Why Bonds Now Belong

Jim Cramer of CNBC has a saying: “There’s always a bull market somewhere. My job is to help you find it!” Rule #5 of Bob Farrell’s famous 10 Rules for Investing states: “The Public Buys the Most at the Top and the Least at the Bottom.” His Rule #9 says: “When All the Experts Agree, Something Else is Going to Happen.”

Bond Market Decline in Perspective

Alpinemacro

There is no doubt about it – bonds are the most hated asset class on Wall Street. That’s why all the above axioms apply. Bonds are in a 50-year bear market as seen from the downdraft in bond prices in the chart above. Prior to that sell-off, Wall Street had been pointing to the paltry yields bonds were returning to their holders. TINA (There Is No Alternative) was the resulting acronym. We wonder, after the recent run-up in bond yields, if we will be hearing about a new acronym: TIA!

The questions that need to be answered about bonds are: 1) Why such a rapid and deep bond sell-off; and 2) What’s the likelihood that it can go further?

The Sell-Off

As we’ve chronicled in this blog since the Fed’s March meeting when the bond sell-off began in earnest, the bond market has compressed the Fed’s contemplated set of rate hikes over an 18-month period (the “dot-plot”) into a matter of weeks, in effect, immediately tightening financial conditions to that terminal 18-month view. Never mind that the “dot-plot” has a paltry 37% correlation with the resulting reality (because the Fed is “data dependent,” it can change its intentions as the incoming data dictate).

In past Fed tightening cycles, “forward guidance” as the dot-plots are now called, did not exist (forward guidance began in 2012). In prior tightening cycles, no one knew what the Fed was going to do until they did it. Since the recent Fed meeting, as inflation has escalated, so has the hawkish rhetoric from Fed governors. That, too, never occurred in past tightening cycles. And, with each of those hawkish utterances, bonds yields have ratcheted higher (prices lower). It isn’t any wonder that everyone hates bonds!

Can the Sell-Off Go Further?

Of course it can go further. We don’t know tomorrow’s or next week’s prices or yields. But we do know some economics that tell us that over the next several months, the economy will slow and inflation will moderate. When this occurs bond yield will fall and the Fed, being “data dependent” will have moderated its hawkishness.

Currently, the Fed has insisted that it will engineer a “soft landing” for the economy. We note that its track record on this score is not poor, it is miserable. And, this time, it has embarked on its tightening campaign at a point in the business cycle where, in the past, it has typically halted tightening actions. We also note that the Fed can’t cure the cause of the current inflation (supply side issues). The only thing it tools can do is suppress demand.

We do believe that much of the hawkish rhetoric coming out of the Fed is posturing (for their credibility), as the public is quite upset over the rapid rise in prices and is looking to government for a cure. (Unfortunately, the government is partly to blame – but that is the subject of another blog.) The tools that the Fed has to “cure” the inflation (reduced demand and likely recession) won’t be much liked either.

Remember, markets have already priced-in the end state of an extremely hawkish Fed. For bond prices to deteriorate from their current levels would take incoming data showing rapidly rising economic growth and inflation accelerating to even greater heights, neither of which are indicated as we chronicle below. Because the Fed says their future actions are “data dependent,” if the incoming data show sluggishness and inflation begins to wane, the Fed will not carry out the hawkish plan already priced into the markets. And, if that happens, markets will re-price to the new, less hawkish, scenario. That would mean rising bond prices and falling yields.

The rest of this blog discusses our outlook for moderating inflation and slowing economic growth outlooks.

What Incoming Data Say About Inflation

  • Headline CPI inflation was 8.5% in March, and it looks to us like that will be the peak. Much of March’s spike was due to the price spike of gasoline (18% in March). While still extremely high, prices at the pump have retreated over the past couple of weeks which will lower inflation in April (look at the right-hand side of the oil spot price chart). In addition, there will be a “base effect,” as the higher denominator in April 2021 (inflation spiked to 4.2% from 2.6% back then) will act as a suppressant on the resulting inflation reading.

WTI Cushing Crude oil Spot Px Index

Universal Value Advisors

  • “Core” CPI (ex-food and energy) rose only +0.3% M/M in March (+3.7% annual rate (AR)). And if we exclude rents from that “core,” the rise was only +0.2% M/M (+2.4% AR), down from +0.5% in February and +0.8% in January. March rents, themselves, rose +0.4% M/M (+4.9% AR), down from +0.6% in February. Readers of this blog know that in prior blogs we discussed the record level of new multi-family units now coming to market and that we were correct in our prediction that these would have a cooling effect on rental inflation.
  • Core Goods CPI fell in March -0.4% (you read that right, prices fell!), the steepest drop since April 2020 (remember the early months of the pandemic?). The Atlanta Fed’s “core flexible” CPI also fell (-0.6%) in March. The Cleveland Fed’s inflation expectations index shows that, one year out, inflation expectations are 3.39%, but are under 3% for every year thereafter. For example, 2-years: 2.66%; 5-years: 2.25%; 10-years: 2.19%.
  • Used car prices, which led inflation on the upside, are now coming down (albeit, slowly). The Manheim Used Car Price Index fell -3.4% M/M in March and was down -2.2% in February (flat in January). Along these lines, the latest Industrial Production Index rose in March (+0.9%) mainly due to surging auto production as the semiconductor shortages have eased. Thus, upward pressure on new car prices will begin to subside, especially since the consumer sentiment surveys say intentions to purchase autos are still in the tank.
  • We see similar price trends in the commodity markets: The table shows the changes in prices from the nearby peaks:

Commodity Percentage Change

Universal Value Advisors

  • Similarly, the cost of shipping a 40-foot box container from Shanghai to Los Angeles has fallen -21% from its nearby peak. And moving, freight and storage prices have fallen for three months in a row (-0.4% M/M in March).
  • For those watching the money supply, the “monetary base” which was up on a Y/Y basis as much as 30% a year ago (April 2021) is now up a mere 0.4% Y/Y, i.e., essentially no change from last April.

The incoming data says inflation has peaked. This notion doesn’t yet appear to be in the market for bond prices which still appear to be marching to the tune of the hawkish Fed drummer. A lower inflation number for April, due out the second week of May, is likely to have a positive impact on bond prices (lower yields) barring any additional unforeseen economic shocks.

Incoming U.S. Economic Data

  • While wages have been rising, real incomes are falling. The chart (Real Average Weekly Earnings) shows that the current fall in real incomes is worse than that suffered during the Great Recession (see chart).
  • We’ve shown the University of Michigan Consumer Sentiment chart of record low consumer intentions to purchase big ticket items (homes, autos, appliances) in several of our past blogs. The chart of how households view their finances has continued in a steep negative trend since early 2021 (see chart).
  • The latest Harris poll says 84% of American consumers plan to cut back on spending!
  • As we’ve pointed out in prior blogs, mortgage applications are rapidly falling, and home sales (both new and existing) have turned lower due to rising mortgage rates.

US Real Average Weekly Earnings

Universal Value Advisor

Household View of Finances: “Much” or “Somewhat” Better Off

Haver Analytics, Rosenberg Research

  • Not only are households (consumers), which make up 70% of GDP, downbeat, but businesses, especially small ones, are too (chart).

Fiscal policy contributions to quarterly gross domestic product growth

Michael Lebowitz, Hutchins Center on Fiscal and Monetary Policy

  • The latest report from the Department of Labor (Thursday, April 14) shows a large increase in Initial Unemployment Claims. The not seasonally adjusted data increased by +223K the week of April 9. This is not a seasonal issue as the seasonally adjusted data also showed a large +185K jump.
  • The unemployment rate in the U.S. (3.6%) appears to be sending the Fed a false signal. If the Labor Force Participation Rate (the percentage of working-age population to the total population) was at its pre-pandemic level, the unemployment rate would be 5.1%. We do expect the unemployment rate to rise as the economy slows.

Incoming Data: The Rest of the World

  • The Russian/Ukrainian war has likely already thrown Europe into recession. We note that the European Central Bank (ECB) has been dragging its feet when it comes to ending its version of Quantitative Easing (QE) and raising interest rates.
  • Then there is China. Its central bank (PBOC) is actually easing. Why? Because China, too, appears to be in recession. Remember, its real estate sector has imploded. The chart shows that the manufacturing sector is in contraction (lower than 50). But, what is really unusual, and shows what a bind that economy is in, is that the services sector is also in contraction (chart).

China PMI

Alpine Macro 2022

  • The reason for the contraction in both the manufacturing and services sectors is China’s “Zero-Covid Policy.” The following chart shows the dramatic progression of lockdowns in March and April. In early March (left side of the chart), most of the economy was green. By mid-April (right-hand side), 65% of the economy had some form of lockdown or restrictions. {Note: This could become a caveat for our moderating inflation scenario, depending on the impact of such lockdowns on the supply chain.}

Most of China’s major cities have imposed some Covid restrictions

Gavekal

When both Europe and China are in recession, and with emerging data so sluggish in the U.S., it appears that a worldwide recession is all but assured.

And Then There is QT

We haven’t even mentioned Quantitative Tightening (QT) in this blog. Just as a reminder, the last time the Fed removed liquidity via QT in 2018, it was at half the pace it has currently indicated it would do beginning in May. Remember how the equity markets swooned (and Powell pivoted)? Currently, equity markets are well off their peaks. And we worry about market reaction once QT begins. In a flat or falling equity market, consumers, now wary about their financial well-being, lower spending and save more.

Final Thoughts and Conclusions

Putting it all together, we have markets pricing-in the Fed’s end of tightening cycle rates at the beginning of that very tightening cycle. It appears to us that we have a Fed that has increased their hawkish posturing as the Y/Y inflation data has deteriorated (i.e. political posturing).

On the economic front, the data shows that we are late in the business cycle. This Fed has been way behind the curve. Usually, at this point in the cycle, they have been tightening for some time, and as the economy weakens, they start to scale back the tightening, or even ease. The incoming data looks weak as inflation has taken its toll on incomes and is in the process of doing so on consumption.

The good news is that it looks like March will have been inflation’s peak (lower gasoline prices and base effects). Perhaps that will reduce the Fed’s hawkishness. If it doesn’t, then a rising unemployment rate surely will. We do expect a 50-basis point rate hike at the Fed’s May meeting, but that is already baked into bond market pricing. We also think the Fed will let the equity markets go lower (i.e., no Fed “Put”). As noted earlier, a falling equity market plays poorly with consumer psyches, especially among the middle class.

If we have read the tea leaves correctly, as the economic scene unfolds, the economy will weaken, inflation will begin to moderate, the Fed will become less hawkish, and, in an era of “forward guidance,” the markets will reprice bonds to lower yields (higher prices). While equity investors are not likely to have a great or even good year (QT), it appears that fixed-income investors will.

(Joshua Barone contributed to this blog.)