September 22 2023

Most Telegraphed Recession

The trick may be talking so much about recession that it never happens. The reality is rather that people tend to forget it would happen.

QT and rising rates were also much telegraphed in 2021 and yet it surprised everyone in early 2022, starting with banks themselves with the weaker ones collapsing into default in Mar23. Bond holders were flabbergasted too, thrown into a positive correlation with equity, suffering through a -12% performance for US aggregate bonds (AGG US) from early 2022 to Aug23. Equities returns were mixed too, with large cap tech outperforming the lot, as we know it.

I see some parallels in the current crying-wolf about an upcoming recession. We’ve been talking about it for so long that it may now falls on deaf ears. And I understand why that is. The messages sent by the economy are cryptic. Take this week’s data on multi-family for Aug23. On one hand, the number of units slightly dropped for the first time in 30 months, hardly causing reason for stress. On the other hand, the drop in unit starts is a jaw-dropping 43%, which corresponds to movements seen in past recessions.

What gives? Don’t look at the Fed for answers. Its actions remain “data-dependent”, which means “after-the-fact”. What we know for certain is we’re now in the longest stretch of an inverted yield curve. The near-term forward spread (NTFS), a Fed’s favorite, which measures the difference between the expected 3-month interest rate 18 months from now and the current 3-month yield, has been inverted since Nov22. This is usually indicative of a recession – “Past performance is no guarantee of future outcome”.

This inverted yield curve is the only thing we know, and this is the issue.

Cash at 5%+ is the investment product with arguably the best risk-return currently. From Bill Gross to Ray Dalio, everybody vouches for short-dated US treasuries. No surprise that Money Market funds engulfed $5.6tn, 24% higher than in Jun22.

Hedge funds love the carry trade too. Buy 2yr treasuries at 5.15%, pledge them to borrow 10yr treasuries at 4.5%, and short them. This spits out a nice spread of 65bps, or more depending on Loan-To-Value.

This shows a very opportunistic love for short-dated US treasuries, and a net disaffection for the long-end of the curve. All the more than, investors factor in higher-for-longer rates.

Liquidity dries up for long-dated treasuries, as fewer fixed income managers are ready to punt on a rate’s inflexion. Banks stay away too, impaired by their higher cost of capital since Dodd Franck.

So far this hasn’t prevented the US Government to ramp up its net issuance of treasuries, let alone the Fed to run down its balance sheet, which decreased by $700bn over the past 6 months. The spread between off-the-run and on-the-run US treasuries, which indicates the liquidity premium paid by the US Treasury for funding, has been stable too.

This makes for a potentially nice scissor effect though, with a situation very sensitive to sudden changes in policy. Looks like we’re coming closer everyday to an inflexion point in the bond market.

“Bonds are back” they say, but those exposed to the long-end will continue to suffer negative marked-to-market, and only yields could bring some solace to for those investment portfolios for the moment. I would turn a wary eye on pension funds if I were you.

Stay safe out there !

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360 Advisory LLC is a Boston-based RIA managing investments