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Next week will be crucial for markets as Trump is set to announce (or disappointingly not announce) tariffs.

In this piece I will highlight the rationale behind my base case scenario and its impact on markets.

Before we do that, I want to share something with you.

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And now, back to the article.

1. Recent economic data provides Trump with cover to go big on tariffs

The biggest risk Trump runs with tariffs is a bond market insurrection: if investors perceive inflation as too high, tariffs can generate an injection of risk premium that launches bond yields to the moon.

In turn this would tighten financial conditions, slow down the economy, hamper Trump’s plans to reduce borrowing costs for the US, and just make him quite unpopular (people hate inflation spikes).

Luckily for him, the recently released inflation report suggests core PCE is trending at 2.3% - not bad:

Additionally, the latest job market report was encouraging and the control group of retail sales is running at 5.4% - around 2018 levels, when the pre-pandemic economy was considered strong. The economic momentum and a 2.3% trend in core PCE inflation provide Trump cover to go big on tariffs.

2. To increase his negotiating power, Trump can target vulnerable economies

As the Fed hiked rates, all other Central Banks around the world merely followed the same strategy. The big issue here is that not all economies were equipped to handle such an abrupt increase in rates.

After the GFC, the US economy has deleveraged its private sector – private debt to GDP is down in the US. The US private sector also borrows mostly on fixed rate for long tenors (think about 30-year mortgages). The US also issues bonds in the global reserve currency, so bond vigilantes are unlikely to go after the US.

But what if another economy had high private sector debt, or upcoming refinancings, or floating rate mortgages and corporate borrowing which makes the passthrough of rate hikes fast and furious?

In that case, the economy will prove quite vulnerable to a prolonged hiking cycle.

The BIS just updated their private sector Debt Service Ratio (DSR) for H2 2024 – this snapshot allows us to verify in which countries households and corporates are under pressure from a prolonged hiking cycle.

Red or green colors refer to how much the DSR is above or below its long-term average in that country:

Notice how Canada and China are under increasing pressure.

And it would make sense for Trump to go after them – negotiating with a weak counterpart is always better. But identifying vulnerable economies is not only about the Debt Service Ratio – politics also matters.

For example, Germany is very unlevered as an economy: the German DNA prevents (for now) any proper deficit spending, and the private sector is also relatively conservative on how much it leverages.

As a consequence, the DSR doesn’t really pick up – yet the German economy is vulnerable.

Its business model of cheap energy imports and outsourcing production and manufacturing has been challenged by the pandemic, and China has made huge progress as a competitor for car exports. The German economy has taken a major hit, and people aren’t happy.

New elections are planned for February, and negotiating with a country in political turmoil is always better. From a game theory perspective Trump could decide to focus on China, Canada and Germany.

3. A tariff strategy to raise the most amount of money, and take the smallest amount of risks

Even if Trump wants to target the most vulnerable economies, he must be careful.

Let’s take a look at the countries the US imports the most from, and in which categories of imports:

The car, pharma, oil and household/tech goods industries are by far the largest import sectors for the US. And Mexico, China, Canada and Germany the top 4 countries that exports the most volume to the US.

If Trump’s intention is to raise the most amount of money through tariffs on the most vulnerable economies, basic logic imposes equally heavy tariffs on all these 4 countries above.

But there is a risk in going huge against China from the get-go. While it’s very unlikely that Canada and Europe will protect their currencies, China could decide to do it.

And if we get 25%+ tariffs on China from the get-go but the CNY doesn’t weaken, US consumers will feel it. Higher import prices on Chinese goods without an offsetting move up in USDCNY = US consumers will take the hit out of Chinese tariffs, and not China.

Here, game theory would hence suggest Canada and Europe are the prime candidates for heavy tariffs.

Conclusions and market implications

Given that:

1) Soft inflation and solid growth provide cover for Trump to go aggressive on tariffs

2) To increase his negotiating power, Trump might focus on the most vulnerable economies

3) China, Canada and Europe are 3 vulnerable economies and the all export a ton to the US

4) But China can hit back via supporting the CNY = US consumers would pay for tariffs

5) Canada and Europe are not in a position to defend their FX, and they face political jitters

My base case for tariffs sees:

* A global tariff rate of 10%

* Additional targeted tariffs on China (phased-in monthly increase of 2.5% with no end in sight)

* Additional targeted tariffs on Europe and Canada for a total of 25% to start (+ monthly increases)

If this unfolds, the market is not prepared. Over the following 2-4 weeks, I would expect:

A) EURUSD to breach parity, and USDCAD to march towards 1.50

B) Bonds to rally at first, and stabilize after

C) An initial knee-jerk negative reaction in stock markets

If you liked this article, please share it with a friend.

And remember: I am offering a FREE trial to my institutional macro research service!

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Speak soon and have a wonderful day,

Alf

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

Good morning, this is Alf - welcome back to The Macro Compass!I wish you a fantastic year ahead: follow your passions, keep learning, and don’t drink cappuccino after 11am.

In this macro piece, we will cover the biggest market mover for H1 2025: tariffs.We will also investigate what’s the most attractive asset class today.

But before we start, here is a present for you to kickstart this new year.

Early next week, I’ll publish my top 3 macro trade ideas for 2025.

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Now, to the piece.

What if tariffs end up being non-inflationary and negative for growth?And what if Trump focuses on short-term painful policies first in H1, to then deliver tax cuts in H2?Consensus isn’t ready for this.

Let’s disentangle the thought process behind the concept of ‘’disinflationary tariffs’’.This paper from the new Council of Economic Advisor (CEA) Chair Steve Miran covers it – I’ll summarize.

The main idea is very simple.

In his previous term, the Trump administration increased the effective tariff rate on Chinese imports by 18%.During the same time span, the US Dollar appreciated by 14% against the Chinese currency.It basically means the after-tariff price in USD to import Chinese goods was almost unchanged.

As long as the USD appreciates, US consumers aren’t going to feel much inflationary pain from tariffs:

Yet we also know that tariffs are negative for business sentiment, investment, and growth.

Even if tariffs are phased in gradually as a negotiation tactic, the message will be clear: if you want to export your stuff in the US, you need to re-think your business model or cut your profits.

Additionally, it’s well documented that a super strong US Dollar acts as a drag for earnings growth in the US:

US companies generate about 60% of their revenues outside the US, and a strong USD doesn’t help there.The charts above prove that was indeed the case in 1996-2001 and 2021-2023: a relentless USD appreciation (orange line down) slowly but surely weakened earnings growth (blue) for US companies.

Under the assumption that countries hit by US tariffs will accept a currency devaluation without a fight, there are reasons to believe that tariffs can be non-inflationary and negative for growth.

But can we safely assume China isn’t going to push back?Why would China not try to stabilize their currency and export some inflation and pain in the US?

Let’s try to think this out as if we were Chinese policymakers.We have three options:

1) Accept the hit: let the CNY weaken2) Fight back: protect the CNY by selling down USD FX reserves, and hit back the US3) Play the long game

I believe China will opt for 3: play the long game. And here is what I mean.

Chinese policymakers don’t face elections, but the Trump administration does – US midterms in 2026.Rather than going for the extremes (1 or 2), China could decide to apply a long-term strategy that relies on two pillars.

A) Allow a steady CNY deval, and plug the hole with fiscal stimulus where needed

As China can afford to play the long-game from a political standpoint, they could opt for a middle ground between a full CNY devaluation and a strenuous defense of their currency by selling USD reserves.

B) Keep using ‘’middlemen’’ to dodge tariffs

We had some fun testing this hypothesis: can we show that China used ‘’friendly neighbors’’ to re-route their goods into the US as a way to circumvent tariffs?

Since the first round of Trump tariffs went live in 2018, China (and Hong Kong) now import a volume of goods in the US which is 5% lower than the pre-tariff era.But at the same time, Vietnam + Korea + Thailand + Malaysia have all increased their trade flow with the US.

Coincidence?Or China trying to dodge some tariffs by re-routing their goods exports to the US through ‘’middlemen’’?

Consensus is strongly positioned for tariffs to be:

* A big macro event

* Negative only for the rest of the world (US growth exceptionalism to continue)

* Adding to inflation uncertainty in the US

I think there is space for consensus to be caught offside on all the above.

I could foresee a world where Trump phases in tariffs, China dodges most of them through middlemen countries, the anticipated inflation volatility doesn’t realize, but growth slows down because business investments are hit by uncertainty.

Given today’s pricing, the most attractive asset class in this scenario would be bonds.

Our models show that the option-implied probability for the Fed to hike (!) over the next 12 months is priced at 40%. That’s quite high, and it show the extent of hawkish pricing people pushed into the front-end of bond markets.

And not only that: the curve has bear steepened, and term premium has been injected in the long end too.

With Fed Funds at 4.25%, the bar being very high for the Fed to hike rather than cut, and 10-year yields at 4.60% (= positive carry) bonds look interesting here.

Especially if you think a strong USD will slow down corporate earnings, and that the hype about the macro impact of tariffs might be exaggerated.

This was it for today.If you enjoyed it, please share this piece with a friend:

Finally: don’t miss the 30% discount on the premium TMC tier!

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Looking back at the 2015-2021 period when I traded bond markets at a large bank, it was quite boring.

Rates were mostly stuck around 0% at the front-end, and to make money you had to find small dislocations and monetize them with leverage hoping volatility would remain low forever.

Today, the story is different: bond markets are truly exciting.So let’s have a fresh look at them.

Before we do that though - an important announcement.

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I expect the Fed to cut rates again in December.

Why?See the chart below:

Even after the recent Fed cuts, today’s Fed Funds (orange) are still markedly above the underlying trend of core PCE inflation (blue).The Fed is a simple animal: their dream is to have a stable labor market with predictable inflation.

And today, the main risk they see isn’t an inflation pick-up.Instead, risk management forces them to protect the US economy against a deterioration in the job market.

Running a real Fed Fund rate (bottom chart, black) at +2% for several quarters on end is an exercise which was last performed in 2007.I don’t think the Fed sees major benefits in running such a tight policy.

Hence, I believe they will cut rates by 25 bps in December.

But here is an argument for them to feel confident the US doesn’t need a major cutting cycle in 2025:

This chart looks at the US private sector (orange) and government (blue) debt to GDP since the 1990s.It’s an incredibly important chart to approach US bond markets today.

The US went through two clear macro phases before today.

In phase 1 (before GFC), the US government refused to lever up: government debt as a % of GDP was at or below 60% and deficits were seen as a bad thing.As the private sector didn’t receive any stimulus from government deficits and it grappled with declining demographics and productivity, it used leverage to achieve higher growth.

In phase 1, the US private sector was forced to lever up aggressively.Until in 2008 excessive private debt and loose credit standards led to the Great Financial Crisis.

This kickstarted phase 2 of the long US macro cycle – the post GFC period.

Between 2009 and 2012 the US government printed money (read: deficits) to stabilize the US economy.This allowed the US private sector to de-leverage: private sector debt as a % of GDP fell below 150%.

But this fiscal profligacy didn’t last for long: between 2014 and 2019 the US primary deficit as a % of GDP was less than -2% on average – mildly supportive for the private sector, but nothing special.So we sat there in this limbo of acceptable GDP growth, but as neither the US government nor the private sector levered up aggressively we lived through a ‘’meh’’ US growth cycle.

Finally, C-19 hit and the game might have changed for good (phase 3).

Since 2020, US deficits have exploded and this has allowed the US private sector to de-leverage.US private debt as a % of GDP is now the lowest since 2003 (!).

So: why does this matter for bond markets?

Because in a world with less private sector leverage, ceteris paribus interest rates can be a bit higher.

When there are less mortgages and corporate loans to refinance vis-à-vis higher nominal wages and earnings, the equilibrium interest rates at which the economy can function should be higher.The flipside is obviously that an increasing load of government debt will have to be refinanced at higher rates.In the US case though, that’s more manageable than for other countries due to the reserve currency status.

This is why the market feels quite strongly about terminal rates being well above 3% this time.

As per today, markets expect Fed Funds to still be at 3.50% in 3 years from now.

The most important implication for investors is this.

If the Fed embraces this new narrative, we are looking at few (if any) cuts left in 2025.This is because if neutral rates are considered to be higher, the Fed doesn’t need to cut rates much more to achieve a neutral policy stance.

With euphoric expectations about earnings growth, nosebleed valuations and a less friendly Fed overly bullish investors might be disappointed in early 2025.

This was it for today. I hope you enjoyed this macro piece.Please share it with a friend:

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The key macro event of 2024 is approaching: US elections are around the corner.

Next week I will release a deep research piece on US elections, which will be centered around the key questions looming large.

How to trade different scenarios?What happens to markets if Trump secures a Red Sweep? And what asset classes to prefer if instead Kamala wins?

This special election piece will be ONLY available to my private distribution list.Sign up for FREE here:

Macro clouds remain on the horizon.Wherever you look at, you see unsustainable economic models: we are either relying on debt-fueled growth (US), trying to squeeze exhausted growth models (China), or succumbing to a slow and painful death (Europe).

Today, let’s take a step back and talk about the business models that Europe and the US are pursuing.Let’s unpack them together, and understand what lies ahead and how to prepare portfolios accordingly.

Europe is slowly dying.

To prove my point, here is one of the most depressing chart you'll see today:

The chart above shows an uncomfortable truth for Europe.

ECB's Professional Forecasters now expect 5-year GDP growth in Europe to come in at only 1.3% - the lowest level ever.Prior to the Great Financial Crisis, this number used to be consistently above 2.0% in real terms.

So while we are talking about the ''Roaring 20s'' for the US, and while we are watching countries like India perform particularly well we are left to answer some tough questions in Europe.

Why is growth so low, and expected to remain so sluggish?1️⃣ An imperfect European infrastructure, and no improvement in sight: we run a ''union'' under one monetary policy, different fiscal policies, and without a banking or capital markets union.2️⃣ Poor productivity, and no structural reforms: while touted the whole time, European politicians are really not busy with reforms to structurally improve productivity.

Over the last 20+ years, European productivity growth has been a meagre ~1% per year.The US is becoming increasingly more productive at a much faster pace:

3️⃣ Bad demographics, and worsening;

Low birth rates imply that Europe will see its labor force shrink by 25% (!) over the next 20-30 years:

Not only that - it’s also a matter of putting people to work in the first place.In Italy, women labor force participation rate is not even at 60%.4️⃣ No appetite for true innovation, and instead an insatiable appetite for more and more regulation

Europe is slowly dying.Yet markets are still in La-La Land.

This week, the ECB cut interest rates once again but nominal rates remain still too high versus the underlying trend in inflation.

As the chart below shows, Europe instead needs interest rates below (!) the level of inflation to have a monetary policy loose enough to stimulate at least some growth:

The chart below is another way to picture this inconsistent bond market pricing.

The long-run equilibrium nominal rate represents the nominal interest rate that allows an economy to operate smoothly and deliver its potential growth rate while inflation hovers around 2%.

Think of it like the interest rate which ‘‘balances’’ the economy.

Prior to the pandemic, the average pricing for the long-run equilibrium nominal rate in Europe was +0.5%.Today, it’s over +2.0%.

What has changed in Europe so that the economy can structurally handle higher interest rates way better than before the pandemic?

In my opinion: nothing.If anything, things look a bit worse now:

Patient Europe is dying.Better make sure your portfolio is prepared for it.

Let’s chat about the US economic model now.

Here are some staggering statistics about the US economy - since mid-2020:

1) US nominal GDP has grown by ~7 trillion 2) US total debt has grown by ~8.5 trillion

Debt-fueled economy, debt-fueled growth:

Look at this excellent chart from E.J. Antoni.

It shows how US nominal growth (blue) has increased less than the increase in federal government debt (red). If you add in private sector debt, the red bar crosses the 8 trillion mark.

Should we worry about this debt-fueled growth model?

Look: our monetary system is centered around debt/credit creation to sustain economic growth. There is nothing inherently bad about that, but the key is to use new debt to fund productive investments and reforms.

We got worse and worse at that:

As the chart above shows, for every new $ of debt we end up creating way less than a new $ of GDP growth!

So: yes, the US economy has done incredibly well since 2020. But more than organic growth, this is once again debt-fueled growth.

Whoever wins the US Presidential Elections, you can rest assured there will be more and more debt creation to try and fuel US economic growth.

Can this model continue to thrive?

I’ll cover this in next week’s flagship US election research piece.You can only access it registering at the link below.

It’s FREE.Don’t miss it - register at the link below:

This was it for today.

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The Chinese real estate market is de-leveraging very hard.

Economists estimate Chinese households have suffered $10+ trillion of wealth losses as a result. There is now a strong urge to stop the bleeding amongst Chinese policymakers.

Last week, China unleashed a ‘‘stimulus bazooka’’.

But what were the measures all about?And will they be effective to fix the Chinese economy?

Chinese policymakers announced the following package:

A) More interest rate cuts B) The Chinese version of the ''Fed put'' C) Vague wording about fiscal stimulus

Interest rate cuts and the ''backstop'' facility are propping the Chinese stock market to the moon.

Yet they are very unlikely to work in a balance sheet recession. In the 90s, Japan cut rates aggressively and that wasn't the solution to the problem:

Cutting rates won’t encourage households or corporates to leverage: corporates were tapped out in 2016 already, and households have just been burnt with excess debt so we shouldn’t count on them.

Lowering interest rates in combination with the new ‘‘PBOC Put’’ can instead help reinstate animal spirits.Chinese authorities set up a BTFP-like facility which allows you to pledge collateral (cash, bonds etc) and get funding to go and buy Chinese stonks.

Yet, this is unlikely to solve the structural malaise affecting the Chinese economy.

Fiscal is the only real fix, and here is why.

There have been 3 key phases of Chinese leverage:

1) Corporates (red)

2) Households (blue)

3) And now fiscal is the only solution (orange)

10 years after entering the WTO in 2001 and once the demographics dividends were exhausted, China embarked in massive leverage to sustain their growth targets.

Phase 1 saw Chinese corporates (red) tap up leverage aggressively (2010-2016). Once corporates’ appetite for debt was exhausted, Xi Jinping tapped Chinese households (phase 2). This led to the creation of a massive real estate bubble which China is trying to deflate now.

The only agent left to pick up the slack is the Chinese government – fiscal deficits are key here (phase 3?).

So while the ''bazooka'' has been excellent at restoring market confidence, there is only one real fix for the Chinese economy here.

It's a large, large fiscal stimulus package.

Will China actually implement it?

Reuters ran a piece discussing a $284 bn fiscal package.This would be very much unlikely to sort things out.

Size matters here: consumers and corporates have been hit by a $10 trillion de-leveraging in the housing sector, and so the fiscal stimulus needs to be large and targeted to make the difference for the Chinese economy.

While we keep monitoring any concrete announcement on fiscal stimulus from China, it’s worth remembering how Chinese policymakers love a ‘‘counter-cyclical’’ Bazooka:

China loves to stimulate (for real) when the global economy is weak.

This way, they can get the best ROI on their money creation and go buy cheap foreign asset/strengthen their trade position/gain shares in crucial markets.

Until the global economy slows down further, China might not be interested in proper stimulus but rather in ''controlling the bleeding'' and get investors occasionally stopped out in their China shorts - a story we've seen happening for 18 months already.

China matters for the world.China needs a large fiscal stimulus.

Large. Fiscal.These are the two key words you should be focusing on.

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The news of the week is NOT the Fed cutting 50 bps - yes sure, that’s important but there is something much more relevant going on.

The Chinese economy keeps imploding from within.And we should pay attention.

The Property Price Index for Chinese tier-1 cities keeps making new lows, and it’s now approaching levels last seen 8 years ago!

At this point you might ask yourself: well, is it so bad if house prices drop a bit?

In standard circumstances I’d tell you this is not a disaster.But for Chinese people, things are different:

Chinese households hold 60%+ of their wealth in Chinese properties.This is way higher than in the US, where households only hold 23% of their wealth in properties while the majority sits in the stock market or retirement plans.

Now imagine if your stock portfolio dropped back to 2016 levels.How would you feel about it?That’s how Chinese households are feeling!

But why is China imploding this fast?It’s because Xi Jinping wants to engineer a new ‘‘common prosperity’’ economic model which relies less on leverage, tech bubbles, bridges in the middle of nowhere and frothy house prices and more on internal consumption.

The problem is that when you deleverage a 50 trillion (!) worth real estate market inflated with absurd levels of leverage…well, that’s not an easy task to achieve.

China is cutting interest rates aggressively to try and limit the slowdown: Chinese 10-year interest rates just dropped below 2% for the first time..ever?

Yet cutting interest rates while the real estate market is deleveraging won’t help much.Ask Japanese people in the 1990s for reference:

China keeps imploding from within and this matters for the rest of the world.For example, China is the number 1 trade partner for many countries and for specific jurisdictions it represents a very large importer for the commodities they produce.

See Brazil for instance:

Everybody is talking about the Fed.But the real macro mover to watch here is China.

Keep it on your radar!

And of course - who am I not to spend a few words on the Fed as well.

This week's 50 bps cut was initially celebrated by markets: after all, if the Fed proceeds with such a sizable cut what's not to celebrate?

The problem with such a simple narrative is that the Fed's monetary policy needs to be measured against the underlying growth conditions.Fed Funds at 4.75% can be:- Still loose: if the US economy is running ultra-hot- Still tight: if the US economy is rapidly weakeningIn other words: the monetary policy looseness/tightness needs to be measured taking into consideration the ongoing economic conditions.

The chart above does just that, and it compares Fed Funds (orange) with the underlying trend of US nominal growth (blue).The US nominal growth proxy is built using core PCE - the Fed's official target for inflation - and the NBER gauge for US real economic growth.

Why the NBER gauge and not real GDP?Because the NBER is the body that ultimately determines whether the US is in a recession, and they do so using a broad basket of 7 indicators tracking every sector of the US economy (from consumers to industrial production to the labor market).The outcome of this analysis is straightforward.

There is nothing to celebrate.The Fed's policy is still dangerously tight.

As you can see, it only rarely happens that Fed Funds (orange) sit close or even above US nominal growth (blue) for a prolonged period of time.And when that happens, it's never good news for the economy.The Fed needs to do more.Or it risks falling further behind the curve.

And now, some big news - adding even more value for you…FOR FREE!

If you enjoyed this piece, you should know I launched a YouTube channel for my weekly show The Macro Trading Floor with Brent Donnelly.Every week we discuss a ton of macro with supporting charts, trade ideas, and trading/risk management education.

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We are observing a true regime change in markets.And for macro investors, it’s incredibly important to stay vigilant and on top of our game at this stage.

It all starts with this: the Fed is behind the curve, and it is playing with fire.

Consider this.The recently released US job report showed the US private sector is only adding an average of 96,000 jobs per month over the last 3 months.Such a weak pace of job creation has last been seen in summer of 2007.The last CPI report also showed another friendly and disinflationary print: core CPI raised less than 0.2% on a MoM basis which is a trend in line with pre-pandemic ~2% yearly inflation trend the Fed targets.

So, why is the Fed playing with fire?The chart below shows you why.

Fed Funds at 5.25% while core PCE is convincingly sub-3% represent a real Fed Fund rate of 2%+.

Real rates are what matter for the economy:

* Investors care about their (risk-free) returns after accounting for inflation

* Debtors care about their inflation-adjusted borrowing costs

With real rates now at 2%+ for quite some time, it's important to look back at past episodes and see what happened when the Fed forced such a tight policy for too long:

A) In 1999-2000, the Fed kept real rates at 3%+ for a sustained period of time and a crisis unfolded in 2001;

B) In 2007, the Fed kept real rates at 2%+ for a while and a crisis unfolded in 2008;

C) In 2024, the Fed is keeping real rates at 2%+ and...you get it.

On top of this, the Fed is also keeping policy very tight while the US job market is showing clear signs of weakness.

The Fed is behind the curve, and it is playing with fire here.And when this happens, the bond market takes over.

The chart above goes back to 1989 and it looks at the amount of rate cuts/hikes bond markets were pricing for the subsequent 2 years.I focused on periods when the bond market was very, very dovish and it priced in a robust amount of cuts.The big question is: what did the Fed ACTUALLY deliver?Did one make or lose money by buying bonds when markets were already super dovishly priced?

Let's look at the data:1️⃣ January 1995, October 1998Cuts priced for the next 2 years: on average 130 bpsCuts delivered by the Fed: 75 bpsIf you bought bonds while markets were already at peak dovish pricing, you lost money (cuts delivered were less than priced in).2️⃣ January 1990, December 2000, September 2007, August 2019Cuts priced for the next 2 years: on average 145 bpsCuts delivered by the Fed: 412 bps (!)If you bought bonds while markets were already at peak dovish pricing, you ended up making a ton of money.The results are very interesting. As a rule of thumb, I always advocate that in macro you don’t make money by only ‘’being right’’. That’s a necessary but insufficient condition: you also need to surprise consensus, or in other words see something before the crowd does + position correctly for it + monetize when they converge to your view.

Yet it seems like the bond market is quite good at sniffing when something is about to go wrong.The bond market is sending a loud message: are you listening?

But it’s not only about the bond market here.It’s also about cross-asset correlations suggesting tectonic shifts are happening:

We are witnessing a massive regime change in markets.

Recently we experienced another large drawdown in equity markets lead by tech stocks - specifically, NVDA stock prices dropped by almost 10% in a single session.

But the big news for investors is that bonds have started to exhibit one of their key features again.

For the first time in a few years, bonds are acting again as a hedge against stock market drawdowns.Or in other words: after a period of positive correlation which wrecked 60/40 portfolios, the stock/bond correlation is turning negative again.

This is a huge deal.

The chart above shows the 6-month (120 trading days) correlation between the S&P500 and 10-year Treasury future prices.

The correlation was negative for most of the last 15 years: this means investors could count on bonds acting as a diversifier during periods of equity drawdowns. But as you can see from the chart, this wasn’t always the case: for most of the ‘80s and ‘90s bonds and stocks were doing pretty much the same thing at the same time – they were positively correlated. The same happened in 2022-2023 as inflation was out of control.Hear me out now, because this is the key message you should bring home.When the stock/bond correlation changes sign, we are looking at tectonic macro shifts with huge implications for cross-asset portfolios.This is because ''bad news is good news'' doesn't work anymore.The market has switched into a regime in which:Bad news is actually bad news.

Once bonds start acting as a diversifier for risky assets, it's likely we are on the verge of a massive regime change in macro and markets.

Macro tectonic shifts are happening.

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We just witnessed one of the biggest market panic events ever seen in the last 4 decades.

At some point, Asian markets were down 10%+ in a single session and the Japanese bank index saw the largest daily loss since Black Monday in 1987.

During such panic events, it’s important to remember three crucial rules:

* Markets can remain irrational longer than we can stay solvent;

* Opportunities abound, but it’s crucial to structure trade ideas and investments in a way that can allow us to sleep at night;

* Keep following your process.

But first: let’s understand the nature of this gigantic liquidation event.Is it happening because a recession is now inevitable?

If this time isn’t different, the recession playbook is unfolding correctly:

* The Central Bank raises rates aggressively;

* Markets signal conditions are too tight: the yield curve inverts

* The curve stays inverted for 12-27 months (!)

* The economy slows

* A late-cycle yield curve steepening (!) happens

* Finally, a recession occurs

The chart illustrates this sequence by setting the x-axis counter at 0 once the 2-10 year yield curve slope inverts, and marking in red the onset of a recession (private non-farm payrolls increasing by 25k or less on a 3-month moving average basis).

Notice how the ’89-90s, 2001 and 2008 recessions all followed a prolonged inversion, and all occurred only once the curve had disinverted (green vertical dotted line).

But the crucial point here is this.

Markets are pricing us close to step 6.Yet data shows we are still at step 4-5.

In other words: the move comes a bit from fundamentals, and a lot from panic.

Private job creation in the US still averages ~150k/month today (left chart, blue) while in the months preceding the 2001 and 2008 recession we were creating only 0-50k jobs/month (right charts, red).And while it’s true that today the US population is bigger and the labor force is expanding rapidly, one can argue that macro data only justifies a portion of the panic move we saw recently.

Just to give you a sense of the panic: the bond market is now pricing 5+ cuts over the next 3 meetings, and some odds of the Fed being forced to deliver intra-meeting emergency cuts.For reference, as we walked into the 2001 recession and the 2008 Great Financial Crisis, the Fed did this:

Markets are now pricing 50 + 50 + 25: something of a middle ground between the 2001 recession and the late 2007 Fed cuts heading into the GFC.To visualize the panic reaction in bond markets, this is the chart that shows the market-implied probabilities that the Fed will cut by 50 bps 3 times in a row = full recession mode:

Ok, so we have:

* Asian indexes recording their worst 1-day loss since Black Monday in 1987;

* The Nasdaq down 16% in 16 trading sessions (<1% probability event);

* Bond markets pricing a full-fledged recessionary Fed cutting cycle in the next 3 months.

Yet macro data are not fully justifying this panic (yet).

So what’s going on? Why is this happening?

And also: here are 2 macro trade ideas to benefit from this market panic!

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The S&P500 realized volatility is below 10%.Credit spreads are super tight, and aside from some short-lived European political drama markets keep marching higher.

Yet, I think macro volatility is coming back.

First of all: we are suppressing economic cycles, injecting an artificial equilibrium which will only make the system more fragile in the long run.

We are not allowed to have a recession anymore.

This great chart from Prof. Lee Coppock shows the number of months the US economy spent in recession in 30-year periods starting from the 1870s until today.

The message is pretty clear: our economic system has become much more stable, as we spend less and less time in recessionary conditions.But why?I would say there are 3 main reasons:

1️⃣ Geopolitical stabilityNot rocket science here, but by having less systemically important wars you are going to have way more financial and economic stability2️⃣ The shift from a Gold standard to a fully elastic Fiat Money systemThe Gold Standard works by pegging the fiat currency to a fixed, hard asset whose supply can't be expanded - gold.Doing that reduces the odds of rapidly expanding or devaluing fiat money over time.But the flipside to the Gold Standard is exactly that: by not allowing for a rapid expansion of fiat money creation when needed (i.e. to stabilize the economy during recessions), you will end up with more volatile economic cycles and hence spend more time in recession.

The Gold Standard had benefits but also downsides, and after the 1970s we migrated towards a fully elastic Fiat Money system.

But this meant that...3️⃣ Policymakers try hard to ''cancel'' the concept of recessionsBeing able to expand fiat money creation in a fully elastic way is great, but politicians can abuse this system.

This leads to where we are today: policymakers are trying hard to erase the concept of a recession altogether.But in a capitalistic system, that doesn't work!

The side-effect of suppressing natural economic cycles is that productivity levels will decline rapidly (think of zombie companies), and most importantly as Minsky once said: (Artificial) Stability is Destabilizing.

Recessions should be part of a standard economic cycle, where the system is allowed to ''cleanse'' and re-start stronger than ever.

Yet, also this time policymakers have chosen to artificially stabilize the economy.

This chart explains why the Fed hiked rates above 5%, and yet the US economy doesn't break.

The last time Fed Funds were raised aggressively towards 5% and kept there with a long, hawkish pause was in 2006-2007.And clearly something broke then: the US housing market, which broke havoc in the banking industry too and generated the biggest financial crisis in the post WWII era.

But there is a key difference between now and then.

The big money expansion in 2005-2007 was Credit-Driven. Today, it’s Fiscal-Driven.

Economies grow above-potential if new money is getting created in large size: this can be done via the government with generous pro-cyclical fiscal stimulus (today) or via private sector credit (bank lending, etc).And if brought to the extreme, these two sources of money creation lead to different imbalances over time.

In 2005-2007, money creation was all about private sector borrowing (blue): the US private sector leveraged up a lot to chase the housing bubble via the subprime mortgage and credit market engines.Back then, the government wasn’t a large contributor to money creation.

In late 2007, the housing market cracked under the pressure of excessive private sector leverage.When private sector credit as a % of GDP rises uncontrollably you often get a Credit Event – or basically: ‘’something breaks’’.The Japanese and Spanish real estate bubble, the Asian Tigers fever, the US housing bubble, or China today.

Ok, sure - but today the story is different.

Private sector credit isn’t the source of excessive money creation and instability - the US private sector has actually de-leveraged since 2008!

Instead, it's all about government deficits!

Today, the story is different: the scale of government deficits (orange) in 2020-2021 was enormous, and that was by far the main driver of money creation which is still circulating in the economy.We also got another fiscal shot in 2023, while private sector credit (blue) has been moderating for 2 years now.

This means the risk this time isn't necessarily that ''something breaks'', especially in the US. The risk is that the US government keeps throwing fuel on the fire, and it might end up re-accelerating inflation and make the macro cycles more volatile.

Which brings me to the real source of upcoming macro volatility: US elections.

Since the Presidential debate, the Bond Market has been sending an interesting signal.

As the debate ended, Biden's underperformance led to a sharpe increase in the odds that Trump might be the next President.These odds have now further increased after the terrible events of the weekend.

The bond market didn't take long to respond.The yield curve has been steepening pretty strongly since the debate, and the steepening pressure could continue.

The chart above shows the market-implied path ahead for Fed Funds (today in blue, two weeks ago in orange). The panel below shows the difference in yields per each point in the curve.

The steepening is very evident.But why is it happening?

So far, we know that Trump's economic agenda involves:1️⃣ A tough stance on immigrationThat's inflationary.

One of the reasons why the disinflationary path has been so friendly so far while the labor market holds in the US is because there is a been a large addition in labor supply - mostly due to net immigration in the US.Hampering that would flow of labor supply would reduce growth while at the same time increase inflationary and wage pressures.2️⃣ Heavy tariffs on ChinaThat's inflationary.Import prices would rise aggressively, and volume of imports/exports around the world might suffer as a result of increased protectionism.3️⃣ Pressure on the Fed to cut ratesDespite the US economy holding fine and his inflationary policies, Trump wants the Fed to cut rates.The risk is that the economy would overheat, potentially generating further inflationary pressures.As Trump's odds of winning the race increase, so do the risks of inflationary (or stagflationary) policies while the Fed is pressured to cut rates.This leads bond market investors to inject term premium: as the uncertainty around future bouts of inflation increases, the curve has to steepen to guarantee a wider buffer (term premium) for bond investors to get involved.

And if volatility comes back in bond markets, you better watch out.We are watching the proverbial calm before the storm.

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The Fed hiked rates above 5%, and yet the US economy doesn't break.

Back in 2022 already, the yield curve inverted and it has stayed inverted ever since.The lags looked relatively short, and the US economy was going through a soft patch in 2023 when it became consensus that a recession was gonna happen.Something even broke in markets (regional banks), and yet nothing really happened.

Here is why.

High interest rates are supposed to break something because an overly indebted economy will have to service a mountain of debt at expensive rates and it will have less money for income and spending.

The problem is that people are looking at the ''wrong'' debt.

Private sector debt levels and trends are far more important than governmment debt.Contrary to the government, the private sector doesn't have the luxury to print money: if you get indebted to your eyeballs and you lose your ability to generate income, the pain is real.

As Dario Perkins' chart shows, the biggest financial crisis happened as a result of high and growing private sector debt. The Japanese or Spanish house bubble bursting, the Asian Tigers, or China today are clear examples.

And this is why we need to look at Debt Service Ratios.

Debt service ratios measure the amount of disposable income which is used by non-financial corporations and households to service their outstanding debt payments.This is a crucial metric because it efficiently visualizes the pass-through of monetary policy tightening on the private sector.

The US debt service ratio is going up but only slowly: it sits at 15% which equals its long-term average.

There are really four ways Debt Service Ratios can move up fast:

* The economy sits on a mountain of private sector leverage;

* A large share of private sector debt (mortgages and corporate bonds/loans) is based on variable rates, hence as the Central Bank hikes households and corporates are immediately faced with higher debt servicing costs;

* A large share of private sector debt works with interest rate resets, so in a short period of time all these debts will have to be reset at higher rates;

* A large share of private sector debt is due for notional refinancing soon (e.g. a large maturity wall)

It’s safe to say the US doesn’t face much of these 4 problems: private sector debt as a % of GDP is lower than 2007, loans and mortgages are mostly on fixed rates with no short-term resets, and maturity walls are gradual.

But what about other countries?

I looked at some of the major economies in the world and found that:- Australia- Canada- Korea- Sweden Are all under pressure: their DSRs are high in absolute terms and higher than their 20-year average, and the trend is also negative as they keep increasing over time.For example Sweden just cut interest rates under the pressure coming from higher debt service ratios.

The US instead sits at a more reasonable ~150% of private debt/GDP and its private sector will take longer to feel the pain from higher interes rates.

Think of the US in 2007 and how different the US economy is today.

Back then the housing market cracked under the pressure of excessive private sector leverage and the Great Financial Crisis ensued.Today, the story is different: the scale of government deficits (orange) is enormous, but private sector credit (blue) is not roaring.

Private sector credit isn’t the source of excessive money creation and instability - the US private sector has actually de-leveraged since 2008!

Instead, it's all about government deficits today.

And in short, this is why high interest rates and an inverted yield curve haven’t broken the US economy yet.Yet slowly but surely, a few cracks are appearing under the hood:

If you lose your job today, it’s quite hard to get one back in a short period of time: therefore, you’re likely to be classified as a permanent job loser.

The share of US permanent job losers as a % of the total labor force is increasing: companies facing 7-8% refinancing rates on their loans/bonds are reducing their spending and slowing their hiring intentions, hence cooling the job market.

The US economy hasn’t broken so far.But if the Fed keeps rates high for a long enough period of time, they will eventually succeed.

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