The Macro Compass

‘‘The most important rule of trading is to play great defense, not great offense.Every day I assume every position I have is wrong. I know where my stops are, and I do that so I can define my maximum drawdown.At the end of the day, the most important thing is how good you are at risk control.’’

Paul Tudor Jones, CEO of Tudor Investments

Different investors perceive and measure risk differently, but there is one common objective they all want to achieve: avoid making stupid mistakes.

For a long-term investor, the worst possible outcome is to experience big enough drawdowns whose magnitude far exceeds her risk tolerance and hence lead to the cardinal sin of them all: ‘‘panic-hit-the-sell-button’’.

This happens when investors assume correlations across asset classes will hold regardless of the macroeconomic regime we are in and/or size their positions without paying attention to the very diverse underlying volatility each asset class has.

In this article, we will:

* Discuss the strategic objective and the main risk management pillars a long-term investor should pursue, and why;

* Announce a couple of exciting news!

Risk Management Pillars for a Long-Term Investor

Actually, before we jump right in.

In an attempt to reduce my innate ‘‘boomer-ness’’, this week I am launching my Instagram profile (link here)!Expect plenty of macro charts and short video clips unpacking price action across asset classes.And when it comes to non-macro content, also expect a healthy dose of Southern Italian food pics and recipes! :)Jokes aside, if you use Instagram feel free to follow my work there too!

Now, back to it: whether you are a medium to long-term investor or a more short-term oriented trader, a healthy dose of systematic approach to risk management is key if you want to survive and possibly try to generate some decent returns, too.

Let’s look at a medium to long-term investor: what’s her objective in the first place?

Many decades ago, Ray Dalio explained how the holy grail for every long-term investor should be to find return-additive, yet not highly correlated assets to add to her portfolio.

You see, a long-term investor is paid to harvest risk premia: when you actively decide to provide funding or capital to a public entity (you buy government bonds) or to a private sector entity (e.g. you buy stocks), you are exposing yourself to several risks and therefore you will be demanding some sort of compensation.

There are several risk factors out there: credit, liquidity, growth, inflation, etc.And for all of those risks you are facing, your main form of compensation should be a long-term, inflation-adjusted positive total return for your investments.

Here is a 200+ years chart of total real returns for US stocks, bonds, gold and USD: it makes a lot of sense, doesn’t it?

But if on a long enough time horizon you can be relatively sure you will be compensated with positive real returns, why would a long-term investor need any systematic approach to risk management in the first place?

Easy: to avoid making stupid mistakes.

The most common being:

A) Assume correlations across asset classes will hold regardless of the macroeconomic regime we are in;

B) Which often contributes to big drawdowns, whose magnitude far exceeds the long-term investor risk tolerance and leads her to the cardinal sin of them all: ‘‘panic-hit-the-sell-button’’ and say goodbye to harvesting long-term risk premia.

How do you avoid these mistakes?

The Macro Compass can help you identifying which macroeconomic regime are we in and hence what to expect from asset classes returns and correlations.If you want to know how it works in details, check this article.

In today’s macro environment where the economic growth impulse is decelerating and Central Banks are tightening monetary policy more aggressively than expected and pushing risk-free real yields quickly above equilibrium levels, correlation regimes can swiftly change.

At the end of 2021 we moved to Quadrant 4, which sees risk assets’ correlations converging to 1: even the long-standing negative correlation between bonds and stocks doesn’t work anymore as the sharp tightening in monetary policy and hawkish forward guidance prevent bonds from rallying despite a decelerating economic growth impulse.

That led to the ''pain everywhere trade'': the 6-month rolling Sharpe ratio (returns in excess of risk-free rate adjusted for volatility) for a basket of S&P500, Treasuries, corporate bonds and gold reached the worst level seen in over 30 years!

Having a robust framework that helps you navigating different macro cycles and correlation regimes is hence important, and The Macro Compass can help you wit that.

But every long-term investor also has a different tolerance for the severity of portfolio drawdowns she is able to endure before making ‘‘stupid mistakes’’.

Yes, portfolio drawdowns are a function of how truly uncorrelated your holdings are but they are also a function of how big your positions are relative to their underlying volatility: even a well-diversified portfolio throughout different macroeconomic regimes can deliver sub-par returns if positions are not sized correctly.

And talking about position sizing and moves relative to the underlying asset class volatility, it’s now time to go into the details of one of the many macro tools I am going to share with The Macro Compass subscribers over the next months!

Some Exciting News!

Before we go into the details of how this tool works, I want to give you some context about what we are going to do over the next few months.

The Macro Compass is now a community of almost 50,000 macro enthusiasts and investors who are kind enough to follow my macro analysis and subsequent portfolio allocation ideas, and this overwhelming support gives me the motivation to further enhance the experience by providing you with some useful macro tools.

The main idea is to give you free access to hedge-fund-level market data and macro models - all filtered down to essential, understandable and interactive tools.

Here is what I have in mind, for starters:

* The Volatility-Adjusted Market Dashboard (VAMD): an interactive, cross-asset dashboard that provides you with an eye-catching overview of macro price action and highlights the biggest volatility-adjusted market movers on a given time horizon;

* The Position Sizing Tool (PST): aimed at more tactical investors or traders, the tool provides you with the right sizing to apply to a new trade given the historical and recent volatility in the underlying instrument, the % of AuM you want to put at risk and the correlation with other asset classes;

* The Macro Compass ETF-Only Portfolio (TMC Portfolio): an ETF-only portfolio for medium to long-term investors whose composition is informed by the Quadrant we sit in and the relative risk/return and correlation profile of several macro asset classes.

In case you have further suggestions or ideas, let me know!

But now, meet your new friend: The Volatility-Adjusted Market Dashboard (VAMD).

* What’s the rationale behind?

The VAMD shows real-time price development across macro asset classes and it color-codes the market moves by comparing the magnitude of the move against the asset class historical volatility using a rolling 5-year window.This way, you can have a quick visual of what’s moving, where and how significant is the volatility-adjusted move for any asset class in global macro land.

* Why a 5-years history?

Although a longer history would be preferable, 5 years allows for a good quality dataset across assets while ensuring different macro cycles and volatility regimes are captured too.

* How does the color-coding work?

The darker the tone, the more significant is the magnitude of the move against the rolling historical volatility in that particular asset class.Any move above 1 standard deviation starts to get highlighted with a slightly darker tone, with tonalities increasing as we move towards >2 sigma events.

* Help me with some of the jargon in the Rates section, Alf!

2s10s and 5s30s: yield curve …

This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit themacrocompass.substack.com

‘‘What we need to see is inflation coming down in a clear and convincing way, and we’re going to keep pushing until we see that: we clearly have still a job to do when it comes to cooling down demand’’

Jerome Powell, May 17th 2022

Powell’s remarks in the Wall Street Journal interview this week were quite interesting, and markets seem to have noticed: we have seen quite some wild moves, but again the most relevant price action is happening under the surface.

In such a choppy market environment, systematic risk management techniques and a data-driven investment approach are key to tell the forest from the trees and reduce drawdowns in your portfolio.

In this article, we will:

* Reflect on some interesting market moves happening under the surface;

* Discuss two of my macro ‘‘polar stars’’ indicators that can help us navigate and explain current market circumstances;

* Introduce for the first time my Volatility Adjusted Market Dashboard (VAMD), a tool I’ve been working on to further deliver value to The Macro Compass community.

The Macro ‘‘Polar Stars’’ Indicators

Actually, before we jump right in.Andreas Steno and I have been putting quite some effort to deliver the most fun and actionable macro investment podcast out there, and so far the response has been huge: almost 50.000 unique listeners per episode across platforms!

If you haven’t yet listened to The Macro Trading Floor podcast, this week is your chance: Andreas and I interviewed a very special guest and trust me, you don’t want to miss this! :)

Links here: Apple, Spotify, Google, YouTube.Please also consider subscribing to the show on your favorite podcast app so you don’t miss any new episodes, and help us spread the word if you like the podcast!

Back to it: Powell played the hawkish horn again, and markets are reacting in quite some interesting ways.

The three main lines from his interview were:

* ‘‘Financial conditions overall have tightened significantly. That’s what we need to see’’;

* ‘‘We need to see growth moving down from very high levels, and we clearly have still a job to do on cooling down demand’’;

* ‘‘If that involves moving past broadly understood measures of neutral rates (i.e. 2.00-2.50% on Fed Funds), we won't hesitate to do that’’.

You gotta admit he can’t be more straightforward than this.

The FOMC is totally comfortable (!) with financial conditions tightening, as we clearly still (!) have a job to do on cooling down demand and if that involves raising Fed Fund rates >2.50% we won’t hesitate (!) to do that as we need to see is inflation coming down in a clear and convincing way (!).

But now, why would I define market reactions as ‘‘interesting’’?We all see the consequent bloodbath in equity markets and it doesn’t strike as particularly surprising, right?

Well, here are a couple of interesting moves going on beneath the surface.

After a relentless move up, for the first time this year US implied real yields between 2027 and 2032 (5y5y forward) have experienced a remarkable drop.

But wait a second, I thought a tighter monetary policy stance would push real yields up via a combination of higher nominal rates (reflecting the new, hawkish stance) and lower inflation expectations (as markets expect Central Banks to be successful in this exercise)? Also if real yields are lower, shouldn’t that support risk assets?

Let me help you understand what’s going on.

Real yields are now responding to markets repricing demand down in a significant way: let’s have a look at commodities and GDP/earnings revisions for example.

Since the pandemic-related trough in 2020, Agricultural Commodities (Invesco DBA ETF, blue) and Industrial Commodities (copper, in orange) have basically moved up in sync: as the gargantuan amount of fiscal spending fed through the economy and supply bottlenecks were popping up, the demand/supply imbalance kept growing and supported price increases across the entire commodity space.

But now look at the divergence in that red box.

Over the last month copper - a bellwether metal for the global economy - has been hit with a 12% drawdown while Agricultural Commodities are trying to test new highs. The rather global-industrial-demand-driven commodities (orange) have started to show signs of weakness against the more supply-bottleneck-driven commodities (blue).

Additionally, credit spreads are kinda blowing up with US high-yield spreads having now exceeded the 2018 peak of 500-ish bps and they seem to be heading towards the 600 bps 2016-global-growth-scare level.

Alright, so this must be reflected in GDP and earnings forecasts too, right?

I mean, Wall Street analysts and us on The Macro Compass must be looking at similar screens and charts after all :)

Analyst consensus for the 2022 US real GDP growth has been consistently revised down this year and now sits at 2.7% - but still nicely above trend, though.

And while even big consumer staples companies (e.g. Walmart, Target) have missed their earnings per share target and have warned investors they could actually deliver negative (!) YoY EPS in 2022, analyst consensus for 2022 EPS growth for the companies listed in the S&P500 index still sits at +10%.

Yes, plus 10%.

So, while forward-looking markets are pricing in a slowdown in demand it seems analysts are still relatively relaxed about the end point - shall we be, too?

Some of my ‘‘polar stars’’ macro indicators disagree.

* Real yields are moving up for the wrong reasons, and they sit above long-term equilibrium levels = not good.

* Despite the sell-off, my equity risk premium metric says stocks are neither cheap nor expensive on a long-term basis and there seems to be more room to reprice further down.

Real yields can move up and down for good and bad reasons.

* Up for good reasons: cyclical economic growth is picking up, and there are some expectations that long-term structural growth might be increasing too (e.g. 2017-early 2018);

* Up for bad reasons: monetary policy is been tightened aggressively in an effort to cool things down, and cyclical economic growth isn’t that strong anymore (e.g. late 2018, early 2022);

* Down for good reasons: monetary policy is been eased strongly and economic growth has bottomed and now picking up (e.g. second half of 2020);

* Down for bad reasons: a major growth scare is coming and earnings/growth needs to be repriced down (e.g. 2016, perhaps now).

As we move back and forth between ‘‘up for bad reasons’’ and ‘‘down for bad reasons’’, my polar macro star indicator instead focuses on the observed real yields relative to long-term equilibrium real rates the economy can handle.

In the chart above I used 10y real rates to get a longer data history, but the main conclusion remains the same: when observed risk-free real yields (blue) either trade above equilibrium level (orange) for a prolonged period of time (red box) or they sharply reprice up in a short time frame (red arrow), s**t happens in markets.

Today, a blend of metrics I use to grasp US observed real yields is trading above equilibrium r* and - most importantly - the repricing from negative real rates to today’s positive and above-equilibrium levels has been extremely quick: not good.

But now, equity market valuations must be attractive after this repricing, right?

Not really.

Let me quickly introduce my simple gauge of Equity Risk Premium.

Investors always have a choice between allocating capital in a risk-free instrument or in risk assets - for which they expect to be compensated: hence, looking at S&P500 valuations in a silo makes little sense.Instead, the focus should be on what's the additional expected return one can generate on top of the risk-free real yield she can get from investing in US Treasuries.

The 12-month forward earnings yield allows me to discount expectations for future earnings growth and zoom in on the valuation side, which I compare to 5y5y real yields: why?

Large-cap companies generally have a decent pricing power. That allows them to incorporate most of the inflationary pressures into earnings without hugely affecting margins, which i…

This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit themacrocompass.substack.com

‘‘Nothing so weakens a government as inflation’’

John Kenneth Galbraith

The latest US inflation report was all but portraying a benign slowdown in inflationary pressures. On the contrary, the less distorted month-on-month measures showed a pickup in CPI and most importantly the composition of such inflationary pressures is quickly broadening towards the stickiest components of the CPI basket.

What many market commentators don’t fully appreciate is that a deceleration in inflationary pressures is not enough for the Fed to take the foot off the gas pedal: the momentum and the composition of such slowdown against the FOMC’s expectations will be the most important drivers behind the Fed’s reaction function in 2022.

In this brief article, we will:

* Look behind the curtain of the latest CPI report, and assess what happened to the momentum and the composition of inflationary pressures;

* Reflect on the ‘‘what if’’ question: what if inflationary pressures remain stickier than the Fed expects? How would their reaction function look like?

* Discuss what probability Mr. Market assigns to this ‘‘what if’’ scenario by having a deep look at the fixed income market.

Without further ado, let’s jump right in!

Let’s Look Behind The Curtain

Actually, before we jump right in.If you are interested in any kind of partnership, sponsorship, or in bespoke consulting services feel free to reach out at [email protected].

Back to it: the US CPI report which came out yesterday showed inflation is moving towards the stickier components in the basket and the pace of the slowdown might actually disappoint the Fed’s expectations.

While most of the headlines focused on ‘‘Core CPI slowed down to 6.2% YoY in April’’, a more nuanced look to the CPI report provides with some more interesting details that conflict with this simplistic thesis.

In particular:

* Month-on-month core inflation accelerated to 0.6%, beating all the 67 estimates in the Bloomberg economists’ survey;

* Core services prices rose at their fastest monthly pace (+0.7%) since 1990;

* For core inflation to slow towards 4% by year-end (Fed’s own expectation), the next 8 monthly prints need to come in below 0.15% against the realized average MoM print of 0.50% so far in 2022.

In the latest press conference, Powell was often referring to month-on-month inflation rather than the yearly change: I agree with him there, as the base effects from early 2021 can easily distort the YoY analysis - think about the crazy swings in used car prices for example.

Well, month-on-month core CPI accelerated to 0.6% and the composition of such acceleration doesn’t look friendly either for the Fed.

Inflationary pressures are moving from the pandemic-related supply and demand imbalances in durable goods (blue) to the stickier services categories (orange).The Fed’s delay in withdrawing accommodative policies has allowed inflation to seep into stickier services categories -- even as many goods prices are starting to decline.

What’s worse is that the pace of this pickup in core services prices is the fastest we’ve ever experienced in over 30 years - however you slice and dice it (MoM, YoY).

But what’s driving such a sharp acceleration in the sticky core services prices?

Apart from the big print in airline fares (+19% MoM) which contributed by about 0.1% to the upside surprise in core inflation, the lion share of the pickup came from shelter inflation.

The chart below shows the contribution of Owners’ Equivalent Rent & Rent of Primary Residence to the overall CPI prints over time: it’s quickly becoming a significant component of inflationary pressures.

As house prices dramatically increased and nominal disposable income levels were supported by the C-19 related fiscal transfers, measure of Owner’s Equivalent Rent started moving up (and more aggressively so after rent moratoria waned).

Here is another way to visualize the contribution to CPI over time:

The contribution from the volatile ‘‘used cars and trucks’’ (red line) and commodities (green) has been moving down while rent of shelter (white) has significantly gone up.

This explains why the Fed has been so adamant in engineering higher mortgage rates.It will inevitably slow demand for houses, which achieves two objectives at once for them: it slowly helps achieving the ‘‘reverse wealth effect’’ and it also lowers shelter inflation via second round effects.

The global real estate market is by far the biggest asset class in the world, and it hence represents a big contributor to the wealth effect we’ve experienced over the last 40 years: more leverage at cheaper borrowing costs = higher asset prices = to some extent, more buoyant attitude towards spending.By cooling down the housing market, the Fed is trying to reverse this wealth effect.

As they slowly work towards achieving this, with a lag also shelter inflation will slow down contributing to their objective to lower inflation.

But now, what could this mean for the Fed’s reaction function?And what does Mr. Market think of such ‘‘what if’’ scenario?

What If?

So, let’s entertain for a second the thought that inflation will slow down much less than the Fed expects and that the endpoint is going to be higher than 2% as price pressures broaden to the stickier categories as discussed.After all, for core inflation to slow to around 4% by year-end (Fed’s own estimates, see here), MoM prints need to slow down to around 0.15% from the current 0.6% and the year-to-date average of 0.50% - not a walk in the park.

How would the Fed have to react?

In one line: in a convex way, making sure to position themselves way ahead of the curve to send a very, very convincing signal to markets and consumers.

Over the last decade, we have been conditioned to think of Central Banks’ reaction functions in a linear fashion.Inflation (expectations) decelerate below 2%, Central Banks ease.Inflation (expectations) accelerate above 2%, Central Banks tighten (ok, that was rare).

Always in a proportional, measured way.

But when core inflation remains too high for too long, price pressures are broadening and inflation expectations are at risk of upside de-anchoring…f*ck the linear reactions.

Policymakers have a clear incentive scheme: keep inflation and inflation expectations around 2% and predictably adjust policy to get there.But when you dangerously move towards the tails and stay there for too long, your reaction becomes much more than proportional: the strongest asset for a Central Bank is their credibility and forward guidance, and you just can’t allow to compromise on those.

So, what’s the probability Mr. Market is assigning to a convex reaction from the Fed?

The easiest way to grasp this is to look at the what traders are pricing inflation (expectations) to be and the implied probability that Fed Funds rates will be much higher (say at 5%) in one year from now.

On the inflation front, while 1y inflation swaps are at 5% (!) here is how traders price in the inflation expectation forward curve by Jun-2023.

1y1y means inflation expectations for the Jun23-Jun24 period; 1y2y means inflation expectations for the Jun23-Jun25 period and so on.

So, strong average CPI prints over the next 12 months but then a downward sloping trend to levels below 3%: close to the ‘‘convex’’ point but with a friendly declining trend to ease policymakers’ minds.

The ‘‘what if’’ scenario in the inflation swap market is priced in with a medium-low probability.

When it comes to interest rates, we can easily assign a number to that probability by looking at the option market underlying the Eurodollar futures with expiry in Jun-23.

The chart above shows the payoff profile of a put spread on the Eurodollar Jun-23 future with strike as 95.25 and 95.00. Sounds complicated, but it’s not - bear with me.

By buying a bearish put spread with these strikes, you make money if th…

This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit themacrocompass.substack.com

‘‘The FOMC is not actively considering 75 bps hikes’’

Jerome Powell, May 4th 2022 Fed Meeting

How do you assess whether the outcome of a Central Bank meeting was hawkish or dovish? Simple: you look at the delivered outcome against the probability distribution which was priced in before the meeting.

It’s not an absolute but a relative assessment.

Yesterday, the Fed delivered a 50 bps rate hike and a balance sheet run-off schedule which closely met expectations but the press conference turned to surprise expectations on the dovish side - and it was a mistaken attempt at sounding dovish, in my opinion.

In this brief article, we will:

* Analyze the Fed decisions and the main highlights of the press conference

* Look at market pricing across asset classes pre and post meeting, and assess what happened

* Discuss what this Fed meeting means for your short and medium-term portfolio allocation

Without further ado, let’s jump right in!

I am Damn Serious about Inflation, Or Maybe Shall we say ‘‘Serious-ish’’?

Before we jump in, I want to share with you guys a lesson I learnt from my mentor.

’’Never proxy-trade; always trade the closest instrument to your underlying macro assumption as correlations can easily break!’’.I’ve noticed you are often looking for easy, direct ways to trade your projections on inflation or the chances of a recession but it might be you don’t have access to complex derivatives and hence end up being forced with imperfect proxy trades.

I recently came across Kalshi and they provide a great solution for that problem: they allow you to directly trade probabilistic economic and market outcomes without the hassle of complex derivatives product or leverage!For instance, you can buy "Yes" or "No" shares on markets such as "Will April inflation be higher than 0.4% MoM?". Pretty cool company, check them out!

Now, back to it.

Yesterday the Fed proceeded with the first 50 bps interest rate hike since more than 20 years.

Moreover, the Fed announced a time schedule and a pace for their balance sheet runoff (QT): the Fed balance sheet will drop by more than USD 500 billion in 2022 and if the pace is kept constant, by an additional USD 1.1 trillion in 2023 too.

This decision package roughly met expectations, but the proper fun was in the press conference.

The presser started with a strong and concise message to Americans: we understand inflation is squeezing you, but we have your back. We’ll get this under control asap.We are serious about inflation!

Powell then proceeded to paint a picture of how strong is the American economy and how tight is the US labor market: several times, he referred to the ratio between the big amount of job openings and the relatively small amount of unemployed people.

Here is the chart the Fed is looking at:

One note from my side is that while cyclically the labor market is indeed very tight, using this ratio ignores the fact that a large number (around 2 million) of the US workforce seems to have just left for good.

This makes the supply of available labor optically very tight, but a structurally shrinking participation rate doesn’t bode well at all for the long-term economic growth of a country.

Anyway, we had already heard this song from the Fed: the US economy is super strong and can take a proper amount of monetary policy tightening without much issues.Now, shall we talk about how much that is and hence the forward guidance?

Here is where we had the two dovish surprises of the press conference, if you ask me.

1. ‘‘The committee is not actively considering 75bps rate hikes at this stage’’

We are watching fixed income markets trying to test the Fed’s resolve since the beginning of 2022 by pricing incrementally higher December 2022 implied Fed Funds rates and higher terminal rates for the Fed hiking cycle.

This was the probability distribution for the Fed meeting in June pre and post press conference:

The probability of a 75bps rate hike (orange bar) moved down, although markets are still trying to push the Fed in that direction.

And this was the probability distribution for where Fed Funds are going to be in December pre and post press conference:

As you can see, the distribution moved to become centered around a Fed Fund rate at 2.75% by December (from 3% before) and the right tail became much thinner as the probability of Fed Funds rate above 3% almost disappeared.

By trying to truncate the right tail of the distribution, Powell attempted at removing some of the hawkish uncertainty in fixed income markets. This lowered implied volatility and encouraged investors to reload on their risk assets exposures: indeed, equities staged a strong rally while credit spreads tightened and the US Dollar depreciated against most other currencies.

But wait a second: stronger equities, tighter credit spreads, weaker US Dollar…this basically means looser financial conditions?! We thought the Fed was all after tighter financial conditions here!

2. ‘‘Assuming that economic and financial conditions evolve in line with expectations, there is a broad sense on the Committee that additional 50 basis point increases should be on the table at the next couple of meetings’’.

After truncating the hawkish right tail (75 bps hikes), Powell then moved on to validate the base case market pricing of multiple upcoming 50 bps hikes but he stressed out ‘‘assuming financial conditions evolve in line with expectations’’.

For reference, here is how the Goldman Sachs Financial Condition Index components moved from the 2nd half of March through the end of April:

April (grey and light blue bars) saw a sharp tightening in financial conditions mostly due to weaker equities and a strong trade-weighted US dollar.

Yesterday, Powell proceeded to first cut the hawkish right tail of the Fed Funds rates distribution and then told us the current bond market pricing is acceptable but only if financial conditions evolve ‘‘in line with expectations’’: it sounds to me as this was an attempt at sounding dovish and slow the pace of deterioration in risk sentiment.

Now, why do I believe this was a mistaken attempt?

Basically, markets will keep forcing Powell to choose between a gentle tightening of financial conditions and getting inflation (and expectations) firmly under control.

The more he tries to achieve both, the more he’ll let markets be in charge: if he winks at risk assets like yesterday, he gets a sharp loosening of financial conditions which goes against his very objective of slowing down demand and anchoring inflation expectations.

And indeed, 5y US inflation swaps went sharply up after yesterday’s FOMC: not what the Fed is hoping for.

In short, I believe Powell mistakenly attempted at sounding dovish yesterday and risked further credibility loss in his inflation fight - he can’t afford that to happen, and markets will keep on reminding him!

So, What About Your Portfolio Allocation?

While the Powell’s mistaken attempt might force a short-term risk asset rally similar to the one witnessed in the second half of March, medium-term my stance remains that risk assets can sustainably rally only if:

a) Things get much, much worse first.This means financial conditions drop to a point where companies lose access to credit markets, or the functioning of the Treasury or repo markets are seriously impaired, or equity markets drop to a point where the labor market starts being affected via second round effects. At that point, the Fed will need to reconsider things and ease financial conditions.

b) Inflation slows down faster than priced in forwards and expected by the Fed.Inflation peaking is not enough: as often, it’s all about moves relative to expectations.In order to allow the Fed to take the foot off the gas pedal, PCE needs to slow down even faster than their expectations (roughly 3% YoY PCE by year-end).If that happens, they can credibly step back and as bond markets sustainably reprice their hawkish expectati…

This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit themacrocompass.substack.com

‘‘Stability breeds instability because stability itself is destabilizing’’

Hyman Minsky

The main point behind the Financial Instability Hypothesis developed by Minsky was that artificial stability and low volatility generate complacency amongst economic agents and ultimately lead to suboptimal decisions: the seeds of the next crisis are sown in the good time.

Once economic agents are confident nothing can ever go wrong, borrowing happens on more and more relaxed terms until anybody qualifies for leverage without credible possibilities to produce enough cash flows to service their liabilities.And at some point, something breaks.

Credit spreads are an incredibly important variable to monitor if one wants to grasp at which stage of the leverage cycle we’re in: very narrow credit spreads imply borrowers have easy and abundant access to leverage while widening credit spreads are generally the canary in the coal mine for things to get worse for the private sector.

In this Bond Market 101 Series article, we will:

* Define credit spreads, and analyze what determines their price action;

* Dig deep into the buyers of credit spreads: what are their institutional and regulatory constraints, and why they matter;

* Look at the credit spread market today and discuss where to find relevant (and free) credit spread data to monitor.

Without further ado, let’s jump right in!

What are Credit Spreads, and Who’s Buying Those anyway?

Actually, before we jump right in.If you are reading this piece, there is a good chance you like macro newsletters - the question is: where do I find them, and in particular the good ones?The guys at Harkster have done a fantastic job creating this free app that allows you to track and find finance newsletters - super handy to use, highly recommended!Go and check out which macro newsletters I’m reading myself - there is some great content out there!

Back to it: in this previous Bond Market 101 Series piece we discussed the below decomposition of bond yields and in particular the risk-free rate (OIS) and the meaning of various yield curve shapes.

Today, we are going to focus on credit spreads - yes, we are leaving that weird animal called ‘‘asset swaps’’ for last.

Credit spreads can be defined as the additional yield over risk-free government bonds demanded by lenders to compensate for the credit risk (default risk) of the borrower.

Let’s take the US and Europe as examples.

In the US, you can lend to the government (buy risk-free US Treasuries) or to private sector economic agents which bear a certain risk of default: you can purchase investment grade or junk corporate bonds, mortgage-backed securities etc. For instance, US companies rated below BBB- (investment grade) have to face on average more than 400 bps additional cost vis-à-vis the US government to borrow for a 5 year period. In Europe, that’s around 450 bps.

Those are credit spreads investors demand to be rewarded for lending to risky business rather than buying risk-free government bonds.

Ok, so far so good but things get interesting now: let’s move to Germany for a second.

The German government-owned development bank Kreditanstalt für Wiederaufbau (KFW) provides funds for housing, environmental protection and to German small and medium enterprises on behalf of the government.

Germany issued a direct and unlimited statutory guarantee that covers all of KfW's liabilities - basically, KFW bears no additional credit risk compared to the German government as its liabilities are explicitly and fully guaranteed by Germany.It’s indeed rated AAA as the German government is.

And still:

What the heck, Alf? No real credit risk, even the same AAA rating and still KFW bonds bear a 30-40 bps credit spread over German government bonds?

That’s because credit spreads don’t necessarily reflect only credit risk, but also regulatory and institutional constraints the big-whale bond buyers have to adhere to when purchasing fixed income instruments.

Who are the big whales? Mostly bank treasuries, Central Banks’ FX reserve managers and pension funds: today, we’ll have a deep look at the first two.

After the Great Financial Crisis, regulators woke up to the fact that commercial banks weren’t owning enough liquid assets on their balance sheet.

Hence, they introduced the Liquidity Coverage Ratio (LCR): banks must always have enough High Quality Liquid Assets (HQLA) to meet deposit outflows in a stressed scenario.

This effectively means that 10-15% of banks’ balance sheet has to be invested in HQLA assets. Do you want to know how big that is?

Summing Europe and the US, that’s roughly $10 trillion chasing HQLA assets.And guess what?

Not only risk-free government bonds, but also some credit risk bearing fixed income instruments are considered as High Quality Liquid Asset: here is how it works.

If you purchase a government bond or keep bank reserves at your domestic Central Bank, you face no liquidity haircut: $100 million US Treasuries = $100 million HQLA in your LCR calculation.

If instead you want to purchase some nicely AA-AAA rated corporate bonds, your liquidity haircut will be 15%: for every $100 million you purchase, you’ll get $85 million counted for HQLA purposes.If you move down the rating ladder, the liquidity haircut will grow to 50%.Go to junk bonds, and they just won’t count for the regulatory-binding LCR ratio.

Can you see the point?

A simple downgrade from AA- to A+ increases the liquidity haircut for banks from 15% to 50%, and hence affects the decision making of this big group of marginal buyer of credit spreads way beyond the mere credit risk considerations.

Ok, but KFW bonds still face no liquidity haircuts: those are issued by a government guaranteed development bank, so how come they offer 35-40 bps credit spreads? In this case, the institutional constraint is not regulation but liquidity.

Which brings us to the next group of big-whale buyers.

When an oil producing nation exports oil to Europe or the US, they get paid in EUR or USD. As this process continues, the country accumulates foreign currency that is very often invested in foreign reserve assets to generate returns.

As you can imagine, these investments have to be very liquid such that the oil-exporting nation can sell FX reserves to support the domestic currency or meet external foreign currency obligations at any point in time.

Wondering how big is the global pool of FX reserves: about $13 trillion.

Very often, Central Banks set their investment risk policy for FX reserves pretty tight: for instance, both the Bank of Israel (here, page 34) and the Swiss National Bank (here) do not allow any purchases of bonds whose issuer is rated below BBB-.

More importantly, they will also set maximum investment thresholds for bonds considered to be less liquid than government bonds - very often, this is determined looking at bid/ask spreads, the size of the bond market and the liquidity of the underlying repo market.

That helps explaining why a AAA-rated, fully government guaranteed entity like KFW bears 35-40 bps credit spreads: the sizes of its repo and bond markets are much smaller and less liquid than Bunds, which means big whales demand a premium (credit spread) that has nothing to do with the inherent credit risk.

Credit spreads are obviously affected by the degree of borrower’s creditworthiness, but as you can see the regulatory and institutional constraints affecting the decision making progress of huge fixed income buyers play an important role too.

Conclusions and market data

The main takeaway here is that while often credit spreads reflect underlying credit risks, regulatory and liquidity constraints affecting the big-whale marginal buyers play an important role.

A bond issued by a government-guaranteed institution can trade at a significant credit spread even if it inherently bears no additional credit risk vis-à-vis the government: a smaller bond market with wider bid/ask spreads and a less liquid repo mar…

This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit themacrocompass.substack.com

‘‘We're in a brave new world of excesses in fiscal and monetary policy, and that's where the bond vigilantes thrive’’

Ed Yardeni

In the ‘80s, independent economist Yardeni coined the term ‘‘bond vigilantes’’ to refer to fixed income investors disciplining authorities for running inflationary fiscal and monetary policies and ultimately restoring order through the bond market.

In 2022, we are witnessing the first preliminary signs of the return of the global macro vigilantes. Amongst others, George Soros is an eminent member of this selected group of macro investors who challenge policymakers across countries and relentlessly chase regime-change narratives once they see a good opportunity.

In this brief article, we will:

* Go through some of the ‘‘macro vigilantes’’ price action going on in global macro, and assess to which extent markets are incorporating any meaningful probability of regime changes across asset classes;

* Announce an exciting news!

Without further ado, let’s jump right in!

Quite some price action in global macro!

Actually, before we jump right in.If you are interested in any kind of partnership, sponsorship, or in bespoke consulting services feel free to reach out at [email protected].

Back to it: there are some quite interesting moves going on in global macro I’d like to shed some light on, so let’s get into it!

* Inflation expectations are talking loudly, while the bond market is whispering

The distribution of market-implied inflation expectations over the next 5 years keeps on moving dangerously to the right.Investors now expect US CPI to average 3.5% over the next 5 years, way above the Federal Reserve target.

What’s more impressive is that investors assign the same probability to these outcomes unfolding over the next 5 years:

* The Fed will be able to get inflation back to their symmetric 2% target

* Inflation will print on average above 5%!

Yes, I had to read it twice to check it was true too.

But wait a second, Alf: it seems like the macro vigilantes are back when it comes to short-term inflation expectations, but are we anywhere near pricing a regime change in the bond market?

No.

The chart below shows how the market-implied terminal rate for the current Fed hiking cycle is still below 3%, roundabout where it was trading in 2018.But back then we had CPI at 2% and inflation expectations stuck around the same level with very thin tails - very few investors were pricing inflation to print above 3%, let alone any higher.

Markets are therefore pricing in a relatively benign scenario where Central Banks proceed with a decent dose of monetary policy tightening and they are happy to see inflation only slowly (very slowly) converging back to their targets.

If you really believe inflationary pressures are not going to slow down at the pace predicted by policymakers and you assign a meaningful probability to a regime-shift there, as a macro vigilante you can’t be happy with US 2y bond yields at 2.32%.

In other words, after making sure inflation expectations reflect a partial regime-change macro vigilantes might decide to seriously challenge the benign assumptions Central Banks and bond markets are using to form their base case today.

Watch out in this space.

2. The Japanese Yen is on the move, and it matters!

The JPY depreciated 10% against other developed market currencies over the last month, which is quite a move in the FX space.

The Bank of Japan has been relentlessly defending the 25 bps yield cap on the domestic 10-year government bonds, and therefore signaling their monetary policy stance isn’t going to move much (or at all) to the hawkish side - quite in stark contrast with all their Central Bank peers.

As interest rates differentials keep increasing (higher rates in EUR, USD etc. versus unchanged in Japan), JPY/xxx keeps depreciating.But are the macro vigilantes doing the hard work already, or just peeking into this?

Despite the sharp move over the last month, option-derived implied annualized volatility in USD/JPY for the next year still stands below 9%.

This level is still consistent with periods of aligned monetary policy stances across the globe (2003-2007, 2019, 2021) rather than periods of uncertainty and divergence.Also here, the macro vigilantes are just waking up from their long sleep but they are not yet doing the heavy lifting.

But why does Japan matter, anyway?

Since the 1980s, Japan has been one of the biggest exporters of capital in the world: an ageing population with high propensity to save and a lack of domestic investment opportunities have led Japan to invest large sum of capital abroad, especially in foreign fixed income markets.

Here is what they see when looking at foreign fixed income opportunities.

The chart above shows US and French 10y government bond yields after FX hedging costs (for 1 year) versus 10y Japanese bond yields: effectively, it measures what would be the opportunity-cost for a Japanese investor to embark in a foreign bond investment rather than just buying the domestic government bonds.

European government bond yields (France 10y, right side) look much more attractive now than US Treasury yields after FX hedging costs for Japanese investors, but the situation was different in 2021 or 2014. This is relevant, as ultimately interest rate differentials and FX hedging costs drive Japanese investors’ flow and Japan is amongst the largest worldwide capital exporters.

When it comes to Japan, macro vigilantes have woken up but if you think we’re heading for more uncertain times and divergent monetary policy path there is still plenty to look for in this space!

3. Commodities are rallying! Wait a second, though…

You must have heard about the upcoming commodity super-cycle, and price action in this space has been validating this thesis…hasn’t it?

Well, spot prices of several commodities have accelerated sharply over the last few quarters but long-dated futures haven’t really moved to the same extent.This has led 21 out of the 28 commodities tracked by Bloomberg into backwardation, a phenomenon occurring when the spot price of an asset is higher than prices trading in the long-dated futures market as a result of a strong and temporary demand/supply imbalance which is expected to fade away as time goes by.

For instance, the May 2025 Copper future is trading at $468/lb while May 2022 Copper is trading at $472/lb. Same goes for the May 2025 WTI Crude future, which is trading at $77 against spot prices above $100: so much for the commodity super-cycle.

If you believe a long-term structural transition towards a marked demand/supply imbalance in commodities is coming, once you look under the hood you realize that the macro vigilantes have barely started to do their homework.

In markets, it’s always crucial to think in probabilistic scenarios and assess your base case against what’s priced in markets across the board.

While we keep hearing about regime-change narratives and price action seems to validate some, a deeper look into global macro asset classes reveals the base case priced in remains this is all going to be ‘‘transitory’’.

If you have a different base case, there are plenty of regime-change, macro vigilantes trades out there - as always, I’d make sure to look for skewed risk/reward trades and size positions according to the underlying volatility of the asset class and my risk tolerance.

Said that, in May I am going to publish my medium/long-term macro ETF portfolio and therefore looking for inspiration from The Macro Compass community: what good risk/reward macro trades do you like here?

And as we are talking about macro investment ideas, it’s time to share the big news!

The Macro Trading Floor podcast is here!

I am very happy to announce my buddy Andreas Steno Larsen and myself are finally…

This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit themacrocompass.substack.com

‘‘There are no gurus. There are only cycles.’’

Michael Gayed

The money printer is out of order in 2022.

Actually, we are even looking at BRRRR in reverse: the flow of credit reaching the private sector continues to materially slow down, as indicated by my G5 Credit Impulse metric.

On top of it, inflation is roaring its ugly head and Central Bankers are committed to turning monetary policy into explicitly restrictive territory as fast as possible.

When the flow of credit slows down and policymakers double down by pushing monetary policy into restrictive territory, you don’t play offense with your portfolio.You play defense.

In this article, we will:

* Update my main macro models, and discuss what are they telling us;

* Look at the risk/reward profile of different asset classes going into Q2.

Without further ado, let’s jump right in!

A Tough Macro Cycle Ahead

Actually, before we jump right in.If you are interested in any kind of partnership, sponsorship, or in bespoke consulting services feel free to reach out at [email protected].

Back to it: my updated macro models continue to indicate we are looking at a challenging macro cycle, and that playing defense with your portfolio is the way to go.

Let’s see where we stand for a second: this is how different macro asset classes performed throughout Q1 2022 (total returns, in USD).

Effectively, all asset classes delivered negative (inflation-adjusted) returns except for certain commodities and commodity exporting countries: a challenging environment for a diversified, long-only investor.

Alright, what next though? Let’s update my main macro models.

My investment thesis relies on several inputs, but my ‘‘polar stars’’ macro indicators are two: the G5 Credit Impulse as % of GDP and the implied monetary policy stance relative to a neutral setting (r*).Charted together in a 4-Quadrant setup, they constitute The Macro Compass.

I will quickly cover the methodology here, but for further info see this piece.

The G5 Credit Impulse captures the pace of change of the flow of credit to the real economy. It tells you whether the private sector is receiving credit at an accelerating or decelerating pace.

Credit creation is the process of creating spendable money out of thin air that reaches the real economy and could be used to increase nominal economic activity. Governments create new spendable money for the private sector every time they incur in budget deficits (stimulus checks, tax cuts etc.) and commercial banks create new spendable money every time they extend a new loan to the private sector.Central Banks don’t print spendable forms of money.

If the real economy was inundated with credit at any given point in time, give it a few months and you’ll see growth (and inflation) pick up. Do the opposite, and it will cool off quickly.

Credit creation is the real BRRRR.

After the largest ever credit creation in the shortest amount of time in 2020-early 2021, we are now witnessing one of the sharpest deceleration in credit creation over the last few decades.

Analysts still expect earnings for the companies in the S&P500 index to grow at 9% this year, but my model suggests this is too optimistic.When I overlay PMIs or GDP growth on this metric, the same conclusion stands: economic activity will sharply decelerate going forward, and consensus expectations are still too high across the board.

My second polar star macro metric is the implied monetary policy stance relative to a neutral setting (r*): both the absolute difference and the pace of change matter here.

The implied monetary policy stance is calculated using a blend of metrics, but for the sake of time we’ll focus on the market-implied terminal rate and only look at the US.The US real terminal rate is the highest level Fed Funds can reach in the upcoming hiking cycle as priced in by fixed income markets, minus the inflation target (2%).

We will compare this market-implied metric with the “natural” rate of interest, or r-star (r*), which is the inflation-adjusted interest rate that is consistent with full use of economic resources and steady inflation. When the prevailing real interest rate in the economy is around r*, the economy runs at its potential rate without excessively under or overheating.

Currently, fixed income markets price the terminal Fed Funds just shy of 3% and hence the inflation-adjusted version at around 1%.My estimate for the US neutral real rate r* is around 0%.

This means the relative monetary policy stance is expected to become restrictive, which is a rare phenomenon since 2015: last time this happened was in Q32018, with risk assets suffering a severe drawdown in Q42018 and the economy decelerating for several quarters.

On top of the expected restrictive monetary policy, the pace of change from a very accommodative setting in 2021 is expected to be very rapid: that matters too, as the private sector struggles to quickly adjust to increased (real) borrowing costs.

Here is a chart showing the pace of the Fed hiking cycles since 1994: the 2022-2023 cycle is priced to be amongst the quickest despite structural headwinds have arguably worsened over the last few decades (e.g. ageing demographics, unproductive debt).

Also, the private sector will be required to absorb an increasing amount of collateral: both the Fed (QT) and the ECB (TLTRO repayments) balance sheets will shrink in 2022-2023 while governments are expected to incur in net deficits.Even if net government borrowing will materially slow down compared to the fiscal deficit frenzy seen in 2020-early 2021, the private sector will be required to onboard more collateral…with less reserves.

As a result, risk appetite and portfolio allocation preferences are likely to shift more defensive as a result.

Where does that leave us in The Macro Compass quadrant model?

We are now sitting in the defensive Quadrant 4, with occasional glimpses into the secular Quadrant 1 if and when certain conditions realize.

The Macro Compass embeds both my polar stars macro metrics and determines a big picture macro allocation according to the prevailing Quadrant.As shown before, credit creation is sharply decelerating (hence we end in the left side of the Compass) and the relative monetary policy stance is expected to become restrictive and at a quick pace (hence we end in the bottom side of the Compass).

The prevailing Quadrant is hence the conservative Quadrant 4, which suggests a more defensive asset allocation.

If and when the economy slows down enough and the expected pace and extent of monetary tightening subsidizes, the Macro Compass might suggest re-entering risk positions in ‘‘secular assets’’ later this year.

Finally, a word of caution: The Macro Compass is not intended to be used as THE single macro model behind asset allocation and portfolio construction.

One of the main limitations of such an approach is that the Compass is mostly a demand-related macro indicator and it doesn’t take the supply side of the equation into account: for instance, even if the credit impulse is slowing and Central Banks are going quick into restrictive territory, the world is going to have a sticky demand for certain commodities.

What happens to the price of these commodities whose demand is sticky, and whose supply is strongly impaired? For instance as China is completely shutting down entire cities?

Conclusion: Asset Allocation in Q2

The flow of credit reaching the private sector continues to materially slow down, as indicated by my G5 Credit Impulse metric.

On top of it, inflation is roaring its ugly head and Central Bankers are committed in turning monetary policy into explicitly restrictive territory a…

This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit themacrocompass.substack.com

‘‘I said that we needed to shift the focus to improving the quality and returns of economic growth, to promoting sustained and healthy economic development, and to pursuing genuine rather than inflated GDP growth and achieving high-quality, efficient, and sustainable development.’’

Xi Jinping, July 2021

China is supposed to become the largest economy in the world over the next decade, and yet it still looks like a black box to many.

By many metrics, investors are still under-allocated to Chinese exposure but arguably there are structural reasons why that’s the case.

So, how does China fit in a global macro portfolio?

In this article, we will shed some lights on China and discuss:

* The future of the Chinese cheap-labor and export-based business model, and Xi’s attempts to transition to a new ‘‘common prosperity’’ model;

* Whether China is an attractive global macro investment on a medium-term horizon, and why.

Without further ado, let’s jump right in!

How did China get here, and what’s next?

Actually, before we jump right in.If you are interested in any kind of partnership, sponsorship, or in bespoke consulting services feel free to reach out at [email protected].

Back to it: China has quickly become a global powerhouse.Over the last 20 years, the Chinese share of global exports of goods has jumped from 7% to 18%!

But how the heck did they get here and what’s next?

There are 2 sources of growth: structural and cyclical.Structural, long-term potential growth is mostly driven by the growth in the labor force and total factor productivity trends.Cyclical growth trends are instead mostly dictated by credit cycles: lever up an economy and you’ll give it a temporary boost, de-lever it and it’s going to be painful.

Over the last decades, China has engineered a tremendous cocktail of both structural and cyclical growth. Let’s see why, and what’s next.

A) In the last 40 years, Chinese working age population grew from 600 million to >1 billion. That’s a whopping 67% increase (!) in the amount of people that could actively contribute to economic growth. It’s huge!

As long as you can keep the employment figures on the right track, such a demographics boost is a massive tailwind to structural growth.(By the way, the chart is from the fantastic Andreas Steno Larsen: must follow on Twitter here and subscribe to his free newsletter here).But what about future demographics trend?

As you can see, the lagged effect of the one-child policy and the widespread population ageing will take a big toll on the Chinese working-age population over the next decades: in the United Nations medium fertility scenario, the Chinese workforce will shrink from >1 billion now to around 700 million by 2065.Ouch!

B) Productivity trends have been very favorable especially until 2011, although they have started to stagnate over the last decade.

The chart above shows the estimated Chinese total factor productivity (log-scale) over the last 20 years.Especially in the early 2000s, as China joined WTO and applied several reforms to reduce external trade and internal migration barriers productivity picked up very strongly (+22% between 2003 and 2011 alone!).

What next, though?

Productivity trends seem to have stagnated a bit over the last decade: WTO tailwinds are behind us and the creation and rapid growth of young Chinese private firms has slowed down. Large-scale and socially ‘‘painful’’ structural reforms would be needed to boost productivity growth going forward.

Effectively, a combination of strong demographics and productivity tailwinds markedly increased Chinese long-run potential (and delivered) GDP growth over the last few decades.But looking ahead, the structural long-term GDP growth drivers face strong headwinds: the Chinese working-age population is set to materially shrink and total factor productivity growth has lost some steam.

What about cyclical growth drivers?

C) As highlighted, since the early 2010s both demographics and productivity growth started to slow down and so China decided to aggressively overlay cyclical growth with an unprecedented amount of credit expansion in a short period of time.

The chart below shows the total debt (government debt plus the often overlooked private sector debt) as a % of GDP in China against US and EU.

Notice how China took only 10 years (2011-2021) to lever up its entire economy from 170% to almost 300% of GDP.It took the US and Europe about 30-40 years to achieve the same credit expansion.

Effectively, when structural growth drivers peaked China resorted to large-scale credit creation to boost cyclical growth.

Debt isn’t bad per se: it’s the long-term productivity of newly created credit that determines whether levering up the economy was a profitable exercise or not.So where did all these Chinese credit creation end up?

Mostly in the private sector: Chinese corporates and households took on large amounts of leverage between 2000 and 2020. Explicit government debt in China isn’t nearly as large as in Western democracies. Why is that the case?

That’s because China has an almost unique feature amongst G10 economies: it can direct credit in almost whatever size, at whatever speed to whatever economic sector they deem fit at any point in time.This is known as ‘‘(credit) window guidance’’.

The credit window guidance was applied in Japan between the ‘70s and the ‘90s and it’s one of the primary drivers behind the creation of the ‘‘bubble economy’’ of the ‘80s. It consists of a model whereby the central bank would impose bank credit growth quotas on the commercial banks. Nowadays, China applies a similar model: large, timed and targeted credit injections towards certain sectors via (shadow and commercial) bank lending.

The sheer size of this credit creation over the last decade has led to several asset-prices inflation episodes (primarily in the real estate sector) and to a widening wealth inequality gap: according to Guo Shuqing, the head of the China Banking and Insurance Regulatory Commission (CBIRC), property-related loans were equal to about two thirds of China’s GDP!

What about sustainable common prosperity?!

And indeed, Xi has noticed and things are changing.

The ‘‘new’’ common prosperity and China as a global macro investment

In his famous Qiushi essay in 2021, Xi stressed out that “genuine growth” (as opposed to what he called “fictional growth”) cannot generate enough economic activity to allow China to hit its GDP growth targets: he is well aware of the weakening trend in the Chinese structural GDP growth drivers.

So, what’s the new plan for the Chinese common prosperity?

Reforms.

In 2021, Xi made already clear that the exuberant spirits and ‘‘fictional growth’’ in the tech and real estate sector needed to be curbed (e.g. tech IPO clampdown, the Evergrande saga etc) and resources should be rather allocated to new sources of ‘‘genuine growth’’.

His ambition is to transition the Chinese economy business model from an export-oriented, cheap labor and surplus running country into a domestic demand powered economy that preserves its prominent position as a global exporter.Well, easier said than done!

In China, private consumption represents only 35% of GDP against 70% in the US and 55% in Germany.

Plenty of room to catch up though, right? In principle, yes.

But in order to boost consumer demand, a larger proportion of economic value-added needs to be redistributed to workers via higher real wages.But it’s exactly low real wages that have helped China boost its status as a global exporter, and so this transition might prove to be difficult to engineer.

Nevertheless, China holds two competitive advantages:

* Xi doesn’t really face a political cycle, and hence he can implement ‘‘painful’’ but useful reforms in a much more effective way vis-à…

This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit themacrocompass.substack.com

‘‘My early blackjack career taught me several things. The first is that if you apply yourself with a lot of hard work and mathematical prowess you can beat the system.’’

Bill Gross

Understanding the bond market is paramount important to achieve that clear macro big picture most investors strive for when designing their investment portfolios: the Bond Market 101 Series is my best attempt to help you unpack and navigate fixed income markets, in plain English.

This is the third article of my Bond Market 101 Series. You can find the first two pieces here (general intro) and here (breakdown of nominal yields into real yields and inflation expectations).

Today, we will answer the following questions:

* Risk-free rates and Overnight Index Swaps (OIS): what are they, and why do they matter?

* Should you look at the Treasury yield curve or the OIS curve shape? And which tenors should you focus on, and why?

Also, I will share with you a website where you can find live quotes for an instrument that can be considered a good proxy for the OIS curve!

Without further ado, let’s jump right in!

Treasury curve? OIS curve? 2s10s? 5s30s? Help!

Actually, before we jump right in. If you’re struggling to keep up with all the good macro newsletters out there, I get you.But the guys at Harkster.com have a handy solution: they created a fantastic, free newsletter aggregator that allows you to keep track of the ones you like, and find brand new ones to read.I am using Harkster myself: you can even check out which newsletters I am reading!

Back to it: today, we will start digging into this bond yield decomposition:

In particular, we will focus on breaking government bond yields into a risk-free rate component and an asset swap spread.

I will use Treasuries to show how it works and why it is important, but this is applicable to basically any government bond out there.

In our monetary system, the closest proxy of a credit-risk-free investment would be parking cash overnight in local currency at your domestic Central Bank.

Central Banks are public institutions mandated and backed by governments to primarily make sure commercial banks can smoothly settle payments against each other’s at the end of the day. They are also in charge of setting monetary policy to achieve price stability, but that’s irrelevant if the interbank payment system is impaired.

Effectively, placing money at a Central Bank would be tantamount to an overnight deposit at the government-backed clearing house for all commercial banks.

Alright, this sounds pretty much credit-risk-free.

But can I compare a 10-year Treasury yield to an overnight Central Bank deposit rate? No.

And do we know in advance what will be the overnight Central Bank deposit rate for every day over the next 10 years? Also not.

So, is there a ‘‘yield curve’’ that reflects the term structure of overnight Central Bank deposit rates over time?

Yes: the Overnight Index Swap (OIS) curve.

The 10-year US OIS rate for instance reflects market-implied expectations for the Federal Fund rate overnight path over the next 10 years.That’s because a 10-year Overnight Index Swap contract implies a counterparty agreeing today to receive a fixed 10y rate and in exchange committing to pay overnight the prevailing Federal Fund rate for the next 10 years.

Today, market participants are finding a clearing price for a 10-year US OIS trade at 2%: roughly, it means the market-neutral expectation is for Fed Funds rate to ‘‘average’’ around 2% for the next decade (I know, discounting matters; but please allow me this simplification for now).

So, assuming you had a bank account directly at the Fed your 10y credit-risk-free investment would be expected to yield roughly 2% per year.

Before we touch upon the difference between OIS rates and Treasury bond yields, a quick word on the shape of the US OIS curve and why it matters.

If you haven’t read it here few months ago already (sometimes I get it right!), you must have recently heard that ‘‘curves are inverting’’ - everybody talks about the Treasury yield curve, but what are OIS curves telling us and which tenors to use?

The chart above shows three often-mentioned curve shapes:

* 30y vs 5y (blue);

* 10y vs 2y (orange);

* 10y vs 3m (grey, dotted line).

As you can see, both the 30y vs 5y and 10y vs 2y OIS curve shapes are basically trading at 0 bps today - actually, the 5s30s curve has inverted a few times already since February.

The 10y vs 3m curve on the other hand is trading way off inversion and it’s actually even steepening.

How come, and which one to focus on?

Curve inversions are relevant because they signal borrowing conditions for the real economy agents are getting too tight (higher front-end yields) against the equilibrium borrowing rate they can afford given their structural capacity to generate earnings to service their liabilities: these drivers are instead reflected in long-end rates.

10-30 years is considered to be a long enough time horizon for structural factors to have an impact on potential GDP growth and long-term inflationary pressures: changes in demographics, productivity, technological trends, debt levels and other structural drivers are therefore reflected in long-end rates.

I marked the US 30-year bond yield chart below for all the most famous ‘‘regime changes’’ narratives which have populated headlines since the ‘90s: the most recent being the 2010 ‘‘QE = hyperinflation’’, the 2013 ‘‘taper tantrum’’ and the 2018 ‘‘bond yields will go to 5%+ again’’.

In reality, long-end bond yields never really departed from their secular downward trend whose drivers are (mostly) listed above.

But what’s the time horizon instead for ‘‘short-term’’ monetary policy conditions?

The most recent hiking cycles have lasted on average around 2-5 years (1986-1989, 1994-2000, 2004-2007, 2015-2019) and traders’ expectations are therefore reflected in 2 to 5 years OIS rates. 3 months OIS rates are not a good indicator as they fail to incorporate the average length of a reasonable hiking cycle, and therefore can only move up once Fed Funds rates have been already increased: basically, it’s a lagging indicator.

Ok, let’s say I convinced you to look at 2s10s and 5s30s OIS curve shapes.Where the heck do you find these data, and why can’t you just look at Treasury yield curves instead?

OIS swap rates are only available if you own a Bloomberg terminal (at least to my knowledge), but I found a good solution for you guys!This website regularly updates SOFR swap rates: it’s not the same as OIS, but it’s the cleanest dirty shirt you can find after Overnight Index Swaps.

To make it simple, SOFR swap rates are mostly based on Treasury repo transactions.A collateralized overnight repurchase agreement with Treasury bonds as collateral hits very close to home when it comes to credit-risk-free transactions: unless there are major problems in the repo market, this should be a decent proxy for the OIS curve.

Ok, but I still haven’t told you why you can’t simply look at 5s30s Treasury yield curve shape instead: let me do it with one chart.

Treasury yields are higher than OIS rates, and the difference (called asset swap spread or swap spread) becomes pretty significant at longer tenors: this increasingly bigger gap makes the 5s30s US Treasury curve look ‘‘way steeper’’ than the 5s30s OIS curve.Today for instance:

* The 30y-5y slope in US Treasuries is +25 bps (still upward sloping)

* The 30y-5y slope in US OIS rates is -2 bps (already inverted!)

Not a negligible difference.

Using Treasury yield curves instead of OIS curves and focusing on the wrong tenors to assess the curve shape are frequent mistakes th…

This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit themacrocompass.substack.com

‘‘We are attentive to the risks of potential further upward pressure on inflation and inflation expectations. The Committee is determined to take the measures necessary to restore price stability. The American economy is very strong and well positioned to handle tighter monetary policy.’’

Jerome Powell, March 2022 FOMC press conference

I am not sure everybody has grasped yet how important was the message Jerome Powell sent yesterday during the FOMC press conference.

While market commentators are focusing mostly on the mere 25 bps hike and the lack of details on Quantitative Tightening, I believe they are missing the point: the forward guidance was very hawkish, and very clearly so.

This piece will try to unpack the Fed decision for you, and more specifically:

* Go through the most important, and yet overlooked parts of Powell’s strong forward guidance for what the Federal Reserve reaction function will look like in the near future;

* How bond markets and risk assets reacted, and how I believe investors should consider adjusting their portfolio accordingly.

Without further ado, let’s jump right in!

Hawkish to the Power of Four

Actually, before we jump right in.If you are interested in any kind of partnership, sponsorship, or in bespoke consulting services feel free to reach out at [email protected].

Back to it: Powell is becoming more and more hawkish as time goes by.

I identified 4 key hawkish messages he conveyed yesterday, let’s go through them.

* Wage growth is very strong, the labor market is extremely tight, households’ balance sheet are healthy: this is the strongest economy in a while.

Powell started the press conference by telling us how strong is the US economy. He deliberately chose to focus on the positive aspects of the labor market, and explicitly ignored any (evident) signposts that could counter his very bullish macro assessment.

For instance, he referred multiple times to a very tight labor market which is causing wage pressures left, right and center: true in nominal terms, but we all know real wages have been shrinking for more than one year. Powell didn’t mention that.

Most importantly, he often referred to a supply/demand imbalance in the labor market: tons of job openings, not enough workers. ‘‘The labor market is hot.’’

Sure, but the constrained supply of workers also acts as a big drag for potential long-run real GDP growth: a lower labor force participation rate (blue, left hand side) constraints the supply of available labor, which is negative for potential economic growth and drags down the equilibrium real interest rate (orange, right hand side) at which the economy can function.

This part was also largely ignored.

By focusing only on the positives, Powell tried to prepare investors for the (enhanced) hawkish forward guidance.

* The Fed is very confident (!) that the private sector can not only withstand, but flourish (!!!) in the face of less accommodative monetary policy

Really, this is quite a statement.It goes to show how confident is the FOMC about the strength of the economic cycle in the US, and therefore how aggressive they can be in tightening monetary policy without impairing the economic recovery at all.

This was also reflected in the Summary of Economic Projections (SEP):

Notice how:

* Federal Funds rate are now assumed to be 1.9% by December 2022, but most importantly at 2.8% in 2023 - which is 40 bps above the longer run neutral Fed Fund rate;

* Even with this sharp tightening of monetary policy to above-neutral levels, real GDP growth is expected to be comfortably above trend and unemployment rate to stay at 3.5% for the next 3 years;

* And that even with this sort of tightening, core inflation forecasts are still above the symmetric 2% Fed target.

Effectively, the Fed thinks the cycle is so strong that it can easily withstand a relatively sharp tightening back to neutral rates, and even ‘‘flourish’’ with interest rates above neutral levels: a truly impressive assessment!

* The FOMC is attentive to the risks of potential further upward pressure on inflation and inflation expectations. The Committee is determined to take the measures necessary to restore price stability.

In this piece I published 10 days ago, I explained how the probability distribution of US inflation expectations over the next 5 years had not only shifted to a higher average level (>3% for PCE, the inflation indicator tracked by the Fed), but its right tail had dangerously become fatter: traders now price in a non-negligible probability of very high inflationary prints between 2022 and 2027.

That’s a scary proposition for Powell, which wants to make sure inflation expectations remain anchored around 2% and expectations for high inflation do not become anchored in investors’ mind. How do you that?

You explicitly tighten monetary policy above neutral rates.

The chart above shows the distribution of FOMC’s participants expectations for the appropriate level of Fed Funds rate in 2023 and 2024; notice that their own median estimate for neutral rates is around 2.4%.

The large majority of FOMC members wants to see Fed Funds rate well above 2.4% in 2023 and 2024, with 7 or 8 Committee members projecting Fed Funds rates at or above 3% by then.

Explicitly tight.Which brings me to the fourth important point.

* Financial conditions are one of the key transmission mechanism for monetary policy, and we will have to see tighter financial conditions to achieve our price stability targets.

Financial conditions reflect the degree of tightness the private sector faces when trying to secure new sources of financing. In December 2021, Powell was asked multiple times about financial conditions tightening and he said he wasn’t impressed by the pace of such move.

This time, he went one important step further: he said financial conditions must tighten in order to help the Fed achieve its objectives (after all, he believes the private sector can easily handle this, right?).

The key components of any respectable financial conditions index are: (real) yields, corporate bond spreads, mortgage rates, equity valuations and FX levels.

If you think the sell-off in equities, move up in USD and mortgage rates, and the widening in credit spreads we have seen this year is impressive…the chart above will serve as historical context for you to think again.

What was that good old saying again?

‘‘Don’t fight the Fed’’.

Market reaction and portfolio ideas

As the Fed promised to convincingly tighten monetary policy and market participants understand the impulse of growth is fading away (contrary to the super rosy assessment Powell is making) at the same time, yield curves continued their relentless flattening and inverted across important tenors.

Here is an update for my preferred ‘‘inversion’’ metric (more on it in this piece):

The slope of the 5y-30y US OIS curve became negative again following yesterday’s FOMC statements, and it’s now trading consistently around zero for weeks.

Also, Fed Funds future project 30 bps cuts (!) from Powell in 2024.Yes, you read correctly: cuts.

On the other hand and to my surprise, credit spreads and equities performed very well post FOMC conference: perhaps the lack of details over Quantitative Tightening and the removal of the biggest tail risk (50 bps hike) helped, but I believe the biggest reason behind the rally was a good old short positioning squeeze.

Going forward, the enhanced hawkish stance from the Fed tends to strengthen my underlying macro thesis and portfolio construction: short selected risk assets, flatter yield curves.

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