just hit another milestone in the currency markets is now trading at its highest level against the British pound since 1985.
If you have been paying attention to stocks this month, there has been a clear surrender of the most recent bear market rally. The ARKK innovation fund is down 22% in the past 30 days, with the NASDAQ down 8% in the same period, and the S&P 500 down 5% as well. What we see clearly is that the further out on the risk curve you go, the more damage is being done. The Dow Jones, which would be considered the most value-oriented index in US markets, is down 4.5% on the month. So if we move from ARKK to the NASDAQ, NASDAQ to the S&P, and S&P to the Dow Jones, the pain is getting less significant. Everyone wants to own the NASDAQ when times are good, but boy is it painful when times are bad.
Even more significant than the routing that the stock market is taking would be the bloodbath in the bond market. In fact, I was listening to The Compound yesterday and the 60/40 portfolio was being discussed. The 60/40 portfolio has become a standard retirement portfolio over the decades, which is comprised of 60% stocks and 40% bonds. The typical 60/40 portfolio is having its worst year since 1936. You have to go all the way back to the midst of the Great Depression to find a worse year for the ‘diversified investor.’
So a portfolio which is supposed to be 40% ‘risk-free’ is getting crushed on both ends. Stocks are getting killed, and on a risk-adjusted basis, bonds are getting killed. On a non-risk adjusted basis, bonds are still doing very poorly. If you recall my podcast from the beginning of the year where I made my 2022 predictions, I said in the podcast that shorting bonds was the most obvious trade going into the start of the year.
Now, I can tell you that when something seems obvious in the investment world, that may just be because you are overlooking something or failing to see another perspective. In this scenario, I knew that couldn’t be the case because bonds had become so expensive relative to stocks, that the risk-reward was a great play in shorting bonds. After all, interest rates were at historical record lows to begin 2022, and bond prices move in the opposite direction of bond interest rates.
When we started the year, the 10-year Treasury was yielding approximately 1.6%:
As you can see, the interest rates on a 10-year Treasury bond have doubled in just the past 9 months alone. This despite the fact the the Federal Reserve, who is the biggest holder of US Treasury bonds in the world, has just only started to sell their bonds just last week. That is why I knew shorting bonds back in January was a no brainer…either interest rates would keep falling from 1.6% making the previously issued bonds more valuable, or the interest rates could shoot up sharply, crushing the prices. But look at what the downside risk was. In actuality, bond yields could only really drop at most by 1.6% (they could in theory go negative but in reality that isn’t a real long-term possibility), but there was no ceiling to how high the interest rates could rise. So in selling short Treasuries in January, there was a small amount of downside risk with a huge amount of upside potential for the trade.
The case remains the same now. Sure, with rates having doubled in the past 9 months, jumping into this trade now does have added downside risk. But the upside reward has increased by much more.
This is the Federal Reserve’s Balance Sheet YTD. During the past 9 months when bond prices were falling and bond yields were rising, the Federal Reserve actually became a bigger purchaser of Treasury bonds. Sure, their balance sheet has come off by some degree since the middle of the year, but dating back to January, they own more bonds now than they did in the beginning of the year. Despite that big volume buying, the bond market has still fallen sharply. Now that the Fed has become a major seller, there is going to be a lot of pressure putting the bond market to the test here.
Here is the YTD decline in the TLT, which is the long-term bond fund I recommended as a short in the beginning of the year. In a year where the 60/40 portfolio is having its worst year since 1936, this would have been a great hedge with some serious outperformance.
Of course, for the broader audience who could care less about the bond market this still has clear implications for the stock market moving forward. The more bond yields rise as bond prices fall, the more higher interest rates will take down stocks further. Going back to the year-outlook podcast, the biggest threat to the stock market this year is a complete bond market crash. If a bond market crash were to actually happen from the Fed’s tightening this fall, that will send interest rates skyrocketing to high enough levels to not only cause a stock market crash, but to also cause a financial crisis and financial panic. That is why I continue to believe that being short the TLT and the ARKK innovation fund is the best way to hedge a black swan event. Not only are both of those funds likely to continue to trade down from here, but if interest rates rise substantially, both of those funds will be in a complete free-fall.
As if this was not bleak enough, let’s now look at the yield curve across the bond market:
An inverted yield curve essentially means that there are bonds with shorter maturity dates paying a higher rate of interest than bonds with longer maturity dates. Generally speaking, if a loan is made for a lesser period of time, that loan should generate less interest because of a few factors, namely the time value of money. If I loaned you money for 1-year and loaned someone else with a similar risk profile money for 30-years, I should receive a much higher rate of interest on the 30-year loan. During a 30-year time span, there is much more inflation risk, interest rate risk, and there is a much greater time value for which I cannot use the money I loaned out productively in other investment assets. When the yield curve becomes inverted, that means that investors are willing to make less short-term loans and favor buying long-term government bonds, showing they have a bleak outlook on the health of the economy and thus want to lower their stock exposure. Since investors are willing to make more long-term loans, their buying of long-term bonds pushes those long-term bond prices up, thus pushing their yields down (bond prices always trade opposite bond interest rates. For example, if I own a bond that pays 3% interest and tomorrow new bonds are issued that pay 3.1% interest, my bond just became less valuable since a trader will only buy it from me at a discount to the bonds yielding 3.1%).
As we look at the current yield curve in the chart above from Bloomberg, we see that a 30-year Treasury currently pays out 3.45% interest, whereas a 2-year Treasury note and a 12-month Treasury bill pay 3.48% and 3.59% respectively. This shows current bond investors are willing to accept a lower rate of interest to make a 30-year loan, foregoing the option to make a 12-month or 2-year loan. That indicates that sentiment on the market is very bad, which has been one of the most accurate signals of recession in financial markets throughout history. Even if you look at the 30-year rate of 3.45% compared to a 3-month t-bill yielding 3% (percentage is annualized, so it pays 0.75% interest in 3 months), investors are willing to accept only a 0.45% higher rate to lock their money up for 30 years as opposed to 3 months. That is one of the worst yield curve inversions we have ever seen. This indicates that not only is this ‘official’ recession actually official contrary to popular belief, but the recession is going to get much more severe moving into the winter months.
Lastly, bond investors at some point will need to start pricing in much longer inflation expectations into bond prices. Meaning, they will need to show a refusal to buy the bonds until interest rates move much closer to the current rate of inflation. If you think about this intuitively, if you are going to buy a 30-year bond yielding 3.45% per year with inflation currently at 8.5%, you would need to expect inflation to be much lower in the future, and in fact you would need to expect some amount of deflation in future decades. That is not going to happen. Not only has deflation ceased to exist since the Gilded Age prior to World War I, but the inflation problem is far from over. So Treasury yields need to rise dramatically from here, which would cause a cascading effect that ripples through all financial markets in general. That is the black swan event waiting to happen.
***By the way, none of this even considers the fact that the US Treasury has become the world’s biggest debtor and is insolvent without the use of the printing press.
In wrapping up, we got an announcement from Unilever’s CEO yesterday that the consumer staple company which owns a big segment of the supermarket space, that they are still seeing very high cost pressures and are going to continue to raise prices for the foreseeable future. Speaking of inflation, we get the release of the August CPI numbers on Tuesday, Sept 13.
The ‘peak inflation’ crowd is still enjoying their lone victory from last month’s 0% increase on inflation. But looking below, in order to find a month where prices actually declined, you would need to go back to April, May & June 2020, which were the depths of the Covid-19 lockdowns, and are clearly outliers in the data.
Prior to those months, we have not seen a decline in the monthly CPI numbers since December 2018. This is even more extraordinary when you think of the CPI in these terms. Despite the fact that we have seen constant percentage increases in prices every month, we continue to add exponential increases to the rate of inflation on top of prior increases in sort of a snowball effect, continuing to burden the middle class as real wages fall and the economy weakens, as signaled to us by the extremely bearish yield curve in the bond market.
Best,
Ryan Garzone
True North Market Research, LLC
truenorthinternationalpartners@gmail.com