More Ackman: We Aren't in Kansas Anymore

I have written continuously over the last year or so about critical yields for the 10 and 2-year Treasuries such that if they were breached, the probability of them going higher would be quite elevated.?

Looking at the following 10-year Treasury chart, one can see that we broke through the 3.25% threshold in late 2022, making 4.00% the next target. This yield was then broken through in late 2022 and hit a cycle high of 4.22% in October 2022. This was finally breached last month when it hit 4.32%, which takes us to last week when this level was blown through after the Fed meeting and the subsequent Powell press conference, with it reaching 4.50% intraday.

We are now at levels last seen during the Great Financial Crisis in 2008. The next critical level to be watching very carefully is 5.00%.

The Fed has beaten the bond market into submission as investors are now taking Powell at his word that rates will be higher for longer. The obstinate Fed has crushed the value of long-term Treasuries as these next two charts show how 20+ year Treasuries have lost close to 50% from peak to current values.

The unrelenting rise in longer rates has filtered through to mortgage rates, which are now at their highest level since 2000.

The reason that mortgage rates are back to 2000 levels versus 2008 for the 10-year Treasury is because the spread required by investors to own mortgages is at a record high and exceeds the levels reached during the subprime collapse when mortgages were under great duress because of the significant decline in home values and corresponding defaults that were only exceeded by the Great Depression.

Today, we have none of those same concerns about defaults because the quality of loans is much higher than it was during the subprime crisis. The issue today is that investors require higher returns on all risk assets, and the Fed, which was a huge buyer of mortgage-backed securities, is no longer purchasing them because it is reducing its balance sheet, not expanding it. And if it wants to keep contracting its balance sheet at a constant pace, then the market is concerned that it may have to start selling these securities rather than just letting them mature because so few are being pre-paid due to market rates being so much higher than the average coupon in place.?

In addition, if investors believe that mortgage rates will not stay this high for very long, they will assume that borrowers of newly originated loans will have a tremendous incentive to refinance and pre-pay their loans when rates start to fall. Believing that these higher interest rate loans will not be out for much time will result in buyers bidding less than they otherwise would for these mortgage pools because they will have their money returned in a lower interest rate environment.

With so many people locked into mortgage rates far below the current market, there is little incentive to list one’s home because most sellers become buyers. And with rates being where they are, combined with still very elevated home prices, the monthly payment will go up dramatically, particularly for buyers who are looking to purchase larger, more expensive homes. As a result, the housing market is essentially frozen, as this chart of existing home sales shows.

There is no prospect for sales improving materially as the inventory of homes for sale is extremely low. Unless suddenly there are one million forced sellers that materialize overnight, I don’t see how this situation will change, given where mortgage rates are. One potential source of supply could be people that have properties they rent out on Airbnb and VRBO who no longer find running those as short-term rentals as profitable or find it to be too much work. Or maybe they think home prices are at a peak. Whatever the reason, they would represent sellers who do not necessarily need to repurchase homes after they sell and would be a helpful supply source. With all that being said, I’m not holding my breath that this will materialize in large numbers, either.

If you’re in the camp that there is no way the economy and labor market can hold up in the face of the freezing of the housing market and other interest rate-sensitive industries, then you will be comforted by the Conference Board’s U.S. Leading Index showing the inevitability of a recession.

Not since the Great Financial Crisis has the number of months the index has declined been this high, which of course, can be construed as an ominous sign.

The resilience of the economy is aided by a large number of homeowners and corporations benefiting from much lower cost, fixed-rate loans as well as by people who have savings that are now earning passive income that was generating no return in April 2022, when the Fed first started raising rates, to over 5% today. That is a huge raise. The converse of this, of course, is that it’s very painful for credit card borrowers and car buyers who are facing much higher rates. Throw in the resumption of student loan payments and higher gas prices, and there are good reasons to believe that the consumer will start feeling squeezed and begin to cut back on non-discretionary spending.

If things start to slow down and then contract into a recession, will we see short rates go back to 0%? I highly doubt it. Rather than articulating my reasons for believing this, I thought I would turn once again to Bill Ackman, who I referenced a few weeks ago in the context of his bet against the 30-year Treasury bond, which he felt was going to go materially higher in yield. So far, his wager has been right on the money. Last week, he came out with a detailed thread on Twitter explaining why he is still betting against the long bond despite its price having dropped with the material increase in rates.

What follows are his reasons for maintaining his short position. I have formatted his tweet so it is more readable.

I believe that long-term rates, e.g., 30-year rates, will rise further from here. As such, we remain short bonds through the ownership of swaptions.?

The world is a structurally different place than it was.?

• The peace dividend is no more.?
• The long-term deflationary effects of outsourcing production to China are no more.?
• Workers’ and unions’ bargaining power continues to rise. Strikes abound, with more likely to come as successful walkouts achieve substantial wage gains.?
• Energy prices are rising rapidly.?
• Not refilling the SPR was a misguided and dangerous mistake. Our strategic assets should never be used to achieve short-term political objectives. Now, we must refill the SPR while OPEC and Russia cut production.?
• The green energy transition is and will remain incalculably expensive. And higher gas prices will raise inflationary expectations. Just ask your average American. They see the prices at the pump and in the grocery store and don’t believe inflation is moderating.?
• Our national debt is $33 trillion and rising rapidly. There is no sign of fiscal discipline by either party or by the presumptive presidential nominees. Each debt ceiling is an opportunity for our divided government and its most extreme actors to get media attention and for our nation to threaten default. This is not a good way to recruit the many new buyers we need for our bonds.?
• The government sells hundreds of billions of bills, notes, and bonds weekly. Historically, major buyers of our debt, China and other foreign nations, are now selling. And the QT unwind experiment has barely begun. Imagine trying to do a massive IPO where the underwriter, insiders, and short sellers are all selling at once, competing to hit every bid on the way down while the analysts downgrade their ratings to ‘Sell.’?
• Our economy is outperforming expectations. Major infrastructure spending is beginning to contribute to economic growth and the supply of additional debt.?
• Recession predictions have been pushed out beyond 2024.?

The long-term inflation rate is not going back to 2%, no matter how often Chairman Powell reiterates it as his target. It was arbitrarily set at 2% after the financial crisis in a world very different from the one we live in now.?

I bumped into the CIO of one of the world’s largest fixed-income asset managers the other night and asked him how it was going. He looked like he had had a tough day. He greeted me by saying: ‘There are just too many bonds’ — a veritable tsunami of new issuance each week. I asked him what he was going to do about it. He said: ‘The only thing you can do is step away.’?

I have been surprised at how low long-term rates are. I think the best explanation is that bond investors thought of 4% as a high-interest rate because rates hadn’t breached 4% for nearly 15 years. When investors saw the ‘opportunity’ to lock in 4% for 30 years, they grabbed it as a ‘once-in-their-career opportunity,’ but today’s world is very different from the one they have experienced up until now.?

The long-term inflation rate plus the real rate of interest plus term premium suggests that 5.5% is an appropriate yield for 30-year Treasurys. And query whether 0.5% is a sufficient real long-term rate in an increasingly risky world. And the technicals could cause yields to go even higher, particularly in the short term. We saw the beginnings of that today. It wasn’t that long ago that a previous generation thought five percent was a low-interest rate for a long-term, fixed-rate obligation. But I could be wrong. AI might save us.

8:09 PM · Sep 21, 2023·3.5M Views

Bill Ackman

I have been evolving to Ackman’s views over the last year and find all his points compelling. And while I do think the Fed is in a “damn the torpedoes” frame of mind and the odds are increasing that something is going to break that will require the Fed to reverse course, I do not believe, however, we are going to return to 0% short rates.

The Fed is very happy that it has a lot of ammunition to cut rates if the economy weakens, given that it believes that rates are at restrictive levels and does not want to be boxed into a Zero Interest Rate Policy (ZIRP) again.

As Dorothy famously said, “Toto, we aren’t in Kansas anymore.”?