Risk Never Sleeps

April 21, 2024

Good Sunday morning, everyone. The Fed enters their blackout period retaining total optionality. Geopolitical risks are front and center but should take a back seat to the 159 S/P companies scheduled to report earnings this week. Earnings matter in this window of pricing out more Fed liquidity.

Our thought was "bumpy" heading out in 2024 and it's been playing out on the rate side. Lately, higher volatility in US Treasuries spilling over to risk assets which is what you'd expect. Some charts and perspective almost four months into 2024.

We are no fan of more spending but the passage of aid likely this week is not a choice for the United States. Domestic concerns and issues will be sorted out one way or another with the election later this year. But if we don't embark on accountability for the spending in this window of time, regardless of who gets elected this year, problems will surface in the coming years.?

Markets have been operating with blinders on throughout the fist quarter of 2024. Between heightened geopolitical tension, coupled with Federal reserve sobriety, dynamics have been shifting. And as the pendulum swings hard the other way, catch-up in some markets, it still pays to remain open-minded, not gripping and ripping toward one narrative too hard.?

Let's Take a Look:?

Well, markets are finally reacting. Last month on the Fox Business Network we were very convicted: one more round of poor inflation data and markets were vulnerable. This is a process. Ran into a friend this morning who manages stock money. He said do you remember in 2022 it was all going down every day. Now, up until recently and the risk-free US Treasury rate excluded, was going up each and everyday. Chart #1 and #2 below: the Bloomberg Financial Conditions Index. Rolling over. The SPX correcting.?

It's been nothing short of an amazing shift in narrative. We remember sitting in our morning meeting in December of 2023. All markets, US Treasuries included, in full- fledged bull mode. A room full of eyes looking at me with a look of, "you've been promoting a notion of higher for longer, what say you now"? "Consolidation. We will need to consolidate off these extreme levels". And we have. To date, and despite a consistent downsizing of Fed expectations, it's been the risk-free rate re-pricing. But higher for longer generally ends poorly.?

Periods of consolidation are healthy. But free lunches are far and few between. And this "pocket of time" proving to be no different. How can it be that market-based financial conditions, loose almost as 2021, GDP well above trend, deficits running to the tune of $1.5 to 2 trillion, militarization requiring more funds, an unemployment rate under 4%, and inflation just gliding back to target. Or close. Chair Powell was optimistic in late 2023. The month over month inflation numbers were very encouraging for most of 2023. The mere talk of rate cuts sending markets to the moon. Chart #3: The BofA Ice Move Index. Spiking and rightly so within this window of time. But not at extreme levels seen over the past few years.

We grew up managing risk under former Fed Chairman Alan Greenspan. There is so much opining now. Of late, what has interested us: 1) Balance Sheet dynamics 2) Perhaps a notion the Fed is not restrictive enough. As we look toward the May 1st decision this FOMC committee, Chair Powell included, the message has been clear. Ultimately, there was never a legitimate reason to be discussing rate cuts. But because the Fed normally responds to aggregate demand issues with the intent of outcomes, the notion of this being primarily a "supply side" dynamic and new mantra emerging from the pandemic, opened the door to potentially being preemptive.?

Chart #4- 2-year UST since 2000. Inflection point as the Fed remains on hold, volatility always a process at turning points, and flirting with another move toward the Fed's intimated terminal rate.?

We've been fortunate to live, trade, succeed, AND get bumped off the trail with this chart. Lol, true. It's a brilliant reflection of time and policy in our view for those interested. Of course, you could go back further. It encapsulates, agree with the policy or not, the period of ZIRP following the GFC where we had 1) Abundant workers (unfortunately) 2) Abundant Homes 3) No jobs 4) 5.32% Fed Funds rate. Focus on growth and labor force participation.? ? We see 6-7% in this chart. Amazing. And 4%, also. It's all real and alive. UST 2-year. Back then it was a "Fed on hold, consolidation lower in yield". We don't want that same outcome this time around for a sharp move lower. The bar for this Federal Reserve to raise rate higher from here is very high. It's not improbable. And keeping inflation expectations in check requires the tough talk we are hearing: "Not baseline but if we need to do more we will". There is a tremendous amount of balance sheet stress under the hood. Chair Powell's posture has remained and will continue to do so next week: 1) Nagging inflation, we are steady for as long as warranted. 2) Room below if needed (we agree).??

And this week the highlight: PCE inflation. Chart #5 below.

The good news is we've come down a ton. The challenge is the Fed getting its arms around the new pathway forward. As the chart highlights, patterns over time and then with relation to appropriate policy.

Chart #6: Core CPI versus PCE.

Big spread diverging. Housing clearly in focus (big weighting CPI).? Chair Powell has been sitting on a rates trading desk in 2024. Things move quick. Think PCE inflation is going to be okay. We've spent a tremendous of time over the course of the last few years writing about supply side challenges. Coming out of 2006/2007/2008, the focus was on the demand side of the economy. In 2020 is was supply. Like then, it will take time and linger to normalize, and this is what the Fed is conceding of late.? We've been bearish US Treasuries. The data could bail this recent move out. Could. But unlike October of 2023, Chair Powell and the FOMC are pricing easy policy out. Questioning whether restrictive enough. The dynamics around "higher for longer" are different from late last year. Markets are holding onto a lower pathway moving forward albeit at a slower pace and higher terminal rate.

Chart #7: SOFR December 2025. Almost 50-basis points higher than the Fed's most recent DOT plot.?

Challenge now is we are still in the adjustment phase (inflation). Jay Powell had no choice but to fold. No Fed Chair wants to keep rates higher than they must. Higher rates are not an evil. But we have a system geared and designed for lower rates structurally. We need to form new patterns that inspire conviction toward 1) A good pattern of inflation. Doesn't need to be 2%. 2-3% is fine. If we reaccelerate, 3-4% rates likely go much higher. And the Fed has no choice given the uncertainty of the world we now live in to interject that possibility into the narrative.?

On the Ground

1Q GDP, PCE, and US Treasury supply 2/5/7-years. Good test for markets at these levels, whether 2-year UST or SOFR December 2025. Open-minded to a little consolidation the other way lower in yield. All focus on earnings and corporate supply this week.?

Have a great day and week ahead!?