The Unlikely Overlap

Opening Outlooks and Tricky Trilemmas?

We have long discussed the multitude of crosscurrents which define volatility aplenty and how to capitalize on opportunities in Fixed Income markets from Emerging Markets to high-quality long end corporate bonds. While Fixed Income saw an initial rally on the back of a series of cooler than expected CPI prints, resilient growth and renewed central bank hawkishness generated a variety of headwinds for core Fixed Income holdings. Here is the interview with BNN Bloomberg again – for anyone interested: ?

Peculiar Projection Probabilities?

As we ponder the trilemma of sticky inflation, hike until things break and a rally in North American Bonds, we must ask: ?

Can these three major forecasts indeed coexist, or is this a masterclass in the art of economic illusion? ?

Many observers, spanning from Wall Street to Main Street, now express unwavering conviction that the predictions previously set forth for the upcoming 6-12 months will not only occur, but all three will materialize simultaneously. This forecast, while initially intriguing, suggests astute foresight, effectively straddling the fence of prediction. The three predicted developments involve key indicators which permeate through macroeconomic, monetary, and market aspects, influencing the underlying health of our economy. Each factor is not isolated but part of an interconnected web, triggering a chain reaction with significant implications. Under usual circumstances, the materialization of one event increases the likelihood of the next prediction coming to pass. Thus, the idea of these three concurrent events is not just a mere prediction, but rather a well-calculated anticipation based on the intrinsic interconnectedness of these components.?

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But all three? ?

What would such a market environment look like, in which each piece of the projection puzzle perfectly pieces together? What underlying conditions would have brought us to this point, and how would such an outlook impact the bond market??

The answer lies not in an echo chamber of opinions, but in a deconstruction of each piece of this puzzling triad. For simplicity, we can consider each of the probabilities both independently and collectively, as shown in the Venn Diagram below.

In this case, the red circle reflects a persistent Federal Reserve, the blue circle reflects significant total return for North American bonds, and the yellow/green circle reflects sticky/structural inflation. One monetary variable, one financial and one economic – all connected to each other – but not completely dependent. The overlaps of each of these circles reflect the joint case of one or more events occurring concurrently.?

We will fill in each section of this diagram as we move forward, starting with a return to base-case first principles...?

Sorting through the Singularities?

Circle 1 (Red): The Fed Hikes Until Something Breaks?

In this narrative, we envisage an unwavering Fed, tightening the screws of interest rates until the economy staggers. The expectation here is that the Fed will stop hiking only when inflation reaches a tolerable level for a sustained period. The effect of the current 500bp rate hiking cycle, coupled with any subsequent hikes, has yet to be fully absorbed, and in this case the economy suffers the brunt of the Fed’s hike-heavy war on inflation. The robust economic data, an end to the base-effect decline of CPI reduction, the Fed's firm stance on reining in inflation, and the market's clear disapproval of increasing the Fed’s inflation target all fuel this prediction. In this scenario, while inflation eventually moderates, growth falters and the economy will soon enter a hard landing scenario followed by the resulting recessionary environment. A good amount of forward pricing has come out recently – yet the market is still suggesting ~100 bps cuts from the peak (Nov 2023) in 2024. ?

Circle 2 (Blue): Sticky, Structural Inflation ?

Initially stemming from a worldwide pandemic leading to a complete shutdown and rapid restart of economies globally, this belief posits an inflation landscape permanently altered, with future inflation rates newly anchored above traditional levels. Persistently hovering at 2.7% (more art than science) or above would require the “naming” of a new regime, a sticky, structural inflation era significantly beyond the Fed's present-day target of 2%. While the market for inflation (whether ILBs or Inflation Swaps), as well as market forecasters continue to expect a swift return to 2%, this prediction brings in a new age in structural inflation beyond acute headwinds. In this world, the favourable tailwind of considerably lower base effects (+ the collapse of energy prices) will be behind us after the June print and the month-over-month pressure will likely begin to trend to the upside again.?

Circle 3 (Yellow/Green) A Rally in Long North American Duration?

Post-yield correction, with recessionary shadows lengthening, longer-term North American bonds appear increasingly alluring. Having been bolstered by the Fed’s ambitious hiking cycle, long-end bonds pose an attractive investment opportunity for investors seeking reliable income and/or price appreciation to wait out the cyclical storm. This viewpoint rests on the assumption that we are nearing the end of the Fed's tightening cycle, inflation is poised for a considerable downtrend, and resilient growth will soon begin to falter. Significant allocations have been made to US fixed Income – particularly on the back of being at the end of the hiking cycle, high historical yields (real and nominal), and the looming recession; this scenario sees them rewarded handsomely for their proactivity.?

Isolated, each prediction has merit, but their simultaneous manifestation is paradoxical. ?

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Puzzling Projections and Poorly Predicated Pairings?

In a vacuum, probabilities can be thought of collectively, so if you flip a coin twice your odds of two heads is 50% x 50% = 25%. Simple enough. One head and one tail? 50% x 50% x 2 combinations (Head-Tail / Tail-Head). Not too bad. But what happens when you only flip the coin once, but want to land on both heads and tails? This is simply not feasible (unless you are the Hulett Brothers), given the mutual exclusivity of the events – the coin only lands on one side. We can extend this concept to our economic example, in which the present state of the US economy is signaling soft / hard / no landing scenario. We introduced these concepts in an earlier piece What’s Next? and most of the analysis holds true today.?

The core message is that the economy cannot sustain itself in multiple camps. Hard and soft data eventually realign, lagging indicators follow leading indicators, and reality catches up to projections. An outstanding red-hot labour market seldom aligns with a collapse in ISM Manufacturing data. A resilient economy, paired with collapsing leading indicators is incompatible and eventual convergence is inevitable. Which side is likely to win out and how does the direction of these indicators impact our perceived projection probabilities??

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Intersection 1 (Purple): A Relentless Fed and a Rally in North American Duration?

An intriguing pairing, symptomatic of the classic hard landing scenario. A decline in economic activity spurred by the overaggressive Fed's tightening could create a conducive environment for a bond rally. However, this combination also implies simultaneous tapering of growth and inflation expectations, when in reality one likely precedes the other, resulting in considerable volatility. Current uninspiring credit spreads and below-average implied volatility seem to cast a shadow of skepticism on this combination, as markets continue to price optimistic outcomes despite the underlying risks.?

Intersection 2 (Turquoise): Persistent Inflation and an Even-More Persistent Fed??

Next, we examine a puzzling combination: an economy struggling, yet stubbornly enduring inflation? This scenario seems perplexing, particularly when we dissect the structural aspects of the anticipated inflation surge. Persistent inflation could potentially jeopardize the Fed's objectives, yet subsequent rate hikes are unlikely to make a dent in this entrenched, or structural, inflation. Realistically, maintaining a continuous Fed Funds Rate of 5.5% to counteract a 2.5% inflation rate over a prolonged period seems improbable. Considering the dual negative impact on demand, stemming from a steep economic downturn induced by the Fed and increased interest rates, envisioning this scenario as a result of demand-side factors seems unlikely. Such circumstances might only arise under exceptional conditions, such as a major oil price surge or significant supply chain disruptions. Nevertheless, current market indicators do not convincingly support this narrative.

Intersection 3 (Orange): Stubborn Inflation and a North American Bond Rally?

Finally, a further challenging duet. A structural increase in inflation often heralds higher rates, thereby threatening the prospects of a bond rally. This scenario might hold water if inflation settles in the 2.5-2.7% 'grey zone' for some time and a significant economic slowdown occurs. While TIPS may show signs of life in the case of a slow growth, sticky inflation combination, it is hard to imagine a broad-based rally in a world in which the inflation intervention is not firmly put to bed. Yet, the market consensus expects a return to the 2% inflation target, and any wavering from this post is likely to send ripples through multi-asset markets.?

Triple Intersection: A Tireless Fed, Structural Inflation, and a Rally in North American Duration?

Bringing all three scenarios together – the Fed's relentless hikes, persistent high inflation, and a rally in long-term bonds. Perhaps the most devastating, this scenario paints a picture of a significant economic collapse paired with tenacious inflation. In this scenario, real yields of Treasury Inflation-Protected Securities (TIPS), currently trading at 1.7%, could plummet to 0% or even turn negative again. This potential outcome hints at a tumultuous environment, presenting a formidable challenge for central bankers worldwide. Would the Fed cut rates if the economy crumbles but inflation remains obstinate? How enduring would the bond rally be? Would it merely be another flash in the pan, similar to what we witnessed after the regional banking crisis earlier this year??

The simultaneous occurrence of all three scenarios seems a slim-to-none chance, as it would require a near-perfect storm of economic events. Their overlapping assumptions appear not as a narrow landing strip but rather a collision course. As we venture further into 2023, we must remain agile, continually question the prevailing narratives, and adapt our strategies accordingly. In the dance of market forces, our objective is not to predict each step and twirl but to navigate successfully through them.?

Everchanging Markets, and Evolving Macroeconomics?

The second half of 2023 promises a dynamic interplay of market forces. In these conditions, our core strength lies not in adopting rigid assumptions but in maintaining flexibility and vigilance. Challenging conditions create credible captains; however, many ships never escape the storm. These times reflect the critical nature of active management as investors may be?poised to pivot with the ever-changing market currents. ?

In essence, our industry is about navigating complexity, not evading it. We are tasked with?navigating the nuanced crosscurrents?from?economic forces,?rather than?distilling it down to a simplistic script. Our goal is not to create a stir, but to create wealth for our clients. Our financial success lies in the intersection of preparedness and opportunity. While the fixed income market of 2023 is shrouded in optimistic uncertainty, the guiding principles of prudent investing remain as clear as ever.?

Recall the words of the great economist John Maynard Keynes:?

"When the facts change, I change my mind." ?

In the same vein, we must remain dynamic in our response to the ever-evolving realities of the market. As we tread the path of the latter half of 2023, it's crucial to remember this timeless wisdom: don't bet on the improbable. Banking on all three occurrences - a Fed push until it breaks, sticky inflation, and a rallying bond market - happening at once stretches the boundaries of credibility. Perhaps more relatable than Keynes, the same sentiment has been echoed by?Mark Twain: ?

"It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so."?

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Congratulations on making it to the end, this time for real ;). I hope that you found this piece enticing and educational...??

Today’s economy offers a myriad of narratives, in which investors of all opinions and positions face both headwinds and tailwinds. As we transition to the next stage of monetary policy, we seek to gain clarity on the future of economic data. As market participants juggle a series of economic outcomes and the resulting market environment, we continue to see opportunities on the horizon.?

I hope that this piece provides yourselves and your clients with insight and confidence towards the unfolding opportunities across fixed income assets.?

If you have any thoughts, comments, or questions - please reach out.??

All the best,??

Konstantin?