The bond market isn’t as wrong about the Fed as some claim

Q1 performance: outsized returns, for those who could overlook volatility

Medium to long-term investors who focus on absolute returns rather than intra-month volatility (so pension funds, insurers, sovereign wealth funds and high net worth individuals) had a respectable Q1. Every major asset class but Commodities and the trade-weighted USD has risen year to date and beaten Cash, with S&P500 +7%, Nasdaq +19%, US Treasuries +2.8%, High Grade Credit +4%, High Yield Credit +2.9% and EM Local +3.75% (chart 1). ETFs related to various forms of innovation and technological disruption (Crypto, blockchain, exponential technology, Cloud, Space) are generally up 10% to 70% (chart 2). For context, quarterly returns this high and this broad are typical of an early-stage cyclical recovery when monetary policy is loose and economic growth above trend. This outcome is quite atypical if, as most economists and analysts expect, the US will be entering recession at some point this year.

Chart 1: All major asset classes but Commodities and trade-weighted USD are up in 2023, and outperformed Cash. Year-to-date returns across major asset classes. Source: YCharts.

Chart 2: Most megatrend assets, or ETFs related to various forms of innovation and technological disruption, are up 10% to 70%. Year-to-date returns across in-related ETFs. Source: YCharts.

What’s gone right in the background

Behind the March implosion of US regional banks and Credit Suisse, three things have been going right for global markets: (1) most key macro data (global PMIs , US labor data) continue to indicate that the global economy is delivering above-trend growth; (2) activity data are still printing stronger than expectations in every region (i.e. economic surprise indices have not rolled over yet); and (3) all major central banks have slowed their pace of rate hikes, for a range of country-specific reasons.?

None of these three factors negates what is seriously wrong with the US economy, like a corporate profits recession that began in Q4 2022; an aggregate banking sector that had tightened lending standards to recession levels even before SVB’s bankruptcy; and a regional banking sector that has become quite dependent on central bank funding to replace its deposit base (chart 4). But for investors who care about timing – and many do – the difference between a recession that begins in H1 2023 and one that begins in H1 2024 has a significant impact on how they position. And there is nothing in the macro data to suggest an H1 start to this very expected recession.

I still favor a late 2023/early 2024 recession start, given the multi-quarter lags between a corporate profits recession and payroll loss plus GDP recession; and the lags between tighter lending standards and a contraction in actual lending. The articles Yes to disinflation, Yes to profits recession, but Not Yet to GDP recession (Jan 13) and The US regional bank implosion, the Fed’s regulatory tightening, and the coming credit crunch ?(Mar 15) provide more detail on these lag structures. ?

Chart 3: Regional banks still dependent on Fed borrowing, as evidenced by switch from discount window to Bank Term Funding Program. Borrowing in USD billions from Fed’s discount window and the Bank Term Funding Program Source: Federal Reserve.

How mispriced is the bond market

I suspect that many investors have lost sight of macro data, because banking sector stress, rates repricing and central bank pivots have been so dramatic. But if we burrow into the bond market and its read-across to other markets, there’s a big debate worth settling around whether yield have moved so much that their normalization will prove disruptive in coming months. First, the numbers. The US money market now expects about 60bp of easing by end-2023 and 170bp cumulatively by end-2024. The Fed , which has been caught clay-footed by the regional bank debacle, projects no easing this year, 75bp of cuts by end 2024 and 200bp of cuts cumulatively by end-2025. Note that the market’s implied Fed path would leave US policy rates below ECB and Bank of England rates next year. That cross-over is important for anyone still wondering whether a very expensive US dollar will rally in trade-weighted terms through the next recession. It won’t, given a large US current account deficit and a rates crossover versus Europe.

The rates repricing has been so large and so sudden that is has triggered broad commentary about an overreaction. An overreaction, by extension, is harbinger of a market reversal at some point that will unwind the market gains from Q1 and thus expose investors to losses on Fixed Income, non-USD currencies and (mostly) Growth Equities (Tech, Communication Services) and the innovation asset ETFs. My view on this allegedly major mispricing is more nuanced. I think that:

(1) the bond market is mispriced for 2023, because the Fed won't cut before the economy begins contracting, but not for 2024, when payrolls losses will become obvious;

(2) delaying rate cuts by several months won’t boost 10Y yields by much entering a late 2023/early 2024 recession, given the demand for duration in such an environment;

(3) the last hurrah in Equities can persist in Q2 2023 due to strong growth, and will be undermined in H2 due to payrolls losses rather than higher 10Y yields. Forward P/Es have not fallen to recession levels for the S&P500 overall, nor for any S&P sector or other broad benchmark (like the Russell 2000). Across Credit, only 30Y MBS spreads have reached recession levels. Neither High Grade nor High Yield have widened to recession levels, though High Grade offers decent total return prospects due to its high interest rate duration.

(4) Growth/Tech Equities plus innovation assets will underperform in H2 not due to higher rates but due to Big Tech’s earning exposure to an economy moving into recession. The earnings boost from the coming artificial intelligence boom is more a 2024 than a 2023 phenomenon; and

(5) The trade-weighted USD will fall rather than rise during the next recession, contrary to its performance during the last three recessions. This reversal was always likely due to the ECB’s hiking path, China’s reopening and BoJ policy. The outcome seems more likely given unilateral US banking sector stress.

The bond market is rarely this wrong

Here's some historical context for thinking about whether the bond market is ever too far off when anticipating the start of a major easing cycle. Chart 4 plots eight instances (including the current one) when the bond market anticipated the start of a major Fed easing cycle before a recession had begun, as signalled by US 2Y yield being at least 50bp below the Fed funds rate at that time. In only two of these episodes (1979 and 1980) was money market curve inversion premature because the Fed, in fact, delivered further rate hikes rather than rate cuts in the year after 2Y yields traded well below cash rates. Of course, 1979 and 1980 were special years in that core PCE inflation rose almost continuously during that period, despite the record level of Fed funds and despite the 1980 recession.

Chart 4: The bond market isn’t always correct in pricing as much easing as it does currently, but the mispricing were all 1970s/80s phenomenon due to high and rising inflation. Fed funds rate versus spread between US 2Y and Fed funds. Blue bars indicate US recessions. Source: Federal Reserve.

The contrast between those two episodes and the current backdrop is notable. It is true that core PCE inflation at 4.6% is above the Fed’s target for 2023 (3.6%) and 2024 (2.6%). But price gains are moving in the intended direction, unlike in 1979 and 1980. And if indeed the combination of profits recession and bank credit/regulatory tightening deliver a GDP recession that begins in late 2023/early 2024, disinflation is highly likely to accelerate (core inflation has tended to slow to sub-2% during recessions over the past 30 years). Even the Fed is forecasting rate cuts of 75bp in 2024, though without forecasting an actual recession. If the economy is contracting next year due to the cumulative stresses many have been tracking for the past year, I doubt the bond market will look as mispriced as some suggest it is now. There is more disruption and volatility ahead after the Q2 last hurrah fades, but the disorder will originate in the economy rather than the bond market.

Recent articles on global macro strategy

What happens to Private Markets after Public Equity & Credit deflate (Mar 24, 2023)

Why a precise definition of a banking crisis matters for the economy and markets ?(Mar 20, 2023)

Five numbers suggesting that investors are still banking on containment, with no imminent recession ?(Mar 17, 2023)

The US regional bank implosion, the Fed’s regulatory tightening, and the coming credit crunch ?(Mar 15, 2023)

There’s a problem in the money market, even if US 10Y rates stay below 4% (Feb 15, 2023)

Powell’s hopelessly hawkish message, and calibrating a market overshoot (Feb 2, 2023)

How Fed policy erases any distinction between cyclical and secular investing (Jan 25, 2023)

Why today's Bank of Japan decision isn't sticking to USD/JPY (Jan 18, 2023)

Yes to disinflation, Yes to profits recession, but Not Yet to GDP recession (Jan 13, 2023)

Market implications of the weakest US Speaker of the House in a century (Jan 8, 2023)

What the last 100 years has to do with the next 12 months: Risk premia, mean reversion and 2023 return forecasts (Jan 3, 2023)

Further evidence that 10Y bond yields have peaked, and what that path means for other markets (Nov 11, 2022)

What to do with the UK’s cheap markets (Oct 18, 2022)

Bonds are worth owning, even after yesterday’s strong US?CPI report (Oct 14, 2022)

Can?Emerging Markets ever be more than a tactical asset class? (Oct 10, 2022)