$21 THE ‘EVERYTHING TRADE’
Examining a potential peak in bond yields, an event that should reverberate throughout the whole financial system
Peak inflation and peak central bank (CB) tightening pace might be here, as CBs bet that the ‘controlled demolition’ of demand pursued this year will be successful in bringing down inflation over the coming months / years
Peak CB tightening pace / a less urgent Fed, slowing inflation and markets already pricing a somewhat high terminal rate (~5%) may put a lid on bond yields in coming months and revive the ‘Fed pivot’ narrative
Peaking bond yields will create a monumental shift across assets affecting all investors, an event that could reverberate throughout the whole financial system
This post discusses—implicitly or explicitly—investments in bonds (ticker: TLT), FX (USD, EUR, GBP, JPY), gold, commodities and equities.
“A stopped clock is right twice a day”
If there is one (mostly) right call I’m proud about over the past year it’s been consistently calling the direction of US bond yields1. If you’ve been following along, you probably know my view, as summarized by the quote below from a previous note:
Following a four-decade bond bull market fostered by deflationary forces (i.e., the triple D) and the largest QE program the world had ever seen over the pandemic, inflation feels entrenched and sometime in Q4 / early 2023 markets may have to come to terms with the notion of structurally higher inflation for longer.
A scenario where inflation hovers above / around 4% would warrant a protractedly restrictive Fed—in terms of both rates and balance sheet reduction, freeing up countercyclical breathing room. That or a Fed that moves the inflation target / goalposts from the arbitrary 2% in a dispassionate exercise of cold, economic realism.
Read more: $14 BAD AND BETTER
Now, I believe the ‘easy money’ shorting bonds may have already been made. I've recently closed my shorts.
This year, bond yields traded up on the back of higher rates (tighter monetary policy), driven by exceedingly high and resilient inflation. Recent developments suggest, however, we might be witnessing coinciding peaks in inflation and central bank (CB) tightening pace. At the center of which is a bet by CBs that the ‘controlled demolition’ of demand pursued this year will be successful in bringing down inflation over the coming years.
In today’s piece I explain the recent shift seen across CBs in developed markets (DMs), how often in history it foreshadows the vaunted CB “pivot” and how to position for it before it’s here.
The end of (monetary) front-loading
CB rhetoric in past weeks indicates the "end of monetary front-loading”, as officials extensively deployed ‘peak tightening pace' rhetoric2. CB action followed words, with the Bank of Canada (BoC) and Reserve Bank of Australia (RBA) delivering less hikes than estimated:
BoC: Undershot consensus with a 50bps hike (vs. 75bps est.) in the policy rate. Governor Macklem stated they were “getting closer to the end of tightening”.
RBA: Hiked 25bps (vs. 50bps est.), with minutes showing officials highlighting this cycle’s fast hiking pace and long and variable lags.
Bank of England (BoE): Raised 75bps, but hinted that markets were pricing too many hikes. Furthermore, Governor Bailey downplayed the hike stating it “should not lead to higher mortgage rates”.
European Central Bank (ECB): Mainly rhetoric pointing toward meeting-by-meeting data-dependency, while softening their December hike commitment.
Examining how pace, “pauses” and cuts interact, I found a fantastic Goldman Sachs piece explaining how it’s not surprising to see Canada and Australia slow down before other CBs—as they tend to front-run the US—while offering a few important history lessons:
Hiking cycles across DMs average 15 months regardless of inflation level, with 70% exceeding the year.
75% of DM hiking cycles incorporate a pause—3+ consecutive months without hikes—an event more common across Europe than in the US (<40%).
Front-loading of hikes allows longer cycles to still average similar cumulative hikes, but inflationary backdrops amplify the dispersion of outcomes.
CBs often stop hiking around the same time—at / close to the peak in headline and core inflation (YoY)—and anticipate substantial declines in inflation by several months.
In 75% of cycles CBs cut within the first year since the last hike. Cuts generally arrive arrive 5-7 months from that last hike and average 200bps, with Canada and Australia generally leading the cutting cycle timing-wise. Inflationary periods exhibit only slightly larger cuts over the first year, despite averaging double the cumulative hikes.
The ‘Everything Trade’
We shouldn’t mistake peak CB hiking pace with the end of the fight against inflation, as CBs have made it clear that smaller hikes do not entail a lower terminal rate and that they are not thinking about pausing yet. However…
Combining Goldman’s analysis which anticipates the proximity of a pause / cuts, a less urgent Fed3, slowing inflation and markets already pricing a terminal rate of ~5% next year (vs. 3.75% today), we might start seeing a lid on bond yields in coming months and potentially the revival of the infamous "Fed pivot” narrative (i.e., deceleration / 'pause & see' in hiking, lower terminal rate or rate cuts / end of QT soon after terminal).
To be clear, I don’t think we are there. As long as circumstances don’t change much, the signal I’m looking for today is long bonds approaching 5%, as I expect them to overshoot. That first leg of inflation down should offer strong upside (particularly for long bonds), despite my view of higher for longer inflation expressed above.
Peaking bond yields will create a monumental shift across assets affecting all investors, an event that would reverberate throughout the whole financial system.
My favorite of these assets on a risk-adjusted basis and with a long-term view are—with Stanley Druckenmiller’s permission—long duration bonds (ticker: TLT), beleaguered G10 FX (long EUR, GBP, JPY vs. short USD) and gold (possibly on an FX-hedged basis). Equities—particularly longer duration might outperform in the short-run—and other commodities should benefit as well. Thus, the ‘Everything Trade’…
To be clear, the situation is quite fluid and the goal posts might change. That’s what I have Twitter for, where I tend to offer updates…
The point of this piece is really to draw attention to the massive impact the bond sell-off has had on the global economy and all asset classes, USD strength being the highest expression. Things might change soon, though… And I wouldn’t want to miss out on this one.
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Thanks for reading,
You often hear investors say that something was clear, always in hindsight. If you hear this relative to bonds, I can tell you it was anything but.
This ‘peak tightening pace' rhetoric includes:
Highlighting this cycles’ historical pace and “cumulative tightening” (i.e., “we were late but will make up for it via massive front-loading of rate hikes”)
Monetary policy working with “long and variable lags” in the monetary transition mechanism (i.e., today’s economy as a reflection 2020-21 monetary policy, as HonTe’s Gurevich recently argued); Powell made headlines, but… Brainard, Daly, I saw you too
Distinction between core and headline inflation (i.e., CBs pushing on a string, impact on largely exogenous supply forces is virtually zero)
A less urgent Fed lessens the odds of a policy error or in the words of JPM’s Marko Kolanovic, it “reduces the tail risk of a policy mistake”. Colloquially, a better chance of not crashing.