Delirium Ends with a Splitting Headache

“The market keeps trying to front-run these rate cuts, only to be disappointed,” said Kathy Jones, chief fixed income strategist at Charles Schwab. “In a different cycle, when inflation hadn’t spiked so much, I think the Fed would have been cutting rates already. This is a very different cycle. There is going to be much more caution on their part.”

That is a lesson that both stock and bond markets have not been able to wrap their heads around no matter how often they lose that bet. Today provided another small example: Stocks had been rising once again on hopes that the Fed is done. They rose more as two Fedheads spoke dovishly, causing more bets on a Fed pivot in early 2024. Then another Fedhead spoke today and sent a shiver down the market’s spine so the so the market’s rosy dawn ended by going to bed with a headache.

The latest market rumble over the prospect of rate cuts came Tuesday morning, when Fed Governor Christopher Waller said he could envision easing policy if inflation data cooperates over the next three to five months.

The markets took that as a given …

Never mind that fellow Governor Michelle Bowman, just minutes later, said she still expects rate hikes will be necessary. The market instead chose to hear Waller more clearly

All the usual talk got trotted out about how large and quick the rate cuts would have to be until today when Fedhead Tom Barkin added his mild comments to Bowman’s, and sent a chill over the market’s warm and cozy hopes:

Richmond Federal Reserve President Thomas Barkin said Wednesday that policymakers need to retain the option of raising interest rates if inflation doesn’t show enough progress coming down.

Markets largely expect the Fed has stopped raising rates and will start cutting in 2024. But Barkin said he’s not ready to commit to a particular policy path with so much uncertainty in the air.

As I’ve argued, the market believes things about inflation that the Fed simply does not. The market chooses to believe what it wants even contrary to the actual evidence.

I guess the bigger point is, there’s no precision that anyone can point to at exactly what the level of rates that exactly handles inflation and exactly the way you want to handle it. So you’re constantly trying to adjust on the fly as you learn more about the economy.

The irrationality of the market is particularly notable in how it chooses to overlook in its pricing the only thing that could possibly get the Fed to cut rates even if inflation stops — a recession:

It could be a risky bet if inflation doesn’t cooperate.

“The Fed doesn’t want to take its foot off the brake too early. I don’t see them cutting just to reach some theoretical neutral rate,” said Chris Marangi, co-chief investment officer for value at Gabelli Funds. “We expect some economic softness next year, so that won’t be a surprise. But a significant cut in rates needs to be preceded by significant economic weakness, and that’s not discounted in stock prices today….”

The idea, then, that the Fed would go on a cutting spree next year would almost have to be accompanied by pronounced economic weakness.

That seems self-evident to me. The Fed isn’t going to cut rates just to cut them after a fight like this. A rational market would have to first price in everything that typically hits stocks during a recession before it even thinks of pricing in a Fed rate cut. The rate cut typically comes after the recession begins. The market thinks it can ignore that because it will be such a soft recession we’ll barely feel it. That is clearly irrational on its own face value: If the recession is that soft, it will certainly not alarm the Fed into risking a resurgence in inflation by cutting rates immediately after a battle like the recent one!

GDP stuff

So, the market didn’t even land up higher on a day when GDP for the third quarter got revised even higher to a whopping 5.2% annualized growth. Stocks that rose strongly upon the GDP revision sunk to nil upon hearing Barkin give merely realistic talk.

Again, the usual lies about inflation got paraded by CNBC:

As growth has held strong, inflation is still above the Fed’s 2% annual target, though it has shown a consistent progression lower in recent months.

If we’re going to talk about what “progression” happened to inflation in recent months, shouldn’t we be actually willing to look at what month-on-month inflation is doing, rather than longer-term year-on-year? Did CNBC not notice, as reported more than once here, that three of the last four months went up and the last one held flat? Is that a “consistent progression lower in recent months?” I’d call it a consistent progression upward, and I would expect year-on-year inflation to start to follow after a few months of upward monthly inflation. I would expect year-on-year to turn up more slowly because it includes months when the Fed was still making significant gains in its fight against inflation.

Common sense.

Barkin says he is …

“skeptical” about inflation and thinks it’s going to be “stubborn” ahead.

Of course it is if monthly inflation keeps going up like it has been. The market is picking and choosing what it wants to hear, but its position is so weak that even Barkin’s mild comments were enough to offset the soft-landing narrative that could have been fed by the revised increase in third-quarter GDP growth, which should effectively make the landing even softer … except, of course, that real GDP was based off inflation that was falsified by a massive healthcare adjustment all year. Even if you accept those inflation numbers as real, GDP is clearly coming down quickly.

“Altogether, the research, data, survey results, and input from business contacts tell me that tighter monetary policy and tighter financial conditions more broadly are biting harder into economic activity,” Bostic wrote. “At the same time, I don’t think we’ve seen the full effects of restrictive policy, another reason I think we’ll see further cooling of economic activity and inflation.”

MarketWatch (via Morning Star) published the following comment about the hot upward revision to third-quarter GDP growth:

Looking ahead: "Evidence of economic strength over the summer could mislead some to assume the economy is on a strong trajectory - it is not," said chief economist Gregory Daco of EY Parthenon.

"Nothing [in this report] was sufficient to change the economy's overall trajectory nor the expectation that growth will slow significantly in the fourth quarter," said chief economist Joshua Shapiro of MFR Inc.

If growth is coming down quickly, it’s coming down hard. We’re not on a gentle glide path here.

More bond doom

Two articles in the news today reinforced yesterday’s Daily Doom editorial about the terrible Treasury auctions and the flight of investors from US bonds. As I wrote in that article, November was beautiful, but “Try to Remember the Kind of November We Had in 2018.”

An article in Zero Hedge describes today how November stood a fierce bear market in bonds on its head, yielding us the best month in bonds since December 2008. Just try to remember what happened in December of 2018 after that splendid November promised a prefect ramp up into a Santa Claus rally.

To think it was not that long ago that Treasuries were one of the year's worst performing assets and only managed to erase their 2023 losses two week ago….

As a reminder, exiting the catastrophic 2022, most investors anticipated that 2023 would be the “year of the bond,” but were instead hit by waves of turmoil as a "resilient" US economy (largely thanks to Biden's department of goalseeked seasonal adjustments) prompted the Fed to extend its steepest tightening cycle for another year.

Fast forward just a few days to today, when the cross-asset rally (and USD tumble) has accelerated substantially, and thanks to several dovish comments from the likes of Fed governor Waller, US Treasuries are now climbing at the fastest monthly pace since 2008. At the same time, in a repeat of the infamous QE trade, the MSCI All Country World Index of stocks has gained 8.7% so far this month, its most since November 2020!…

The last month that saw a stronger rally than the current one was December 2008 when the Fed cut rates to zero, pledged to boost lending to the financial sector following the collapse of Lehman Brothers Holdings and started QE.

But it’s all floating on ether, Folks, because underneath all of that rising action for bond prices (falling yields) in the resale market of Treasuries we have new Treasury auctions that are falling apart like a stinking corpse.

For some, markets are getting ahead of themselves in pricing such magnitude of cuts. Justin Onuekwusi, chief investment officer at St. James’s Place, said the ECB has been very hawkish on inflation and will likely start easing just toward the end of next year.

Not just ahead of themselves but totally out of synch with the new trend in new Treasury auctions according to Semaphor:

Nobody wants U.S. Treasury bonds.

Once a symbol of America’s economic might and accepted as a global coin of the realm, they have fallen badly out of favor, with serious consequences for taxpayers, investors, and financial markets.

Elementary economic forces — too much supply and not enough demand — have collided to create the worst stretch for U.S. government bonds since the Civil War. The government keeps borrowing to cover its budget deficits, while once-reliable buyers of that debt, both at home and abroad, have pulled back.

In the battle between markets of existing Treasuries and new issuances, which one do you think will win? The one based on ephemeral hopes created by talking Fedheads or the one based on longterm rising supply and declining demand for new government bonds? Hmm. Huffing hopium or banking on actual supply and demand? Which will it be? The realities of rising government deficits extending beyond the visible horizon, the worst divided congress in history that is uncapable of solving this problem or the hope that the Fed will forget all about inflation in a couple of months and start drastically cutting interest rates because it fears a mildly soft recession? Which will it be?

Investors [in direct Treasury auctions] are demanding the steepest yields since 2007. Auctions of fresh bonds that were once routine are now going terribly. And bond portfolios are getting absolutely hammered. The longest-dated Treasury bonds are in a bear market worse than the dot-com bust and almost as bad as 2008.

Well, that was until November, but which is the anomaly — the bear market in fresh bonds in the face of foreign investors fleeing US debt and soaring US deficits or the soaring market where old bonds sailed into the sun like Icarus in spite of all that was happing in Treasury auctions?

China, Russia and Japan all have their own currencies to prop up, which they are doing by selling US bonds to buy their own bonds; and two of them have no interest in US bonds anymore. These three were the biggest financiers of US debt, outside the Fed, which also says it will stay out of the bond-buying game even if and when it lowers interest rates. So, supply and demand, or hope? Which will you bank on?

Beware: Delirium ends with a splitting headache.