XRT - Time To Buckle Up Campers

2023-10-06 10:37:41 ET

Summary

• 10-Year treasury yields just hit their highest levels since late 2007, just before the Great Financial Crisis.
• The rise in rates is negatively impacting the housing market, consumers, banks as well as being able to service the gigantic and growing national debt.
• Unfortunately, the Federal Reserve is likely to continue to keep interest rates 'higher for longer' until inflation is finally squelched.
• This is likely to trigger a recession, which the current market is not correctly priced for.
• Why it is time for investors to buckle up and hunker down is discussed in the paragraphs below.

The problem with socialism is that you eventually run out of other people's money ."? Margaret Thatcher.

Noted economist Mohamed A. El-Erian noted in an article that was published earlier this week that:

An intense period of rising interest rates, high oil prices and a stronger dollar is pushing the financial market consensus on US economic growth away from the comforting notion of a soft landing '

This is notable given that Mr. El-Erian has been a prominent proponent calling for a " soft landing" now for the better part of a year.

To this I reply, stealing a famous line from the movie " Die Hard ," ' Welcome to the party, Pal! ' My regular readers know I have been dismissing the notion of a soft landing as unlikely for many months now. Most recently, in an article entitled " Why I Am Still Not Buying The 'Soft Landing' Narrative " on September 12th, and previous to that a piece " The 'Soft Landing' Fallacy " in August.

Whatever chances there were around a soft landing have been diminished greatly by the recent surge in interest rates. The yield of the 10-Year Treasury (US10Y) surged past the 4.8% mark earlier this week, touching their highest levels since the fourth quarter of 2007, just before the beginning of the Great Financial Crisis.

The 10-Year Treasury yield has moved up some 100bps from its levels just in June of this year. In April, the yield on the 10-Year Treasury was just 3.3%. This surge in treasury bonds has boosted average 30-Year mortgage rates past the 7.5% mark for the first time since the beginning of this century. This has reduced the housing market largely to all-cash buyers.

This obviously will have a longer-term negative impact on home builders, especially if more inventory eventually goes on the market eroding prices further. This was one reason I initiated some bear put spreads against the SPDR® S&P Homebuilders ETF ( XHB ) this summer. Ancillary industries dependent on the health of the housing market will also face headwinds. One reason home furnishing sales were down by more than 10% on a year-over-year basis in the August retail sales report .

Consumers are also being negatively impacted as rates for auto loans, credit card balances and other forms of personal credit continue to go up as well. The average payment for a new car is now north of $700 a month, as one small example. As I recently noted, " The Consumer Is Toast " and that was before just over 40 million borrowers had their student loan payments unsuspended starting this month after an over 3-year taxpayer financed hiatus.

I initiated long-dated, bear put spreads against retailer Williams-Sonoma, Inc. ( WSM ) last week, as the company should be impacted by both the punk housing market as well as the multiple headwinds facing the consumer. In addition, the company's CEO sold $15 million worth of shares in this high-end retail firm on September 26th. I have had a decent size holding of long-dated, bear put spreads against the SPDR® S&P Retail ETF ( XRT ) for several months now as well.

Higher interest rates also are a challenge for banks at they have to pay more from deposits given short term " risk free" treasuries now yield 5.5%. Nor do they help U.S. banks' bond portfolios that are already stocked with low yielding long duration bonds including long-term treasuries from a few years back. A recent piece estimated rising interest rates boosted these " unrealized losses" by some $140 billion in the third quarter to a whopping $700 billion. These unrealized losses were a key factor in triggering the demise of Silicon Valley and a couple of other significant regional banks earlier this year.

Then we have the impacts to our already scary national debt, which recently went over the $33 trillion mark for the first time. What is truly mortifying is that $2 trillion has been added to the U.S. national debt since the " debt ceiling" was lifted just four months ago.

This is the key reason I have said from the start of Powell's monetary tightening that began early in 2022 that the Federal Reserve will keep to their official two percent inflation target and not lift that target to three percent as many have speculated over the past year and a half. Servicing the national debt on a long-term basis is simply not tenable at current rates. Just north of 30% of the national debt needs to be refinanced over the next 12 months and just over half needs to be rolled over during the next three years. This means the central bank will continue to keep rates " higher for longer" until inflation is squelched, which will then force down rates making debt service more affordable.

Given CPI has drifted up both in July (3.2%) and August (3.7%) after reaching three percent in June, the most likely scenario is the Fed will have to put the economy into a recession, possibly a significant one, to achieve its inflation goal. Equities are simply not priced correctly for that scenario at these trading levels.

As I noted again earlier this week in More Shades Of 2007 , when this realization is eventually made by investors, equities will experience a significant sell-off of at least 20% peak-to-trough in the S&P 500. The main way I have girded my portfolio for this likely pullback is by taking out quite a bit of " portfolio insurance" in the form of long-dated, out-of-the-money bear put spreads against the SPDR® S&P 500 ETF Trust ( SPY ) during June and July, when the S&P VIX Index ( VIX ) was trading in the 12-14 range. I also have 50% of my portfolio in short-term treasuries.

As of the close of the market Thursday, the S&P 500 was down 5.5% from its recent highs on July 31st. So, buckle up campers, the ride is likely to get quite a bit bumpier from here in the months ahead.

A government big enough to give you everything you want is a government big enough to take from you everything you have ."? Gerald R. Ford.

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