Now, let me set the scene. I’m 30,000 feet up (in the first half of this article), typing this on my tablet thanks to Qatar Airways’ shockingly good Wi-Fi (seriously, why is airplane Wi-Fi better than half the cafés I’ve been to?) and then I remind my self that I explained why in our Space Economy primer.

I’m sipping an relaxing gin&tonic, watching the deepseek drama from above monetizing some hedges over the Mt.Blanc, and honestly, all I’m thinking is: stay hedged, hodl cash, and wait for something truly worth buying (yesterday should be seen as a black friday deal and I used 1/4 of my cash on the plane).

Being away from my usual setup has its perks. Instead of iterating code and crunching data, I’m just stepping back and thinking about narratives and how a simple Ctrl+H can wreck the party. Case in point: AI-adjacent (and some ai-hyped-energy-names) equities. Investors went all-in on the AI-is-gonna-change-everything hype, and now? Yeah, they’re rethinking those capex and opex numbers, but the good news is that AI can only get more epic (and commoditized?) from here.

If you haven’t already, check out our prior Tech Equities Odyssey note—it’s a little cheat sheet for understanding why these stocks are acting like they’ve got whiplash.

The Rise of Fiscal Dominance

As the Federal Open Market Committee (FOMC) gathers to deliberate on its policy path, it does so in an environment where the dynamics of economic policy are gradually shifting toward fiscal dominance. Traditionally, the Federal Reserve’s control over funding markets and liquidity conditions—evident in its recent efforts to combat post-COVID inflation—has placed it on equal footing with the Treasury in shaping financial stability. Yet rising debt service costs and structurally large deficits are slowly positioning the Treasury, rather than the Federal Reserve, at the center of liquidity flows. This gradual shift is altering how financial conditions evolve, with profound implications for markets—particularly tech and growth equities. Maybe American exceptionalism relies on exceptionally fiscally out-spending the rest of the world.

This FOMC meeting is widely expected to mark a pause in the interest-rate cutting cycle. But the real spotlight should be on what the Treasury does in the coming months. As the costs of financing federal debt continue to climb, the Treasury’s decisions on cash management and debt issuance will play an outsized role in shaping liquidity, leaving the Fed with diminished influence over financial markets.

The Mechanics of Fiscal Dominance

Fiscal dominance arises when fiscal priorities—namely deficit financing—dictate systemic liquidity flows, reducing the effectiveness of monetary policy as the primary driver of economic conditions. At the heart of this shift lies the Treasury General Account (TGA), the Treasury’s operational account at the Federal Reserve. Traditionally a passive tool for cash management, the TGA has become a powerful lever for liquidity, reshaping the financial system’s inner workings.

This is not the first time fiscal dominance has shaped economic outcomes. The post-World War II period offers an early example, when the Federal Reserve was compelled to maintain low interest rates to accommodate the government’s massive borrowing needs. This era saw inflationary pressures emerge as the central bank’s ability to act independently was constrained by the sheer scale of fiscal requirements. Similarly, the inflationary surge of the 1970s highlights how expansionary fiscal policy, combined with monetary policy accommodations, can lead to destabilizing price pressures when fiscal priorities take precedence.

Fast-forward to today, and the dynamics are familiar. During the recent debt ceiling standoff, the Treasury was forced to draw down its TGA balance, injecting liquidity into the banking system. Every dollar spent from the TGA reappears as reserves in commercial banks, temporarily easing liquidity pressures created by the Federal Reserve’s ongoing Quantitative Tightening (QT) program. For risk assets, including the tech-heavy Nasdaq, these liquidity injections have provided a tailwind, mitigating the tightening pressures from QT and rising interest rates. Now that the debt ceiling is back in place, we already see the TGA draining with the Treasury spending down its cash without offsetting it with debt issuance to maintain cash balance, we therefore have a continued broadly bid on equities and will continue to see passive flows.

But history shows that these periods of liquidity relief are fleeting. Latin America provides a cautionary tale, with nations like Argentina demonstrating the long-term risks of fiscal dominance. Repeated cycles of government debt monetization have led to chronic inflation, currency devaluation, and economic instability. Similarly, during the debt ceiling disputes in 2021 and 2023, prolonged delays in the U.S. drained the TGA entirely, flooding the financial system with liquidity.

Once those disputes were resolved, the Treasury rapidly rebuilt its cash buffer, issuing substantial volumes of debt that pulled liquidity out of the banking system. These liquidity whiplashes left markets vulnerable, especially as the Federal Reserve’s Reverse Repo Program (RRP)—a key liquidity buffer—absorbed excess cash. However, with RRP balances now standing at just $118 billion, down from over $2.5 trillion at their peak, this buffer is nearly exhausted, leaving little room to cushion future liquidity shocks.

A Fragile Balance

The interplay between fiscal and monetary policy has reached a critical juncture. The Treasury’s liquidity injections, driven by its need to manage the TGA, have temporarily masked the tightening effects of QT, propping up asset prices and delaying the full impact of monetary policy. But as the TGA drawdown ends and the Treasury pivots to replenishment, this dynamic will reverse, intensifying the liquidity drain from QT and creating new challenges for markets.

Compounding these challenges is the structural decline in reserve balances. As reserves approach critical thresholds—historically around 8% of GDP—the risk of funding volatility rises. This echoes the 2019 repo crisis, when a sudden spike in funding rates forced the Federal Reserve to intervene to restore stability. Today’s near-depletion of the RRP further limits the system’s ability to absorb shocks, leaving markets exposed to a potential liquidity crunch.

Adding to this delicate balance is the significant foreign ownership of U.S. equities. A substantial portion of U.S. stock market capitalization is held by international investors, who have historically sought the relative safety and growth potential of U.S. assets. However, as global macroeconomic conditions evolve, these foreign owners could look to repatriate capital back to their home markets if higher returns or improved stability elsewhere arise. Such repatriation flows would exacerbate liquidity pressures in the U.S. market, creating additional headwinds for sectors already strained by tighter domestic monetary conditions.

These patterns of fiscal dominance carry echoes of the "unpleasant monetarist arithmetic" described by economists like Sargent and Wallace. When fiscal deficits grow large enough, they force monetary policy to accommodate fiscal needs, limiting the central bank's ability to control inflation. The lessons of the 1970s remain relevant here, as persistent inflation eroded economic stability and exposed the risks of insufficient coordination between fiscal and monetary authorities.

For tech and growth equities, the risks are clear. The sector’s sensitivity to liquidity conditions makes it particularly vulnerable to the tightening cycle ahead. While fiscal dominance has temporarily insulated markets from the Fed’s tightening campaign, this insulation is rapidly eroding. The confluence of QT, TGA replenishment, and long-term debt issuance represents a powerful tightening force that could reshape the investment landscape in 2025.

The Liquidity-Market Nexus

Tech and growth equities remain highly sensitive to liquidity conditions, thriving on the availability of cheap capital as their valuations hinge on future earnings expectations. When liquidity is abundant, capital flows sustain speculative, growth-oriented investments. In the current environment, where liquidity remains supportive, risk assets continue to find a bid, even in the face of sector-specific adjustments like the recent AI capex growth forecast revision driven by DeepSeek.

The selloff in AI capex/opex growth equities was clearly driven by adjustments to growth forecasts, not a broader re-rating of equity multiples. This distinction is crucial: the downward pressure was localized to a subset of equities directly tied to AI capex themes, while broader market indices like the Dow saw no such impact. The Dow’s positive close during the same period illustrates its lack of correlation to this theme, as it remains largely insulated from the specific drivers affecting AI-linked sectors. Liquidity-driven flows into equities, particularly through passive vehicles, continue to bolster indices broadly, neutralizing isolated headwinds from sector-specific recalibrations.

Importantly, the neutral stance in crypto flows throughout this selloff further underscores that this was not a systemic liquidity event but a targeted adjustment within a niche of high-growth equities. Passive flows, which indiscriminately allocate to indices like the S&P 500 or Nasdaq, have helped stabilize markets broadly, reinforcing the resilience of risk assets in the face of localized volatility.

However, this liquidity-driven stability depends on the current fiscal and monetary backdrop. As the Treasury continues its TGA drawdown, injecting liquidity into the banking system, and passive flows sustain market demand, the immediate outlook for risk assets remains supported. Yet, this dynamic is inherently cyclical. Once the Treasury pivots to replenishing the TGA and issuing longer-term debt, the resulting liquidity drain will amplify the tightening pressures of Quantitative Tightening (QT).

The pivot toward longer-duration debt issuance under Treasury Secretary Scott Bessent could introduce new pressures. While aimed at reducing rollover risk, this strategy will increase the supply of long-term bonds, requiring higher yields to attract buyers like pension funds and insurers. This steepening of the yield curve could weigh on growth-sensitive equities, particularly those trading on elevated valuations.

For now, liquidity flows continue to support risk assets broadly, masking the impact of sector-specific corrections like those in AI capex equities; I am a buyer of this pullback with a focus on Nat-Gas names and Software. But the delicate interplay between fiscal-driven liquidity injections, Treasury issuance strategies, and macroeconomic tightening remains pivotal. Investors should monitor these dynamics closely, as any shift in liquidity conditions could significantly alter the trajectory for equities, particularly in sectors with stretched valuations.

Like ancient mariners lured by the sirens’ song, investors in tech equities are drawn to the shimmering promises of growth—mesmerized by valuation mirages that gleam under the golden light of liquidity. Yet, as Narcissus once gazed into his own reflection, transfixed, so too do many forget that the pond dries up when liquidity wanes, leaving only cracked earth where dreams of infinite returns once flourished.

Drop a <3 if you found this interesting!

Cheers!

The Treasury market is bracing for its New Year’s detox—necessary, overdue, and mildly uncomfortable. After years of Janet Yellen’s fondness for short-term borrowing, 2025 brings a maturity wall with billions of dollars in Treasury bills set to roll off the books. Enter Scott Bessent, the long-end enthusiast and vocal critic of short-term overindulgence, ready to take the reins with a strategy that swaps short-lived fixes for more durable excesses. As the Treasury shifts gears to refinance on the long end, the supply surge looms like a treacherous mountain pass, testing the resolve of investors as they shoulder the weight of a long and uncertain journey. Meanwhile, the short end might be the last homely house amid the chaos—offering solace, if only the Fed resists the temptation to tinker with its inflation expectations yet again (our book should favor this outcome).

Our end-of-year tactical rates trade, structured to capitalize on the final FOMC meeting of 2024, proved highly rewarding amid the inflation tinkering we had anticipated since the first Big-Mac rates cut. Looking ahead, I expect inflation forecasts will require frequent and substantial revisions throughout 2025, aligning with our increased inflation volatility thesis. Revisiting this trade could provide valuable insights for the year ahead, as similar tactical opportunities are likely to arise.

Fed’s Holiday Playbook

Let’s now focus on what the Treasury is about to do and some trade implications.

Tails and Covers

Our first hint at investor malcontent emerged during the Treasury’s final TIPS auction of 2024—a $22 billion reopening of 5-year Treasury Inflation-Protected Securities (CUSIP 91282CLV1). Demand faltered, marked by a 7-basis-point tail, a striking divergence from the auction's expected yield of 2.05% that ultimately settled at 2.121%. The bid-to-cover ratio dropped to 2.1, its lowest since 2019, reflecting investor hesitation amid uncertainty about inflation and the allure of nominal Treasuries yielding 4.44%. Yet, as often happens in troubled times, those who acted found an unexpected reward: a real yield exceeding inflation by 2.121% and a price below par. It was a chance, perhaps fleeting, to secure a measure of stability while others waited, reluctant to tread paths where the way seemed uncertain.

The Fellowship of the Bills: A Quest for Cheap Financing

Under Janet Yellen’s tenure as Treasury Secretary, the Treasury leaned heavily on short-term Treasury bills (T-bills) to fund deficits—a strategy born of historically low interest rates and the urgent fiscal demands of pandemic-era stimulus. “The priority is to finance at the lowest cost to taxpayers,” Yellen asserted, highlighting the agility and efficiency of short-term borrowing. She added that “short-term securities provide critical flexibility in managing the nation’s financing needs,” particularly during periods of elevated fiscal churn.

The playbook was elegantly simple: issue an avalanche of short-duration debt to tap into a financial system brimming with reserves parked in the Fed’s Reverse Repo Program (RRP). At its peak, the RRP ballooned to $2.5 trillion, serving as a reservoir for excess liquidity during quantitative easing (QE) and anchoring short-term rates. By deploying T-bills, Yellen effectively redirected cash from money market funds (MMFs) out of the RRP and into government debt, unleashing a flood of liquidity into financial markets and the real economy. This maneuver counterbalanced the Fed’s quantitative tightening (QT) efforts. Remarkably, in 2023, T-bills financed over 100% of the fiscal deficit—a feat rarely seen outside recessions in the past quarter-century.

A Reverse Repo Story

The result was a powerful liquidity injection that fueled stock market momentum and kept a lid on bond yields. Think of it as liquidity crack for markets—cheap, fast, and dangerously effective. Yet, this heavy reliance on short-term debt planted the seeds for a looming refinancing headache in 2025. With a significant chunk of this short-term debt coming due, the Treasury now faces the unenviable task of steering through a precarious funding landscape, where flexibility may be in short supply, and costs are anything but.

The Shadow Beyond the Wall: A Looming Battle for Fiscal Stability

Scott Bessent, the incoming Treasury Secretary, has taken a critical stance on the heavy reliance on short-term debt. While Janet Yellen’s approach delivered flexibility and kept borrowing costs low in the near term, Bessent sees it as a precarious balancing act, exposing the Treasury to refinancing risks and the mercurial nature of short-term markets. He has likened the $3.6 trillion maturity wall in 2025 to a structural fault line in the nation’s fiscal stability—an ominous feature that demands immediate reinforcement. “Issuing at the long end reduces rollover risk and provides a more stable funding base,” Bessent remarked, outlining a decisive shift toward longer-term debt issuance as the linchpin of his strategy.

The RRP has operated as a liquidity sponge, soaking up excess reserves in the financial system, particularly during the Federal Reserve’s quantitative easing (QE) era. Money market funds (MMFs) flocked to the RRP, attracted by its risk-free nature and yields directly tied to the Fed’s policy rate. At its peak, the RRP held a staggering $2.5 trillion in 2021-2022, reflecting a surplus of reserves and the lackluster appeal of alternative short-term investments like T-bills, which often offered lower yields during this period. By enabling MMFs to park cash securely, the RRP indirectly bolstered the Treasury’s capacity to issue short-term T-bills for deficit financing, all while leaving bank reserves largely untouched in a system awash with liquidity.

As quantitative tightening (QT) gained momentum and Treasury issuance ramped up, short-end yields, including T-bills, began to outpace the RRP’s rate. This sparked a migration of funds from the RRP back into T-bills, as MMFs pursued higher returns in the Treasury market. The RRP balance has since dwindled to $250 billion, reflecting this reallocation. While this shift has reduced liquidity held at the Fed, its broader impact has been more about redistributing liquidity across financial markets. Notably, this reallocation has mitigated some of QT’s tightening effects by enhancing short-term market liquidity. However, the overall financial conditions remain shaped by a complex interplay of factors, including reserve levels, Treasury General Account (TGA) operations, and the pace of Treasury issuance.

As the Treasury shifts from refinancing maturing T-bills to issuing longer-term bonds, market flows will adapt. Long-term bonds, less attractive to MMFs due to their duration risk, will rely on demand from pension funds, insurers, and mutual funds, which draw liquidity from sources like bank deposits, corporate cash reserves, or portfolio reallocations. This transition reduces MMF participation and channels liquidity from shorter-duration instruments into longer-term securities, tightening short-term liquidity availability. In a market already grappling with elevated yields and constrained reserves, this reallocation could intensify pressures, reflecting a shift in liquidity distribution rather than its overall mechanics.

Front End of the Curve

The interaction of short-term yields, liquidity conditions, and capital flows will undergo significant shifts as the Treasury refinances maturing T-bills with longer-term bonds. The expected reduction in T-bill issuance is set to create scarcity, driving yields lower as robust demand from money market funds (MMFs) intensifies. While the Reverse Repo Program (RRP) theoretically remains an alternative, its yield disadvantage compared to T-bills, particularly in an environment of steepening, discourages a reallocation of MMF cash. T-bills also offer critical operational advantages, such as superior liquidity, tradability, and portfolio management flexibility, making them indispensable tools. As anticipated Fed rate cuts further erode the competitiveness of the RRP relative to T-bill yields, MMFs will prioritize T-bills, exacerbating the scarcity and placing continued downward pressure on short-term yields.

Over the past two years, the decline in RRP balances has mitigated the impact of QT on overall system liquidity, acting as a critical buffer that absorbed excess liquidity and prevented acute disruptions in short-term funding markets. However, with RRP balances now nearing depletion and the Treasury’s General Account (TGA) also reducing, this cushion is rapidly diminishing. These reductions have temporarily slowed the decline in bank reserves, but once the RRP is depleted and the TGA drawdown concludes, reserves will have no buffer left, leaving them with no direction but downward. Historically, reserves approaching critical thresholds, such as 8% of GDP in 2018, have amplified funding market volatility. While reserves currently remain above these levels, the depletion of the RRP and the end of TGA reductions increase the risk of reserves falling to stress-inducing levels. This evolving dynamic will amplify competition for scarce high-quality assets like T-bills, further shaping the equilibrium in short-term funding markets.

The importance of this administration’s progress on bank deregulation also becomes evident here. By easing regulatory constraints, banks have retained greater flexibility in navigating tighter liquidity conditions, delaying the onset of systemic funding stress. However, as reduced T-bill supply intersects with tighter reserve balances, short-term rate volatility becomes increasingly likely. In this environment, competition for scarce high-quality assets like T-bills will intensify, with the evolving dynamics of the RRP, TGA, and reserve levels shaping the short-term funding landscape.

Trade: Long ZT with half year 20delta calls which serves as a hedge for monetary tightness affecting corporates, namely main-street small businesses. (35bps NAV)

The Tail End of the Curve

The tail end of the yield curve—anchored by longer-dated Treasuries such as 10- and 30-year bonds—will bear the weight of the Treasury’s pivot from short-term refinancing to longer-term issuance. The increased supply of long-term bonds will place upward pressure on yields, driven by the fundamental mechanics of supply and demand (sometimes Econ 101 really is enough). Investors tasked with absorbing this surge in long-duration debt will demand higher term premiums to compensate for heightened interest rate risk, inflation volatility, and fiscal uncertainties tied to elevated debt-to-GDP ratios.

Compounding the challenge is the current scarcity of natural buyers for long-term Treasuries at prevailing yield levels. Unlike T-bills, which enjoy robust demand from money market funds and liquidity-driven investors, long-term bonds depend on participation from pension funds, insurers, and mutual funds. These buyers, while steady, are less agile in responding to abrupt issuance shifts, especially when yields fail to adequately reflect inflation risks and increased supply. To clear the market, the Treasury will need to offer more attractive yields, effectively steepening the yield curve and introducing additional cost pressures for servicing the federal debt.

The Treasury’s management of the General Account (TGA) becomes a critical lever in moderating these pressures. A significant TGA drawdown could inject temporary liquidity, easing upward pressure on yields. However, the scale of maturing debt and ongoing fiscal requirements severely limit the Treasury’s ability to rely on this strategy for long-term stabilization. Without a marked reduction in issuance, the trajectory for long-term yields remains biased upward, driven by structural supply-demand imbalances, tightening liquidity, and investor unease over fiscal sustainability.

Trade: Continue the short on ZB, this serves as a hedge for equity multiples contracting from liquidity reducing

Reverberating to Risk Assets

Quantitative tightening (QT) adds another layer of complexity to the long-end dynamics. As the Federal Reserve continues reducing its balance sheet, the absence of a major institutional buyer for longer-term Treasuries shifts the burden onto private markets. This exacerbates liquidity pressures, particularly as declining reserve balances constrain market participants' capacity to absorb the additional supply. Unlike the RRP, which primarily parks excess reserves, the absorption of long-term bonds actively drains liquidity from the financial system, requiring investors to reallocate funds from other assets or increase leverage to finance purchases.

Until now, the decline in RRP balances has largely offset the impact of QT on total liquidity, preventing significant disruptions in financial markets. However, with RRP balances nearing depletion, future QT will directly reduce bank reserves, tightening liquidity more acutely. This shift increases the risk of funding stress, particularly as reserves trend toward critical thresholds where interbank markets become more sensitive to shocks. While the Fed has introduced tools like the bank reserve monitor to track stress, their ability to react preemptively remains uncertain, raising the stakes for risk assets.

The resulting upward pressure on long-term yields will ripple through the broader economy and financial markets. Elevated yields raise borrowing costs for corporations and households, curbing investment and consumer spending. For equity markets, higher discount rates disproportionately affect growth-oriented sectors, where valuations hinge on future earnings expectations. Credit markets face similar challenges as wider credit spreads emerge, reflecting heightened risk aversion and competition from increasingly attractive Treasury securities.

Trade: Mix of March/April 20 delta puts on ES and NQ (85bps NAV total). After such a green day, well worth to load up on cheap hedges. Currently working with a 30% cash position while waiting for an outsized opportunity. This is a time to be hedged and focus on high conviction trades

Cheers!

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We are now observing the one-month anniversary of the first U.S. rate cut, which occurred at the September 18 FOMC meeting. Back then, rate traders were pricing in a jumbo 50bps trim, and that is exactly what they got. Today, to celebrate the occasion, markets are pricing in a 25bps cut with 100% certainty in the next meeting. The point of this note is to put a number on what is being priced in by rates today as a quick numerical reference for future notes.

I apologize if this is starting to look like a macro blog – it is not; my study of the subject is the first part of identifying the equities I am interested in. A great company can be a terrible investment in the wrong environment.

A month ago, this repricing of rates provided an attractive entry point to short 30-year bonds to hedge inflation volatility.

While we put on an initial long on the 5-year to hedge against negative economic data subsequent to the repricing from the surprisingly positive NFP. This trade is thus far out of the money (hence I like to remind my self it is a hedge)

The rationale for taking on these trades has been laid out in the following notes:

Fed and China go big or go home

Due to this, I am long the short end (below 5y with ZT & ZF) to benefit from the continued steepening of the curve and short the long end (above 10y with ZN & ZB) to hedge against inflation picking up.

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Quick rates update post NFP

I am now interested in setting up an initial position (75bps of nav) on ZT’s (2y, 50%) and ZF’s (5y, 50%) now that our entering condition of closer to 25bps successive cuts in the STIR markets is much closer to being priced in. This position can serve as both a recession hedge from pricing in another significant cut, causing short rates to rally if negative data on growth comes in, and benefit from the cyclical goldilocks regime we currently are in of short-term stable inflation and continued growth.

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The macro setup for equities

Saying that structural risks are shifting away from economic growth to inflation does not preclude economic contractions, but it does imply that a fiscal spending put (à la Fed put) is to be expected, which will attempt to limit the scope and frequency of economic contractions.

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One month later, what is the state of the U.S. rates complex?

The STIR markets achieved on the 18th of October a remarkable level of certainty pricing in a 100% probability of a 25bps cut for the November meeting. This is in contrast to the 60% probability priced in wrapping up the FOMC.

Looking ahead to one year, how has the STIR market implied probability of the terminal rate evolved? The overall rate distribution has shifted up 50bps from a mode at 300bps top of the band (-2% from today’s 500bps) to 350bps top of the band (-1.5% from today)

The upward shift in probabilities (move down in STIR price) through the last month is logical given the string of positive economic data implying continued growth. The market mood before the first cut was that the Fed had missed the boat (frequent citations of Sahm’s rule) and that growth was likely to see a substantial slowdown due to the Fed’s inaction and that a 25bps cut was not enough. I did not agree and framed it as follows:

Now, the market seems to think the soft landing is upon us (this has been our view for a few months now, albeit with some inflationary concerns), and equities are rejoicing.

Data from last week:

We have argued at length in the prior notes the following:

• There will be fiscal spending put (a la Fed put), which will smooth over recessionary pressures. This is due to a shift from pro-capital economic policies to pro-labor. Governments, whether democratic or autocratic, realize that there is little tolerance for inequality-generating economic adjustments such as contractions in labor demand or wages. Fiscal spending which directs liquidity into the real economy has a direct and supportive impact to reduce the effects of economic impulses that increase inequality in a first order view.

• The flip side of government-led deficits will be a regime of increased structural inflation volatility with a floor of 2% (this does not equate to a sustained inflation spike). Given that bond sensitivity to inflation increases with duration and sensitivity to growth decreases with duration, we have a neutral to negative view on long-duration bonds while using the short end as a growth hedge.

Even right now with improving outlook for growth the Federal government is accelerating spending (probably an effect of the election as a last ditch effort). The total federal debt jumped some $500billion early October, now bringing the total at $35.75TN.

I want to put some quick estimations around the rates term structure to frame the likely path for rates and what needs to happen to move them beyond their path of least resistance. This is also to respond to a couple of conversations regarding the long end of bonds being a good place to diversify an equity portfolio for growth scares.

The chart below needs to stay in the background as we go through this exercise. I’ll make a few quick observations.

• The 30-year has been on a constant bull market for some decades. Owning duration far out has been a good way to hedge recession risk.

• Each time there is a recession, the 2s10s and the 10s30s steepen. That implies that the term premium for longer durations gets erased as capital moves to shorter durations.

• The steepening also reflects the pricing expectation that yields on the front end will rally from fed funds rate being cut while the long end projects that economic growth will return and the Fed will eventually raise rates.

When looking at the real cost of money in the system, the rate that matters is the benchmark rate adjusted for inflation. The Fed typically looks to target a fed funds rate some 75-100bps over inflation assuming inflation is moderated and growth is sustained. We have a quick model of the inflation distribution under continued but slow growth which averages some 2.67% inflation. Historically the 2 year tracks fairly well 50 bps over the Fed funds rate in periods of inflation below 3.5% with economic growth while there is no expectations of Fed rate hikes, which lines up with our view on the economy.

Given we expect some 2.67% average running inflation (keeping in mind our inflation volatility arguments from prior notes), we can expect the terminal Fed Funds rate to be 3.5% in line with the STIR market. Then we can expect the 2 year to price at 4% which is where it prices today.

Then to look at the 10 year, we need to model the 2s10s spread jointly with the two year yield distribution. We model this as a multivariate beta distribution. The choice of beta here is to avoid tails towards infinity but rather towards a reasonable structural upper bound.

This allows us to derive the long-run 10-year yield distribution, assuming continued growth and increased inflation volatility. Here, we diverge from the market, given the current pricing of 4.1% vs. our 5.0% expectation. However, we do attribute a 20% chance of moving towards lower yields than where they are today (not insignificant), which is a risk we need to be cognizant of when putting on the short longer duration bonds. Our quick model does show that there is not much room for long rates to move lower, hence our focus on shorting the long duration bonds. This exercise does, however, provide us with a framework to formulate an exit condition to our inflation hedge. As we move closer to the mean, we will start taking off the hedge.

I suspect that the market currently demands little to no term premium due to a lack of inflation worries. The term premium can be interpreted as the pickup in compensation for inflation dragging on real returns of the bonds. The risk of lending to the U.S. government is not credit risk but inflation risk. Right now the market is stating that the U.S. treasuries have neither risk. This is where I believe the market is mispricing risk, and where we will put on risk.

Now let’s move away from our base case and model recessionary impulses in the economy which are met by insufficient fiscal stimulus. The steepening of the curve (empirically some 200bps) counteracts any benefit of holding long duration bonds:

Here is the impact on the 10 year distribution with no steepening. Looks like a good hedge.

But with the average of 200bps of 2s10s steepening we typically see during a recession, the hedge looks much less effective and we still expect rates at longer durations to sell-off in the long run, just at a decreased magnitude and probability from our base case. The 2s10s spread is modelled looking at the month on month change in its speed as a function of both growth and inflation. The general direction is a faster positive speed in change of the 2s10s as growth slows and faster negative speed as growth accelerates. Simultaneously, for stable and relatively slow growth, 2s10s widens as inflation picks up; its sensitivity to inflation reduces as growth moves away from positive low single digits.

You would essentially need a catastrophic event and growth well into negative territory accompanied with deflation for the long end to behave as a recession hedge. And even then you don’t even get 100bps of rally in your long duration yields; a significantly worse performance to the short duration bonds. Given our view on the political climate that justifies sovereigns to issue deficit spending in order to stave away growth slowdowns, this is a more remote possibility now. I will note that the long end here is calibrated on prior recessions, I suspect given the fiscal puts we can expect globally, the long end will perform worse than what is implied historically. Our severe downside to being short the long end is relatively muted, as such the trade has an excellent risk/reward.

It seems simpler to me to focus on shorter duration and credit spreads. We discussed the credit spread hedge here:

STIR butterflies from Yield curve flip flops

I am not willing to bet that credit spreads will widen substantially anytime soon, and hope to make money on it. However, I would want to buy meltdown insurance for as little carry as possible, given the tensions in the broad market with CDS spreads being relatively tight (CDS spreads should remain at these levels given my base case as outlined in the consumer outlook piece linked above, but I like to suffer less when I am wrong).

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This is why we use the front end as a much cleaner representation of the recession risk, hence why we own bonds on the 2 and 5 year to hedge growth risk and short the long durations to hedge inflation, but this should be a great trade on its own.

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Cheers!

In the prior research report, we framed the paths for U.S. inflation and introduced a constructive view on risk assets broadly. In this note, we will provide a synthesis of the macroeconomic variables we are monitoring in the U.S. and interpret the latest economic data prints in preparation for our equity allocation views.

Fed and China go big or go home

A framework on how to think about U.S. inflation and the structural impact on rates and how to think about international capital flows in U.S. risk assets

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The two following reports provide frameworks that lay some of the groundwork for thinking about the impact of consumer behavior on economic growth and an overview of monetary balance-sheet policy, which is less in focus than but equally important to benchmark rates.

What is my credit card limit?

We review the health of the American consumer and how it relates to risk assets. The constructive view provided continues to be supported by the latest employment data.

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A Reverse Repo Story

We provide monetary balance-sheet mechanics that demonstrate the net easing of financial conditions, which started over a year ago via the Fed’s reverse repo facility and supported risk assets despite tight rates and a shrinking balance sheet.

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We have received both CPI and PPI numbers this week, showing a continued trajectory of broadly easing inflation but at a decreasing speed on the consumer side.

The picture becomes more nuanced by drilling into the index’s components. Here, we note that the energy component substantially contributes to the PPI’s cooler than anticipated print. Given the energy’s volatile contribution, it is helpful to look at PPI components individually. We note that services have remained on an upward trend since early this year.

It is a similar story when we look at the consumer side. Concerning factors to keep monitoring is inflation in shelter and services more broadly. This data supports our concerns over inflation volatility and our structural floor of inflation at 2% thesis. Due to this, we will continue to put a bias toward managing inflation risk over growth risk with a nuance which will be elaborated further in the note.

Putting things together and building off the conclusion from our quick rates update from Monday:

Saying that structural risks are shifting away from economic growth to inflation does not preclude economic contractions, but it does imply that a fiscal spending put (à la Fed put) is to be expected, which will attempt to limit the scope and frequency of economic contractions. Fiscal spending along with federal debt issuance can be observed in the treasury general account (TGA) which sits on the Fed balance sheet. We covered in depth the mechanics between the different accounts at the Fed and their interaction with the economy. The conclusion there is that given the expected increases in federal spending along with the debt ceiling waiver ending at the start of next year, the TGA balance will be forced to contract, injecting liquidity into the real economy and supporting inflation volatility while also supporting risk asset valuations.

This mechanic implies that signs of growth slowdowns will spur increased fiscal deficits and accelerate the TGA account’s draining, adding to the inflationary pressure and providing liquidity to risk assets. Due to this, equities will first be sensitive to changes in the speed of growth rather than inflation, conditional on the Fed’s rate cut path being along current expectations. We can expect increased equity volatility around economic growth data relative to inflation prints, while valuations and revenue growth are supported by liquidity expanding in the real economy. This expansion in liquidity will be supportive of inflation volatility and impede the Fed from reaching its two percent target.

This is why we put a focus on monitoring economic health, namely consumer health and behavior. The NFP number from the previous Friday (act. 254k, for. 147k, prev. 159k), with unemployment ticking down to 4.1% from 4.2%, supports our American consumer thesis laid out in mid-august that consumers remain broadly healthy and supportive of spending in the economy. However, concerns remain when looking at the margins with low-income households, where delinquencies are rising. We, however, can reasonably expect that the speed of rising delinquencies will decrease as monetary easing from lowering rates trickles up to higher APR debts and reduces the interest burden for low-income households.

One interesting measure to monitor is the delta between chargeoffs and delinquencies for consumer loans. We can observe that when chargeoffs start catching up to delinquencies (essentially if you are delinquent, your probability of going bankrupt increases), then that is a sign of difficult times ahead. In the 2020 covid shutdown-induced recession, the impact on delinquencies and charge-offs was muted due to the range of consumer-supporting policies implemented to mute the effect of lost incomes. The effect can however be observed in 2001 and the GFC where fiscal stimulus was slower to come and support the economy. We currently observe the rate of chargeoffs accelerating relative to delinquencies but unemployment was rapidly accelerating during the three prior recessions; something we are not observing currently.

The ISM PMI’s also help get a sense of economic growth and we note that services are still in an upwards trajectory for the year. Manufacturing however is in contraction but we can expect to see an uplift there from loosening monetary conditions.

Given manufacturing currently composes 30% of economic activity, overall growth continues supported by services.

Now that we have some confidence in the economic trajectory for growth in the U.S. we can start thinking about which equity sectors we are interested in allocating to. Sticking to the macro synthesis nature of this note, I want to quickly look at the defensive equities before doing sector-by-sector fundamental analysis in the next one.

A quick look at the flows between defensive (utilities and staples) and cyclical (energy , materials, industrials) equities shows an interesting picture of capital guided by uncertainty.

Now, we agree with the market that uncertainty is well and thriving. However, we diverge on the efficacy of defensive equities in protecting against uncertainty, given our views on inflation. In line with our framework detailed above, equities had virtually no movement from the hot CPI print. We should continue expecting a muted impact of inflation readings relative to growth for the time being. This lack of volatility pick-up coincides with the increased positioning in defensives, which have some characteristics of long-duration bonds. Given our shorts on 20+ year bonds, we also believe that defensives will underperform relative to other equity risk profiles. The increased allocation to defensives presents an opportunity to enter or increase allocation into some equities that can benefit from inflation at attractive valuations despite all-time highs for equity indices.

The rates market justified the view laid out on Sep 29th after the CPI report, with the 30y gradually selling off while the 5y quickly rallied and retraced but remained bid on Friday’s close compared to the 30y, which keeps selling off, in part an effect of inflation volatility remaining heightened. This continues to provide justification to be long below the 5 year and short above the 20 year.

I wanted to put together this synthesis on U.S. growth and inflation in one place as a reference before exploring the equity sectors of interest. In the following research piece, I will promptly tackle these equities without macro-deviations.

In our prior research note, we established that China is experiencing a consumer-driven residential property balance sheet recession.

Fed and China go big or go home

What problem does China have, and what will be the impact of its stimulus efforts?

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Here is the conclusion we reached:

China’s National Development and Reform Commission managed to unveil pretty much no details on the make of their stimulus aside from some 100bn yuan ($15bn) in additional spending for 2025, which pales relative to the pace of debt repayments from Chinese households and corporates:

China is currently attempting to cut a tree using a hammer. Monetary easing is not the appropriate toolset, and Chinese fiscal spending must step in. For now, given the insufficient outlook for fiscal spending, I am taking profit on half of my Chinese and HK equities along with the rest of the market. I won’t go to the point of shorting local equities as we do not know if and when Fiscal spending announcements will be made.

I formally issue an errata, renaming the prior research piece to: Fed goes big and China goes home.

This is a positive outcome for U.S. equities in the medium term, as liquidity won’t exit the U.S. and park in Chinese risk assets. We will need to monitor how this crisis evolves in China and signs that weakness is leaking out of the second-largest economy and into other markets (a future note will cover this).

Last Friday’s positive nonfarm payroll numbers, unemployment print, and continued hourly earnings growth cast a shadow on the Fed’s 50bps cut decision as being too hasty given the current resilience in employment and made inflation look closer in the rearview mirror.

This data promptly cleaned the slate of bets on more than a 25bps cut for the next FOMC and even added a slight chance of no cuts in the next meeting while bringing the chance of a 50bps cut in the December meeting down to less than 20%.

Looking at the yield curve, the 2-year has retraced two months’ worth of rally while the 10-year has moved halfway between two and three months ago. This presents a significant tightening of the financial conditions

Here is how we framed our yield curve plays on Sep 29, which emphasized waiting for the short end to reprice before taking a long position while immediately going short the long end.

Fed and China go big or go home

Fed goes for 50bps and China gives you money to buy domestic stonks… So what’s the trade a week later?

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I am now interested in setting up an initial position (75bps of nav) on ZT’s (2y, 50%) and ZF’s (5y, 50%) now that our entering condition of closer to 25bps successive cuts in the STIR markets is much closer to being priced in. This position can serve as both a recession hedge from pricing in another significant cut, causing short rates to rally if negative data on growth comes in, and benefit from the cyclical goldilocks regime we currently are in of short-term stable inflation and continued growth. I will also increase (from 200bps to 300bps of nav) my existing short on ZB’s (you can also use TLT) and long (350bps to 400bps of nav) gold (80%), silver (10%) and platinum (10%) to protect against inflation rising given the sustained pace of employment and the expected fiscal spending post-election.

Our view on inflation comes from a pro-labor environment in which governments prioritize deficit spending in lagging sectors of the economy over fiscal discipline at the expense of growth in those industries. The objective behind this politically popular economic policy shift is to avoid corrections in the labor market, both in quantity and wages, by providing capital for those industries that would contract otherwise and maintain full employment and growing wages. The tradeoff of policy shifting away from being pro-capital to pro-labor comes in the shape of the structural risk in the economy moving away from growth to inflation. We concluded in the prior note that U.S. inflation will maintain above the 2% target while its volatility will remain heightened (hence our view to short long duration bonds).

Rates trades and hedges set up from the Fed’s first (Big-Mac) cut.

In line with market expectations but against economist consensus (yours-truly included), the Fed decided to skip the hors-d’œuvre and go for the plat de résistance with a 50bps cut to the policy rate. This clearly conveys that the core concern in the FOMC’s dual mandate today lies with full employment mandate rather than price stability. Here is how I framed the 50bps possibility on Sept 10th:

And here is the virtually non-existent reaction of the market on STIR futures (the implied reference rate is simply read as 100-price). This lines up with the view expressed above; neither a 25bps nor a 50bps cut would have done much to reprice the short end of rates, so why not 75 or 100bps to actually ease financial conditions? Maybe that would have been quite alarmist…

More important to the 50bps cut is Chair Powell’s guidance at the press conference, where he pushed against 50bps as the pace of cuts moving forward. This guidance is what has put pressure on the long end of rates, tightening financial conditions on the long end given those were also pricing additional 50bps cuts along the way:

This expectation management is the noteworthy event around the Sep 18 FOMC meeting, as it negatively impacts longer-duration bond returns even one week later. This has effectively tightened for the time being financial conditions on the long end bear-steepening the curve since the FOMC as opposed to the bull-steepening we have seen up to the FOMC meeting. (I have recommended since early July the steepner trade which is now taken off after 2s10s became flat) One caveat to the tightening of rates on the long end is that we continue to see 30Y fixed mortgage rates going lower, now sitting at 6.09%, which will strengthen homeowners’ balance sheets and provide some support for middle-class consumers. As the policy is meant to tackle unemployment and ease promote consumer spending this is a good first effect, the issue for now is that the middle-class which is not where consumer weakness resides.

What is my credit card limit?

A look at the the American consumer and what that means for growth and where consumer weakness resides.

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There is also the net easing from balance-sheet-driven monetary policy for over a year as explored in this prior note won’t which I wont reiterate here:

What is the likely path for growth now? A Reverse Repo Story

We study the net easing effect the reverse repo facility has on monetary policy despite an overall shrinking balance sheet.

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One hypothesis we can make regarding an easy Fed is that if signs of inflation start to pick back up, this would be negative for the long end of bonds as stagflation concerns trickle in. We will need to be careful where in the curve we own duration, as it is unlikely that the bond story will look like this: lower policy rates lead to higher bond prices across the curve, but something more nuanced. If inflation picks up, the impact on the long end will be disproportionate adjusted for duration given the curve’s flatness after the 2s10s inversion with very limited premium beyond the 10 year.

Due to this, I am long the short end (below 5y with ZT & ZF) to benefit from the continued steepening of the curve and short the long end (above 10y with ZN & ZB) to hedge against inflation picking up [if one is more amenable to using etf’s then TLT is a reasonable proxy for 20+years]. I would not focus here on duration matching the trade to implement a proper steepner for the following reasons: If there are signs that inflation does pick up, I will start overweighting the inflation hedge leg of this trade. One also needs to be cognizant that currently, much of the performance from rate cuts is already priced on the short end, and I would wait for STIRs to price successive cuts closer to 25bps before putting on a position. Whereas there is room to price in a stop in the trend of inflation reduction on the long end of the curve.

A compelling argument in favor of a pickup in inflation comes in the form of the shift in economic policy from being pro-capital to being pro-labor, where stagnation in wages in real terms (both adjusting from inflation and international purchasing power from FX) is little tolerated by the electorate. Policies that provide fiscal stimulus by increasing spending and borrowing in order to smooth over recessionary impulses, hence, a reduction in the quantity of employment and purchasing power are taking the front seat in driving the economy. From that perspective, there is little absolute difference between the two options the American people have access to this upcoming November. Regardless of what happens, government spending will be at the center of driving economic growth forward.

One likely economic scenario in line with the above argument is that the US will enjoy continued nominal growth at a reduced pace with the help of fiscal stimulus while the Fed will be forced to stop its cutting cycle with a policy rate above the highs of the pre-covid cycle to focus on its price stability mandate while the fiscal side takes care of employment.

It is important to note that even with the cutting cycle being initiated, we are still in a period of high growth and inflation uncertainty despite the confidence expressed by the FOMC meeting in the sustained reduction in inflation towards the 2% level while maintaining growth. This can be observed with bond volatility sitting at a 7% handle vs the 3% before covid.

One point I have seen mentioned is that given the Fed is cutting the benchmark rate and easing financial conditions into yet above-target inflation, that inflation is bound to start worsening again. This is not a straightforward deduction to reach given inflation is mechanically a monetary problem tied to the amount of spendable fiat in the real economy, while financial conditions impact first the value of duration, credit spreads, and, by extension, equities, which is not a first-order impact on inflation, unlike fiscal largess and the availability of credit which directly impacts it. Hence, the prior point on pro-labor policies is to look for signs of inflation from government spending rather than monetary policy. The metric I will closely monitor here will be the primary deficit (the difference between revenues and spending, excluding interest payments on the debt). The exclusion of interest payments is important because some 85%+ of treasuries are owned by institutions who do not spend their treasury fixed income in goods and services going into the CPI basket. Excluding interest payments is not anodyne but necessary to get a clear picture of where inflation could go. Currently, interest payment is 10.7% of the total federal spending, while only in 2021, it was half of that. Moreover, the total deficit currently is 6.5% of GDP in Q3 and moving towards 7% for year end, which leads me to believe that 2% will be the lower bound for inflation, and we should expect to be in an environment of elevated and persistent inflation volatility moving forward.

Regarding how to play inflation volatility with inflation being structurally floored at 2% (if we are lucky…), long gold paired with shorting long-duration bonds would be a reasonable risk-reward as a base case and a good hedge for inflation moving higher. Moreover, given the premium that gold has vs silver, platinum, and palladium, I would also consider adding some exposure to those metals for some added skew to the trade. I will need to make a separate note to go into detail about my views on silver and platinum (the end of the catalytic converter is not the end of platinum) and how to play these metals, namely the African geopolitical risk involved.

China wakes up to its balance-sheet recession

A quick wrap-up of the first salvo in easing from the PBOC:

• 7-day reverse repo rate cut by 20bps down to 1.5% and 1 year MLF rate reduced by 30bps

• The Reserve requirement ratio (RRR) was reduced by 0.5% liberating up to $145bn (1 trillion yuan) in liquidity and is guided to be followed by a 0.25-0.5% cut later this year.

• Lower mortgage rates for existing loans and cut the down payment on second homes by 10% to 15% (which is ironic because, in the 19th CCP congress, the following idea was proposed: “property is to be lived in, not to be speculated on.”)

• Central government supporting local governmental entities to purchase unsold homes with loans backing the full purchase price.

• Loan prime rate and deposit rate cuts to secure financial institutions’ liquidity.

• 500 billion yuan liquidity support for Chinese stocks: Institutions get access to central bank liquidity to buy stocks, and banks are incentivized to lend to shareholders for share buybacks. In addition, we are also guiding for an additional 500 billion if the program works as expected.

If we try to back-solve what problem the PBOC is attempting to fix by looking at the set of policy decisions, we would guess that they are trying to have less tight bank balance sheets and incentivizing lending while not only promoting home ownership broadly but incentivizing individual homeowners to use a second home as a form of investment. All while providing a PBOC put on house price to guarantee a bid from local governments in whatever private individuals or companies are not interested in buying. All that while directly supporting domestic equities, increasing Chinese net worth, and giving them the power to buy more unwanted real estate and potentially sustain consumption.

Well, let’s get a helicopter view of the Chinese economy and take a punt at guessing if this policy path would ease their economic woes (this frankly deserves a standalone article but let’s make this quick for now)

Today, 70% of Chinese consumer wealth is in real estate where 80+% of households owning a home and 20% own multiple homes today. Home ownership in China has seen sustained growth from 20% in 1980 to 45% in 1996 and 72% in 2000. This contrasts significantly to the American dream of home ownership where the consumer net worth percentage in real estate is of 30%. Why do Chinese people rely so much on housing to build wealth? Real estate appreciation was the way to participate in the Chinese success story. To maintain competitiveness in manufacturing, Chinese policy managed to suppress wage growth. When China joined the WTO in Dec 2001, they gained access to global markets and trade. To benefit from this new tool, China prioritized their internal competitiveness on the international stage to gain manufacturing market share. Homeownership has, therefore, been the most effective way for consumers to take a slice of Chinese prosperity. This was something that the central government realized and to support the creation of wealth for its citizens while not increasing wages to uncompetitive levels with the implementation of supportive monetary policy for prospective homeowners and fiscal support to get a first house and home constructions. One-Child policy had, however been a substantial policy error on the economic front as the growth of a manufacturing economy depends on population growth (at least in that time), hence structurally slowing GDP growth which is one of the guiding measures the politburo uses to benchmark performance. This impact was starting to be observed prior to the GFC. When the crisis came, China took advantage of the West’s deleveraging to take on the newly unused capital and seek to boost its slowing growth using debt and promoting real estate development through highly leveraged developers. The issues with this highly financialized approach to economic growth started materializing in in July 2021 with the start of a structural decline in real estate valuations with the fall of Evergrande, a recent story we now well know.

This story can be summarized with the term: balance-sheet recession (idea formulated by Koo in 1996). What is it? A typical recession, as the one investors are currently worrying about in the US, is caused by overproduction or rising inventories, decreasing consumer spending, inflationary pressures, and corporations being profit-maximizing; this forces job losses, productivity declines, and reductions in growth. Now, balance sheet recessions have the odd behavior that corporations stop being profit-maximizing but rather debt-minimizing, even with extremely low or zero interest rates.

Assuming rates are zero (or why not negative), why should a corporation not just borrow and put the free money to work? Simply because the said enterprise has seen the asset side of its balance sheet (in China’s case, residential real estate) be severely marked down, and the responsible thing to do for stakeholders is to pay-down debt.

This allows shareholders to maintain some future implied value for their equity, employees to remain employed generating cashflow to gradually paydown the debt and debtors not be subject to a default and have to do the work of liquidating assets to get paid back. The enterprise-level issue becomes a balance-sheet recession when a large sector of the economy is operating under that framework. For China, Evergrande was not the only property developer to go bust, and the ensuing house price decline has caused homeowners’ equity to be underwater. The consumer is where the balance-sheet recession is taking shape.

What problem does this issue cause then? Simply put, the economy is composed of savers and borrowers which interact in the financial system. Benchmark rate policy works well when all entities interacting in the financial system are profit-maximizing as a change in the cost of money can drive more savings or more borrowing to attain a desired equilibrium between savers and borrowers. Now, you might as well toss monetary policy out the window when you get to lower your rates to the point where money is basically free (taking inflation into account) and entities still prioritize paying down their debt because it is the responsible and necessary thing to do. There does not exist an interest rate where an enterprise or individual with a broken balance sheet would look to increase debt to generate more profits over simply paying down the existing debt, at least to the point of reaching equilibrium with the assets.

I am guessing that Chinese non-financial corporate debt repayments keep increasing after 2022 (data comes out slowly and uneven). Looking at the 10-year Chinese bond yield now below 2.2% I would wager that the corporate credit repayment which started in 2021 is still underway. The rational is that given China is a competitive developing economy with one of the largest investment opportunity sets globally, such a low 10y bond yield means that Chinese non-financial corporates are not prioritizing adding new leverage but rather repaying debt which liberates capital from investors which then allocate that capital to government bonds, lowering the yields to the levels we see today.

This explanation received further empirical justification from the markets, as the 10-year yield spiked from 2% to 2.18% after the PBOC policy announcement and the anticipated sovereign bond issuance announcement of 2 trillion yuan. This implies that capital moved away from Chinese government bonds into Chinese risk assets to benefit from the perceived stimulus.

The decreased propensity to borrow and active repayments of debt creates a consumption problem due to the money-multiplying effect of the banking system grinds to a halt. Effectively, one person’s income is partly saved getting stuck in the bank with his spending being someone else’s income and we iterate forward into reducing the amount of money in the economy and GDP growth and eventually contracting GDP.

This is precisely what happened in the US great depression, Japan and european debt crisis which lingers on to today, and is what the PBOC is attempting to tackle however entered around household debt from residential real estate depreciating rather than corporate or sovereign debt issues. However, as we have elaborated, no amount of monetary easing will turn the necessary cogs to solve the fundamental balance-sheet imbalance problem, and Japan has empirically demonstrated the futile nature of that exercise. The Chinese government will need to step in to borrow and spend. The 2 trillion yuan is a step in the right direction, but the beneficiaries of this spending will speak to the efficacy of this stimulus.

The only response that can slow the net impact of debt repayment is fiscal policy, which involves the government borrowing unused money from the financial sector and spending it on goods and services to assume the role of borrowers/spenders in the economy. I expect China to unveil ambitious fiscal stimulus beyond the anticipated 2 trillion sovereign bond issuance to motivate spending on industrial, staples, and discretionary. If it were not for that conviction, I would be taking a short on Chinese equities and letting go of metals after this pump. The key question is what shape will said stimulus take? For that, I will use patience and hold Chinese equities (HK listed) that should directly benefit from Chinese government spending as labeled above as well as maintain a long position on copper futures, materials (XLB ETF is a good proxy) and junior miners across the board. OSVs should also benefit from Chinese fiscal stimulus.

Now, what about the impact on non-China equities?

The first thing to look at is USD.CNY, which will follow a path similar to USD.JPY. The expectation is that the dollar will lose value broadly. It was no accident that the PBOC waited for the Fed to initiate the cut before it started easing financial conditions.

I don’t think there will be much room to come back from DXY under 100 once the dollar crosses that line.

Moreover, a weak dollar could pressure crowded U.S. equity trades (more mechanical details on that and dispersion in the next section to introduce the idea). We have indeed seen performance outside of the U.S. outshine American exceptionalism in the week after the Fed cut.

This is likely due to foreign capital flows. The US equity market is currently more than 40% owned by foreigners. The set of charts below should paint a good picture of the significance in foreign capital to U.S. capital markets. This implies that the sensitivity of American asset valuations are increasingly dependent on capital flows from abroad.

All charts above were sourced from the Fed and Treasury

Given the Chinese stimulus attempts, I expect a portion of the money owned by Chinese entities to be repatriated back home. When meaningful Chinese fiscal stimulus starts being deployed, I expect the speed at which foreigners allocate capital to the US to reduce in search for growth drivers, but this would depend on earnings picking up in Asia while earnings disappoint in the US. I will be gradually increasing my EM exposure, focusing on Asia x-Japan. (some country spotlights to come)

What does this mean for risk-assets?

The important thing to realize here for equities is that this cutting cycle, as long as it remains within market expectations, provides a neutral impact on U.S. risk assets. The performance of risk assets will be primarily determined by economic health. The simple framework is as follows:

• If the U.S. economy remains growing and avoids a recession then we can expect a bid on domestic risk-assets while longer-duration bonds will be sold.

• If we do see increased consumer weakness translating into reduced spending and slowing corporate earnings, then the converse can be expected. There is one nuance worth noting: some equities should be expected to be resilient through this scenario (and we will review those in the next note as a form of recession/slowdown hedge.)

• The inflation scenario laid out in the first section.

For now, we remain in the first scenario, given nominal growth of 3% and inflation (PCE) sitting on 2.7% currently and 2.2% by the end of next year as projected by Fed economists. However we are actively on the lookout for data that the economy rolling over à la dot-com bust, leading to the fundamentals of corporates following suit and degrading valuations.

Looking at the moves toward all-time highs in equities, it is clear that we will need to select our equities carefully to minimize the impact of a reduction in valuations on our portfolio from popular longs (AI and co). The evidence of the discrepancy in sensitivity of valuations between different sectors was clear during the partial unwinding of the Yen carry trade, which increased dispersion across equities.

I use dispersion here in the technical sense as defined by the CBOE:

The Dispersion Index calculates as the square root of the difference between (i) the weighted average expected variance of constituents of the Basket Index – ranging among all such constituents whose expected variance can be calculated at that point in time – and (ii) the expected variance of the S&P 500, as represented by the square of the current level of the Cboe Volatility Index (“VIX”). The Dispersion Index is floored at zero.

The dispersion between equities allows to frame three concepts for portfolio construction:

• First, increases in dispersion provide a statistically significant opportunity to enter or exit specific equities based on their relative performance independent of their fundamental thesis.

• Second, given a portfolio of lazy equity longs, dispersion allows for the optimization of putting on hedges to minimize negative-carry over time and reduce portfolio volatility by hedging against those sectors that have the highest propensity to correct while using less capital.
  (this bullet point will be the focus of a future note, which builds on our work on clearinghouses being engines of volatility:

Hysteria from Hysteresis and Path Dependence – Clearinghouses

We will study the risk created by path-dependency, where various trajectories that end up in the same place provide drastically different outcomes on portfolio performance, we saw this with the Yen carry trade unwind being reversed in the span of a week which gives us information on market microstructure. A hypothesis on why these behaviors can occur is in the calculation of margin from central clearinghouses which in a regime of low volatility and crowded trades can cause a spike in volatility

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• Lastly, dispersion is a tool that can help inform the distribution of equities in our portfolio by rank-ordering those equities that first have less sensitivity to the economy turning around with stable revenues across cycles and second have valuation multiples being less sensitive on the downside to changes in capital flows. (this will be touched on in this note)

Long story short, despite being in a risk-on environment, the margin of safety in some themes, such as artificial intelligence, is much reduced relative to other sectors due to crowding, and we should size our bets accordingly. (this does not mean no AI… I actively ask our robot servants(/overlords?) to plan my trips abroad and give me ideas for a good night out!) Due to this theme being the most overbought and expensive. Hence, the point at which they will be bought again in an economic downturn will be much lower than other sectors. I will maintain a strategy of rolling 20 delta RTY puts and monetizing when ATM and capture vol spikes using 0 delta straddles, maximizing gamma on NQ. (more on this in a subsequent note)

The reason for puts on the Russell is that this is the most sensitive sector to growth concerns.

While straddles on the nasdaq to monetize volatility spikes and foreign flow of capital bringing valuation multiples in line with other major indices.

In the following note, we will cover the sectors I find interesting. Some themes we will cover is the move from cyclicals into defensives and the opportunity that presents in some asset-heavy businesses like OSVs, materials, medium-sized industrials given our negative view on long bonds which defensives are a proxy for.

Some energy plays will also be reviewed, namely nuclear and natural gas. What happens to renewables? The connectivity sector is also quite interesting given its depressed valuation and revolutionizing technology in the transportation of data. Here is a quick note I wrote to a colleague mid August:

 Quick note on an inflection point I am seeing unfolding in public equities which could be an opportunity for telecom valuations. The telecom supply chain is quite interesting right now, it’s a somewhat pre-historic type of technology that has gone through a secular devaluation which should see renewed interest in the process of upgrading telecom infrastructure supported by fiscal stimulus (there won’t be a shortage of stimulus under either potential president). Moreover, technological upgrades in the movement of low-latency data and high latency (for volume) are coming to a turning point that doesn’t need AI to justify their existence but it sure does help. Results from CSCO show the start of this trend. The suppliers to the telecoms should benefit from large capex spend, fiscal support, and multiple rerating. This is also a competition issue on a geopolitical level and won’t go under Washington’s radar.

Cheers!

Looking at the mixed signals from Friday Sept 6’th, employment figures:

This print indicated that overall employment continues to support economic growth at a slower pace, in line with the framework laid out in this note:

What is my credit card limit?

How has Yellen’s shopping been doing?

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The market broadly interpreted the data to imply a 25bps cut (70% chance) over 50bps at the next Fed policy meeting. Here are some charts that provide context as to the market reaction:

We note here the impact on the Nov 7 meeting pricing from the jobs print, which increased the market-implied likelihood of an additional 25bps or 50bps cut vs no additional cuts. This shows that the jobs report, while quite mixed, was viewed by the market as skewed to the downside, hence the pricing for the subsequent meeting. A similar story can be read in the December meeting as well.

The policy rate could be reduced by 25bps for the following reasons:

• The Fed is biased not to be seen as political and provide economic stimulus potentially benefiting the election results in favor of the sitting administration. This would bar a reduction of the policy rate beyond what the economic data implies as being the minimal necessary cut.

• The Fed does not like being wrong, and a 50bps cut would imply it has been overly patient when warning signs of growth slowing had already appeared before the last meeting.

• The Fed will likely offer up a reverse Greenspan (dotcom crisis) and issue successive 25bps cuts up to the point that it considers supportive of the labor market while not stimulating inflation excessively as a simple solution to the tensions in the labor market.

• The jobs market has proven to be resilient thus far and consumer spending is healthy despite tight monetary conditions (but not that tight as explained in the reverse repo note), and the weakening was to be expected from a normalization of inflation.

A Reverse Repo Story

Show me the Money!

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And could be cut by 50bps for the following reasons:

A 25bps cut would not stimulate the economy in the short run ahead of the next meeting but only provide the stepping stone to future stimulus. This is due to current contract pricing in the possibility of 50bps at 30%, so a 25bps cut would effectively tighten financial conditions on the short end of the curve. Moreover, a 25bps cut would do little to reprice rates on the long end where corporates borrow and would see improvements on their balance sheets that can eventually translate into more job creation and improved wages. The Fed would need to be deeply convinced that the labor market is on the verge of a steep deterioration before taking the 50bps route, but why not just 75 or 100bps in that case?

In aggregate, 25bps is the path of least resistance. There is, however, little asymmetry in taking that view. Even betting on a 50bps cut provides a poor risk-reward (2 to 1 on STIR future options) if it is eventually justified. It would be more interesting to look at the total number of cuts in a longer timeframe to put on a hedge with more convexity (in the risk-reward sense, not bond math).

This week’s inflation numbers will be used to gauge the rate of change in growth slowing, and I suspect a slightly hotter inflation print would be welcome by equities.

If the CPI numbers and subsequent initial jobless claims come in cooler and weak, respectively, that could increase the market-implied probability of a 50bps cut, and there might be something to do here on the short end, but patience for now.

The bull-steepner has been one of the trades mentioned in the following publication:

The tale of Goldilocks being eaten by the Bears

I have been to many stakings- you have to know where to stand! You know, everything in life is positioning, positioning, positioning…

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It was put on as a hedge to equities moving sideways or down and has been an excellent way to smoothen out the returns on a lazy-equity long book through the rotations in equity-bond correlations, namely on Aug 5’th where it had managed to provide a quarter’s worth of hedge PnL and was promptly taken off.

Now that the curve has steepened to the point of being flat, we should consider if there are better opportunities in the rates complex to position hedges and if the bull-steepner could still provide opportunities despite being crowded.

On a practical note, what does flattening mean when determining the flow of capital? Simply put, that risk can move to longer durations by having yields now equivalent to the short end and credit spreads not widening despite growth scares. This implies there will be a natural bid from safe-yield seeking institutions moving towards further durations, solidifying this uninversion; this means that we now have a natural floor for yields on 10’s relative to 2’s. We are unlikely to see the curve invert again, given the Fed’s cutting path, which is now well-telegraphed. I mention credit spreads in the above relation as default probabilities evolve at a multiplicative rate at longer timeframes.

Making a quick parenthesis away from rates, I find it somewhat perplexing that credit spreads have not widened through August and have persisted their downward, starting in Q3 of 2022.

Now, my confusion can be explained away by noting that corporations have navigated the earnings season without showing signs of worsening balance sheets and continue on a path of earnings growth, albeit with some notable expectation management from executives.

I am not willing to bet that credit spreads will widen substantially anytime soon, and hope to make money on it. However, I would want to buy meltdown insurance for as little carry as possible, given the tensions in the broad market with CDS spreads being relatively tight (CDS spreads should remain at these levels given my base case as outlined in the consumer outlook piece linked above, but I like to suffer less when I am wrong).

The HYG/HYGH etf (High Yield Bonds and its rates hedged brother) is intuitively the most straightforward way to do this, and a well-timed short would have paid during Aug 5’th (I don’t like any strategy that requires good timing…).

Well-timed is key for the HYG complex, given bid/ask on options wipe out half the value if you were to regret placing the trade on the same day, and borrowing a unit to go short means you need to pay up the 8.79% dividend yield in addition to your brokers stock borrow costs. This gets quite expensive quite quickly.

One other option is using inverse etf’s like SJB. Like most inverse etf’s these track daily performance, which for highly volatile underlying erodes value very quickly (they will end up buying high and selling low by construction on volatility spikes). The saving grace here is two-fold. First, the instrument pays you a respectable 5.07% div yield from the underlying treasuries used as collateral for the default swaps held in the trust. Second, volatility is generally subdued and constant in the high-yield bond index due to credit spreads being compressed and increases in volatility have come from negative credit views supporting the value of SJB relative to its benchmark irrespective of when you put on the trade relative to a traditional short with no daily hedging. This means it has tracked well the inverse index with minimal erosion and would provide protection when vol spikes during a negative credit event. Given I don’t think there is room for CDS spreads to move lower from here, there is some convexity to be had from this instrument in terms of payoff for protection against a deterioration of credit conditions.

For now, I would have this instrument at some 50bps of NAV and stick to the primary hedging strategy of straddles maximizing for gamma that benefit from dispersion widening (following note) until I find a cleaner pure play on widening credit spreads suitable for retail (and taking any insight to be had on this topic!).

Back to rates and our lazy equity-long rates hedging problem…

Currently, the rates market is implying a 50/50 chance of hard landing when interpreting that as the distribution of bets on the June FOMC meeting will bring the benchmark below a 3% level. Here is the distribution change for the June meeting:

The reader can quickly derive this probability on a spreadsheet pricing butterflies on June STIR contracts where the ratio of the cost vs the payoff is a simple proxy to likelihood. For context, if the Fed cuts by 25bps every meeting to June, the rate should be in the 3.75% range, so the market implies an additional 75bps of cuts to our base case between now and June’s meeting.

Given the mixed to positive economic data (but inflation TBD) and current path by the Fed through the end of the year being reasonably well-telegraphed, I would be long SRM4Z4 (steepner, long and short respectively the M4 and Z4) taking into account concerns that the economy could deteriorate. The Fed be forced at a later stage to cut deeper than current expectations on the back of negative news, I would short SRZ4M5 (flatner, short and long respectively the Z4 and M5) providing us with an elegant hedging solution given rich pricing saying to the market: you are wrong in the short run, Powel won’t frontload cuts anywhere close to the election and data prior the end of year will show the economy is still growing in line with its reduction of inflation, but maybe you are not wrong in the longer term, and there could be a recession, so I’ll tag along with that as a hedge. This is the plot of the SRM4Z4M5 butterfly where we sell the belly (1/-2/1) of the curve:

I’ll start unwinding the steepner if economic data starts coming in negatively earlier than the mixed signals I expect for the next few months in line with the note on consumers and move that capital to the flatner portion of the trade.

If economic data starts improving on both the growth front and inflation, the flatner portion of the trade can be changed to steepner to go in line with the 25bps successive cuts view we laid out. The downside is that it would lose its hedging value for unforeseen downside shocks to the economy.

Now we need to go back to evaluating the bull-steepner on the yield curve, which we took off on Aug 5’th. We remain at a point of heightened bond volatility, as seen through the MOVE index.

Relatively high bond vol in conjunction with the current consensus pricing of the steepner trade on 2s10s and pessimistic view on the economy makes this position broadly unattractive to put on. The primary two arguments I see to put back on the long on 2s10s is that now that the curve has uninverted, there will be a natural shift of capital towards the long end, putting a natural bid on it and providing us with a limited downside to the position barring any change in Fed cutting trajectory. Moreover, this trade, although already richly priced given the recessionary view that bonds are showing, offers a good hedge for worse-than-expected economic prints where this position could see another Aug 5th style of risk aversion pricing, which is where this trade shines.

I would consider adding position back tactically on any pullbacks on the spread. I expect that FOMC will be the correct opportunity to go long bonds via ZT and ZN after the expectations on the 50bps cut get washed away, and we see pricing along the curve fall in line with 25bps each meeting, assuming that the data keeps coming in mixed.

From a portfolio construction perspective, this is now a good time to be cyclically long equities and bonds. There are two main scenarios for financial markets:

1) Economic prints keep coming in mixed to good and we continue a goldilocks regime where equities are skewed to the upside while bonds yields drop (70% chance)

2) Economic prints come in mixed to bad and the bears eat goldilocks where bonds should be in a sustained bull market while equities get repriced downwards (30%)

Cheers!

Prior post on monetary theory

What is the underlying growth story?

One of the issues with how economic data is presented comes with the one-dimensional semi-binary view taken at each print within the good news or bad news is bad news or good news or vice versa or contrapositive or something to the point where a 7000-person difference between realized and expectations in unemployment claims numbers ushered in the end of the great growth scare of 2024 which lasted 5 days on the back of a 20bps worse unemployment number than expected a week prior which was still well within the margin of error for the estimate. Taking a more complete view of the economy and its drivers should help position trades and investments to generate excess risk-adjusted returns over this cycle and understand what proportion of the portfolio should be allocated to adverse scenarios caused by a pickup of inflation, deflation, growth slow and maybe recession while knowing the answer won’t be buying puts on NQ during a selloff.

I’ll focus this first primer on the consumer broadly as he is a core component of the economy (which is made of people in addition to GPUs). A 70% of economic activity in the U.S. is driven by consumer behavior. Later primers will provide a framework to relate consumer trends to growth and we will dive into the various industries that make the economic landscape.

The Consumer                                                                                                         

To understand the current state of the economy and estimate which sectors are set to outperform this cycle, we need to take a look at where everything starts… the American consumer. After all, what’s the point of credit card debt if not to buy H100 pro max’s?

Before looking at debt, it would be useful to know if the American spender has the ability to spend. Wage growth is one of the key metrics to appreciating the health of the consumer relative to inflation. If costs of goods outpace the ability of earners to increase their wages, we can expect to see a longer-term contraction of spending and investments in durable goods. Currently, we are observing a continued recovery of real wage growth from peak inflation in mid-2023 indicating a capacity to support spending or accrue wealth. This should be supportive to also see an increase in the percentage of homeowners in the US which has flat-lined since covid as mortgage rates come down; we are already seeing refi’s more than double on the pricing in of rate cuts.

We also should get a handle on the job market and try to extrapolate if the current disinflationary impulses should lead to sustained decreases in job creation and potentially job losses while also getting a sense of job quality.

U-5 is the official rate plus discouraged workers     

U-6 is basically U5 plus part-time workers for economic reasons, I think there is value in looking at the three together as part-time workers who would otherwise prefer to have a full-time job also are an indicator of weakness in the economy. We see however that the delta between U6 and the other two measures remains relatively constant at the level before covid and through the health crisis, so we can focus on the changes in the official measure.

Now despite unemployment ticking up, jobs are still being added to the economy but at a decreasing rate which we see with the Non-Farm Payroll numbers which is indeed what we expect to see during recessions. The caveat here is that the starting point for the NFP numbers is artificially high due to the post-COVID surge and is currently well within the expected NFP adds we see during periods of growth. For now, we should expect NFP’s to move towards pre-covid levels (150+ from the current 170) without necessarily implying the beginnings of a recession but rather the expected slowing of growth from fighting inflation using monetary policy. A similar story from continued claims that are creeping up back towards the pre-covid levels which should be expected from the normalization of the economy that we are seeing. Now this does not preclude that the economy overshoots towards deflation.

Another view on the rate of employment which provides a notion of the speed of job creation and employment in the economy comes from the hire rate, separation rate, and the voluntary quit rate as a percent of the unemployed population. The Hire and separation rate is calculated with the employed population as the denominator where separations reflect voluntary and involuntary.

First, we note the employment and separation rates are at the levels seen during the 08 financial crisis.

Ok, time to stop writing this and blindly press the big red sell button…

But wait we are currently in a situation near maximum employment so the denominator being looked at is substantially different. Moreover, during the GFC, the separation rate exceeded the hire rate, which we are not currently seeing. So what is this parallel decline in both ratios telling us? Well not quite sure without looking at a third metric, the voluntary separations as a ratio of the unemployed population which is in decline but now at levels before the health crisis.

As a general rule, if jobs offering better opportunities are harder to come by then we should expect the rate of people resigning from their jobs voluntarily (excludes sickness and retirement but does not exclude extended holidays to write this primer on the banks of a Vietnamese river) to be declining. This is reflecting a weakening of the job market where opportunities are harder to come by, however, within the context of almost full employment, an economy with positive but slowing growth should be expected. One thing to look for will be then the hire and separation rates flip with an acceleration and persistence in the decline of the quit rate. One caveat for using this indicator is it’s backward-looking nature, rather when it flips your hedges should already be in the money.

How has Yellen’s shopping been doing?

By today’s account, more than well! She probably went out on an H100 shopping spree! However looking historically, we notice that the month-on-month retail spending number is highly oscillatory and not quite the indicator of good and bad times for the economy. The year-on-year number is much more interesting and shows easier-to-distinguish trends for us making gambling decisions by eyeballing charts using the fundamental and self-evident natural laws of technical analysis. We observe that on a year-on-year basis, the US consumer is consuming incrementally less but is still putting to good use the real wage growth we have observed previously. It will be important to monitor all the prior metrics in conjunction with this one to evaluate the health of the US consumer bearing in mind much of these indicators would be fundamentally backward-looking, so also understanding the interactions between these elements and extrapolating their likely path forward is key.

We are currently in a cycle of decreasing growth, positive real wage gains but at a decreasing pace, jobs being added to the economy but the quality of the jobs diminishing, and with spending keeping up but slowly relative to what is desired by our technocrats… Maybe a chance for the consumer to become a saver, but who am I kidding? Look at the next chart…

The American consumer has been building up a bad habit of saving less and less of their disposable income, now at a measly 3.4% creating less resilience in the long term to economic weakening. So my story above is not all daisies and roses and implies that the gamma on economic health is quite accentuated (if I may permit myself to make derivatives references and pretend to sound smart) and skewed to the downside. Now I can’t blindly blame the consumer for their saving habits, rising costs play a large role in the ability of individuals to save.

Now, what is the consumer without all his debt?

Before anything, it will be good to contextualize the composition of debt within a household. I’ll let the graphs speak for themselves. 

First looking at the quarterly debt service payment on disposable income, we see a very optimistic trend here. Despite higher rates, the share of disposable income eaten up by debt is at historical lows outside of the covid helicopter money period.

This implies that the effective debt burden of the American consumer is manageable historically speaking sitting at 7.8% of disposable income. Note that the numerator here includes scheduled interest and principal payments. Looking through to mortgage and consumer debt service individually we note that mortgage payments have a substantially smaller burden on the average consumer while consumer debt burden is substantial and represents 60% of the total burden. In a subsequent deeper dive into the consumer, we will break down the split between “social class” and the individual debt burden and look to understand the shape of this distribution between mortgage and consumer debt burden by economic status. What I expect to see is that consumer debt is skewed towards those in more difficult economic situations while mortgage debt is skewed towards those who are better off while reminding ourselves that mortgages allow for the creation of wealth while consumer debt does not have such a clear path towards creating equity. If that hypothesis is confirmed that poses a serious question as to the resiliency of the US economy. The overall picture however remains supportive of growth and wealth accretion broadly.

This picture of the debt service also helps explain delinquency trends diverging between mortgages and consumers. The divergence should be further explained by the hypothesis on economic status and the make of debt.  

We currently observe that mortgage delinquencies are stable at the 2.5% level which is a historic lower bound on the metric.

On the other hand consumer debt delinquencies have been on the rise, with the curious observation that credit card delinquencies are highly concentrated in small banks. This data point will come to be useful when we construct a long/short good and bad banks framework at a later stage.

 I would not posit that rising consumer delinquencies are excessively worrying at this point as we will need to study its distribution across different segments of the population but are certainly a sore thumb in the overall narrative and demonstrate a weakness in the overall economic picture.

The overall picture of the consumer landscape does not immediately point towards a recession and when we broach more explicitly its relation to growth, should see that growth scares are currently excellent opportunities to tactically enter equities at improved valuations within the sustained path upwards which I expect through the end of the year and potentially into next year barring any events carrying substantial entropy. 

In the next section, we will discuss growth specifically and inflation trends, and one key downside scenario to the economy, unless I change my mind and feel it timelier to write about something else. 

Cheers!

But anyway, the silliness of the markets aside… let’s look at what is actually going on with economic growth and chart a path forward with the hopes of generating some risk-adjusted gainzzzz. 

The Fed has generally maintained, before the Covid-stimulus an implied lower bound of 100bps of Fed Funds over CPI. This target should be expected to be a point of convergence maintained inflation continues to show signs of abating as long as economic growth remains positive. Real rates currently sit at a 2+% level which indicates the quantity of rate cuts that we can expect within this cycle.  If the economy starts a contraction, the Fed would have a reason to reduce that implied target spread but we are not there yet. It is important to appreciate the reaction function of the Fed toward setting the policy rate relative to inflation and growth. Given a growth rate, the policy rate will parallel shift along with inflation. Given fixed inflation, a reducing growth rate reduces the spread between the policy rate and inflation, this second relationship is harder to quantify (it is policy and not math after all) but remains directionally correct. It is this tension between growth and inflation that the market is implicitly extrapolating. In this primer, we will set the foundations of understanding the direction of growth and inflation starting with balance sheet-driven monetary policy and consumer health.

So… what are the components of economic growth indicating and what is the dispersion in signal between these indicators? Over the last few months, there has been a sprinkling of negative economic data which increases the number of paths to reach a recessionary environment. Quantifying or at least qualifying the probability that these paths come to fruition will be the exercise we need to perform independent of market reactions to position our portfolios over this cycle and tactically benefit from mispricing such as that of the great yen-carry-trade-unwind-Monday (mispricing is not quite the right word but will make a primer on carry trades and how clearing houses exacerbate their unwind later).

One question we will need to keep an eye on is how persistent will unemployment be. We have seen in history several 20bps+ print increases from the prior month which have not led to recessions, since 1967, 45% of such prints have not been in periods of recessions; a good chunk of those are in periods of broadly stable or decreasing unemployment. Now… not a very useful statistic to gamble our money on but gives us time to think about the components of growth and GDP.  

And yes, I have known about Sahm’s rule since last week when it became relevant but I like to KISS (Keep It Simple Stupid) and stick to first principles.

The monetary easing cycle has already started about a year ago with the Fed discreetly waving its balance sheet arm under our noses and providing a supportive environment to risk assets. This may seem somewhat counterintuitive given the Headline QT to combat inflation the Fed has been implementing to which continues albeit at a slower pace since June ($95bn to $60bn per month). The topline number for the Fed’s balance sheet is contracting peaking at $9tr in Aug 22 and now at $7.2tr, however the make of the Fed’s accounts has resulted in a net easing of financial conditions.

Let’s go through liquidity mechanics to appreciate the monetary easing taking place given the data today.  

The monetary base is composed of money held by the public and commercial banks while the treasury general account (TGA) and Reverse Repo Facility (RRP) reflect money held by the Fed. The monetary base provides a better picture of liquidity in the system as it is effectively high-velocity capital that is ready to be deployed for economic activity and investments. The dollars held at the Fed are removed from the financial system and do not provide liquidity to banks and by extension, are not in circulation and being used for economic activity. 

The amount of liquidity in the real economy or high-velocity money is principally affected by the interactions between QE/QT and the treasury’s debt issuance via the TGA. Headline QT is the process of letting UST's expire on the FED’s balance sheet and the proceeds not being reinvested. Here the treasury is paying the central bank from its TGA account which is held at the Fed and with sufficient outflows from the TGA, the treasury will be forced to issue more debt removing liquidity from public markets, hence tighter financial conditions. When the treasury issues debt funded onto its TGA account, that debt issuance can either be absorbed by the FED such as during the Covid stimulus which then circulated into the economy and adds liquidity by moving dollars into the monetary base/into the hands of the public, corporations and banks as the federal government spends this money raised by the FED or it can be absorbed by the public market reducing liquidity in financial markets, raising bond yields and gradually easing as the government deploys spending. QT on the UST’s can be visualized as a leak from the TGA onto the FED’s black hole which then needs to be filled with additional debt, this additional debt is money from the public which moves onto the FED’s low-velocity money balance sheet. The same process can be done with MBS directly targeting homeowners and therefore reducing cash on hand at commercial banks. 

The issue with QT and QE is that the magnitude of the impact on the economy is unknown especially since its impact can be altered by fiscal policy. With QE for example, there is a point where so much cash has been added to the system that rates on the short end go to zero and eventually flip negative. To solve the magnitude problem organically, the overnight reverse repo facility allows market participants to give money back to the Fed at a set award rate (since June 2021 moves in lockstep with rate hikes/cuts and was 0% prior) instead of absorbing lower yields. The RRP behaves like a sponge for excess liquidity and effectively reduces the quantity of dollars that would otherwise be circulating in the monetary base putting a floor on yields. By definition; the RRP has no credit risk and no duration risk; which implicitly targets money market funds that have a goal of being completely risk-free across duration and credit and redeemable at par. The RRP is by construction the best investment for MMF’s above Treasuries given an equal yield.  

During the easing cycle post covid, the RRP balance grew from 0 to $2.5tr from early 2021 to early 2023 and represented about 30% of the Fed’s balance sheet. This effectively absorbed the stimulus from QE during that period. On June 1’st 2023, through congressional wrangling, the debt ceiling was lifted (surprise surprise) to avoid a technical default and allowed the treasury to issue T-bills (short-term debt) and fill the gap left by COVID-19 stimulus in the TGA. Part of the reason for issuing T-bills in particular is to avoid locking in higher rates with longer duration given the anticipated rate cuts and maintaining stable long-duration yields. The constant supply of T-bills into the market caused yields on the short end to rise above the policy rate for the market to absorb the increased issuance. Due to the excess supply, the bond yield has stayed above the RRP award rate which created a draw away from the RRP by MMF’s adding to the volume of high-velocity money in the economy and raising liquidity in the system offsetting the tightening caused by QT and Treasury bond issuances to the public markets.  

The RRP now sits at a measly $400bn of balance. This mechanism of the RRP and its interaction with the TGA has effectively been supplying the market with a constant bid on T-bills away from the RRP, offsetting the liquidity drain from new treasury issuance in addition to QT. At the current rate of $60bn in tightening, the RRP has enough capital to keep the total Fed balance sheet constant and offset/funds QT for another 8 to 10 months. The RRP will only function as long as it is funded; as we approach it being emptied, the FED will be forced to reduce the speed of QT further or simply stop it to avoid subsequently reducing bank reserves. I expect this to be announced in tandem with the first anticipated rate cut in September. 

Another source of balance sheet easing we can expect to kick off in 2025 comes from the potential shrinking of the TGA balance which incidentally is also inflationary, hence the importance of having hedges across the various paths the economy can take. Taking the TGA balance out of the first plot in this section helps us appreciate the mechanics we can expect given the natural behavior for the TGA and what can be anticipated from the coming election results.

Currently, there is no debt ceiling on the national credit card until the start of next year, however, Supreme Leader Yellen dictated that she will maintain the same balance through this period. When the unlimited credit card runs out, the treasury will be obliged to eat into its cash reserves reducing the TGA and directly injecting liquidity into the real economy (and indirectly into the pockets of the elite with rising asset valuations). Neither Trump nor Kamala are keen on reducing spending, hence this process should be fairly speedy and supportive to asset prices in the first half of 2025. We can moreover predict the next haggling over the debt ceiling to happen in Q2 of 2025; should be fun TV! In the meantime Yellen will do her part to prop up the US economy by stimulating consumer spending, she probably singlehandedly helped raise retail sales by 1% above all estimates this glorious Aug 15th.

Furthermore, the regional bank crisis forced a rapid liquidity spurt into the banks through the term funding program, increasing cash assets and reducing leverage. This ameliorated the health of the banking sector stimulating the origination of credit at some ~2% annualized despite higher rates. This has been another source of effective easing in the economy.  

These effects have been broadly supportive of liquidity in the economy, the creation of credit, and by extension supportive of the cyclical valuation risk assets which are set to continue.

What is the net effect of all these shenanigans on the monetary base (M2)? We see through 2024, the circulating amount of money steadily increasing which reflects the net easing the economy has experienced during this period of monetary tightening.

Simultaneously we have also seen an acceleration of corporate credit originations and equity raises, a consequence of easier money circulating the economy.

Next post for part numero dos on the consumer

Cheers!

Now that we have seen the fires of Mount Doom in the shape of unemployment numbers ticking above expectations; the only rational thing to do is to ignore all other economic data, and cyclical mechanisms and press the panic sell button. Well… fine not quite what happened… The rates markets have been experts at overshooting to the upside and downside with every piece of economic data and this time may not be so different. On the back of the unemployment print last week (act 4.3% vs exp 4.1% vs prior 4.1%) preceded by manufacturing PMI (act 46.8 vs exp 48.5 vs prior 48.5) the market was prompt to price in a 50bps cut to the policy rate in September in addition to a 40% chance of an emergency rate cut; fearing the Fed had made a mistake of not cutting on the FOMC meeting before the economic numbers. Just that same week, everyone talked about Goldilocks on a rocket ship to the moon with steady 25bps cuts on the back of softer but positive economic data (well I was at least). This volte-face made the yield curve bull-steepen to the point of uninverting intraday. Not too long after; another volte-face to the volte-face: the ISM services PMI data materialized out of the rubble and turned out better than expected (act: 51.5, exp:51.0, prior:48.8) calming fears about a recession.

Clearly retail was a fan of this economic data given they bought the dip in droves on Monday averaging 1.8bn...

I’ll make one point around the market’s tactical positioning with the now common knowledge Yen carry trade (we also had the Russel funding short trade unwind not long ago) and avoid plagiarizing every newspaper on this earth. These positioning unwinds are expressions of leverage in the financial system and the start of a negative response to an economic print can provide a spiral that flushes out leverage from a trade and should not be confused with cyclical behaviors which investors can benefit from using a longer time horizon than market participants. This tactical unwind provided however a great opportunity to sell short-term vol for those who have the tapdancing shoes to do so. The materialization in a few trading days of a few months’ worth of yield rallies should provide for the expectation of a mean reversion and take profit on rates-driven trades with the expectation of a narrow rates selloff (relative to these daily black swan moves).

Although vol has considerably abated to the 25 handle from its highs, the bid on vol of vol is at the level seen at the start of Covid in addition to one-month equities implied correlation being at record levels. This implies a few things about how equities can reprice in the coming days.

1)      The VIX has a high likelihood of being bid, we have seen the start of that this Wednesday.

2)      If the VIX is bid, the speed at which the VIX would go back to highs can be equivalent to the price action we saw on Monday. This implies we need to be looking at wider ranges for equities to move within.

3)      Rapid price actions are skewed to the downside given the implied correlation between equities is at highs and the diversification by industry and sectors in portfolios will be muted in the coming days. This also implies that hedges using broad equity indices will be more effective.

4)      I would be long vol right now and focus on buying vol to hedge the downside in equities. Given the vol of vol, further out of the money puts on ES, NQ, and RTY provide the best risk-reward in the coming days (but hope they end up being sacrificed to the macro Gods)

I also expect a continued inverse correlation between equities and bonds to persist through the next few economic prints while we obtain clarity on the direction of growth and consider maintaining long bonds across durations (focus on ZT - 2y and ZN - 10y) currently as a hedge for the lazy equity longs.

I want to quickly mention an uncomfortable situation the central banks find themselves in due to this positional unwind which could change the current general trajectory of the cycle. The cheap Yen funding short was used by both Japanese and foreigners buying Mag 7 and Japanese equities respectively which caused the three assets to become highly correlated. All that was needed was for the expectation carry between USD and JPY to narrow at a faster pace than had been priced before the start of growth scare talks. For now I don't have an answer to how much has been flushed out, JPM claims 75% for now but we shall see. 

 Given the central banks do implicitly look at market volatility to guide their behavior, the FED would in part be incentivized to cut at a reduced pace than what the market is currently pricing in to stop the bleed on the USDJPY and calm the equity selloff. Now if the economic data continues skewing on the weaker side, the reduced speed of cuts to calm the USDJPY would be perceived as a policy error on the economy and accelerate recessionary concerns. In either of the two scenarios, equity valuations collapse either due to USDJPY funding short becoming more expensive and the leveraged players having to unwind or due to growth scares forcing the unwind of US equities and due to the linkage between the three asset classes the other two fall in tandem. Basically having to choose between being staked in the heart or burning at the stake. However, there is a path threading the needle between the two where economic data comes in supporting the continued growth thesis between now and FOMC where Goldilocks could be hiding after eating the bear’s porridge. But maybe she was already eaten...

One last guiding principle to help navigate the weeks ahead: "One Central Bank to rule them all, one Central Bank to find them, one Central Bank to bring them all, and in the uncertainty bind them"

In the next section, I want to focus on what this cycle has in store for those who can accommodate a longer time horizon than that expressed currently in the market and go into the probability-weighted paths for the US economy and liquidity. We will then go over portfolio composition with a focus on real assets (very long-dated futures or call options on metals and energy, namely oil) with uncorrelated returns to equities and bonds and equities that should outperform during a recession or be supported by fiscal stimulus (good thing both presidential candidates are experts in fiscal stimulus).

The initial macro thesis that was posed a few weeks ago was that we would see a gradual bull-steepening of US rates over the next few quarters while rate cuts start materializing into sustained but slower growth. This was clearly very wrong on timing but the mechanics driving that conclusion still apply today and can be worth revisiting. 

July 11:

July 24:

Cheers!