QQQ - Yield Disagreement

Summary

• Yield and risk continue to disagree with the latter taking the cue to rise from the former. I believe this is unsustainable and will resolve itself in one-of-three ways.
• In scenario 1 of stagflation, EM shorts would lose as would gold and commodity short-positions. Tankers would outperform on global transportation-demand. Long US-banks and short-UST positions would still do well.
• In scenario 2 of severe recession in nominal growth - short oil production and price, short high-yield corporate debt, short emerging markets all outperform.
• In scenario 2 - short gold and long tankers (storage/contango demand) would also likely still do well. Long US banks and short US bonds would not perform.
• In scenario 3, which I view as mostly likely - the US economy proves resilient while the CPI comes down achieving a soft landing for the domestic US economy. Though in this case - negative spillovers to emerging markets from higher real-UST-yields and a stronger USD would cause commodity and metals prices to weaken and lead to a general risk-off environment and lower asset prices. Much of the portfolio would outperform in this environment.

This article was originally published 10/25/22 under Tri-Macro Research.

I completely disagree with the combination of downward pressure in yields with elevated oil prices and US equity markets. The bond longs are trying to say the US economy is going into deep recession from Fed hikes. OK - that would be a nominal growth recession (where both inflation and growth come down) rather than an inflationary induced recession which are caused by declines in real inflation-adjusted economic growth from a CPI outpacing nominal growth, also known as stagflation.

I argue stagflation would be risk-on as it lifts the burden on emerging markets by preventing a strong dollar, commodity markets would rally, global demand would rebound, and Fed policy would be deemed ineffective or irrelevant. These effects would clear a lot of market worries.

The only way yields fall (scenario 2 above in bullets) is if a recession becomes so deep and severe, the Fed must U-turn on policy - which we clearly are not even close to that point either regarding the labor market, aggregate demand in the economy, nominal growth or the CPI.

If the second type is the case, that is a nominal growth recession, then why is oil not down? Why are equities not down? And if it is a first case, stagflationary recession (negative real-GDP growth due to high CPI, see scenario 1 in bullet summary above) and weak dollar, risk-on environment- then yields would go even higher than in a more nominal-type growth recession (lower CPI and growth, scenario 2) or positive real growth scenario (where nominal growth outpaces inflation - see scenario 3).

This is because yields have not kept pace with the CPI so there is a greater potential magnitude of a rise in yields due to long-run inflation expectations becoming de-anchored to the upside than if Fed policy is effective in bringing the CPI down - though I feel yields rise in both of those cases.

The Fed can affect real-growth (inflation adjusted GDP growth) higher by bringing the very high CPI down even if there is a slight hit to nominal growth and thereby still be able to achieve positive US GDP growth which is the third soft-landing type scenario.

To reiterate - if declines in US nominal growth and job losses (which we are not seeing) is going to force the Fed to turn dovish, oil and equities would be selling off harder on days like today. Equities and risk-on such as oil taking their cue to rise from low yields is a speculative bubble that was reinforced by an era of low inflation and easy monetary policy. Both have changed.

A stagflationary recession would be more bullish for risk than a severe drop in nominal growth and corporate earnings. In the case of persistent inflation leading to negative real GDP growth, yields would be rising (not falling such as today) on the inflation expectation component of yields catching up with the CPI.

Not only would yields be rising in a stagflationary environment but at a quicker rate than that of the monetary policy induced rise in the real-component of long-term bond yields or interest rates. This is because as I mentioned yields have not tracked the CPI meaning the bond market is pricing in effectiveness of Fed policy and inflation coming down. Long-run (5Y+ inflation expectations) are anchored around 2.4% while the CPI is around 8%. 10Y TIPS yields have surged and we are much more seeing a contribution into long term yields from Federal Reserve policy than rising inflation expectations.

I have noticed oil and equities are rising on days where UST yields decline which is again untenable. This makes me lean toward scenario 3. If we were going into a risk-on inflationary outcome, UST yields, oil prices and equities would all be rising and positively correlate. Instead, we are either seeing lower yields subsidizing risk or higher yields undermining it.

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