The Macro Compass

As macro investors we are often inundated with flashy headlines, and recently Japan has been front and center.

Yet with all this noise it’s easy to miss the forest for the trees.

That’s why in this piece we will:

* Explain what really drove the recent moves in JPY;

* Discuss the real underlying macro trends in Japan;

* Assess what the BoJ is likely to do next;

* Cover the implications for global bond markets and the Yen.

The outsized moves in JPY and Japanese bond markets have been catching headlines recently - the common narrative is that Japan is finally there to unwind their super easy monetary policy and that pushes yields higher and the Yen stronger.Evidence says the move in JPY has more to do with something else.

The chart above shows the very tight relationship between 10-year US vs Japan yield differentials (blue, LHS) and USDJPY (orange, RHS): if yield differentials shrink rapidly, the Yen gets a boost.

It's really simple and intuitive FX pricing theory: wide yield differentials and low volatility will make people interested in borrowing JPY and buying USD, and when yield differentials narrow like today this ''carry trade'' will unwind and the JPY strengthens.Why are yield differentials narrowing? Because of the BoJ?Not really.

Bonds have been catching a bid globally since October: the rapid decline in the blue line from 350 bps to 270 bps is almost exclusively due to Treasuries (not Japanese bonds).

And now mind the gap in the red circle.At this level of yield differentials, USDJPY should already be at 140.Back in July the 10y yield differential between Japan and US was 280 bps and USDJPY was 138.Today it's 270 bps (lower!) and USDJPY is 144 (higher!) yet people seem to find the JPY move out of whack.

The other important global macro driver of JPY price action has been crude oil.

Japan is a net importer of crude oil, and the US is a net exporter: guess what happens to USDJPY when the price of oil goes down rapidly?

USDJPY goes down: the Yen appreciates because the terms of trade for Japan become more favorable.

In other words: the Yen is adjusting to international macro fundamentals, not reacting to Japanese macro or an immediate risk of a BoJ hawkish shift.

Japanese services inflation (orange) was running at 3% in May but it’s now back below 2%, and nominal wages (blue) are growing at only 1.4%.

If Ueda and the BoJ wanted to react to immediate price pressures, April/May was the moment to do so - the situation is much less urgent today.

Imagine this.

After 20+ years of ZIRP and QE the Bank of Japan tightens policy now, but global inflationary pressures continue to subsidize.The Yen strengthens rapidly, and it kills any hope for Japanese inflation and wages to actually settle at 2%.

The deflationary mindset kicks in again, and Ueda doesn’t look great.

Ok, quick recap:

* Services inflation and wage growth in Japan don’t justify a BoJ hawkish shift;

* Yet the JPY has been rallying rapidly: that’s a function of two things;

* A global bond rally which compressed yield differentials;

* Oil prices collapsing which helps Japan as a net importer of crude;

The last piece of the puzzle to assemble here is the impact these crucial Japanese developments might have on global bond markets.

Japan is a massive exporter of capital: Japanese investors own trillions of dollars of foreign assets and they are big in Treasury markets.

What are they doing there?

Japanese investors have been absent from Treasury markets since late 2021 and actively selling a ton of bonds in 2022.

They are now back at buying Treasuries - what drives them?

Japanese investors involved in buying foreign bonds will also face FX risks.To buy Treasuries they need to convert JPY into USD, buy the bonds, and at some stage revert back the FX transaction.This means USDJPY will largely affect the P&L of their bond transaction.

This is why they generally look at Treasury yields in a different way: the orange line shows 10-year Treasury yields in the eyes of a Japanese investor which also hedges USDJPY risk for 12 months to cover that FX risk for a reasonable time.

You can see the relatively tight correlation between the attractiveness of FX-hedged Treasuries (orange line up = more attractive) and the actual net buying flows in foreign bonds from Japanese investors (blue line up = they buy more).

In 2022 Treasury yields went rapidly up but Japanese investors were on strike because the USDJPY FX hedging costs were prohibitive.Things are a bit better today, and Japanese investors are already back at buying.

The Fed drives these USDJPY hedging costs more than the BoJ, and once again it’s global macro drivers that matter more than some flashy headlines about Japan itself.

Get US growth and inflation right, get macro right.Don’t miss the forest for the trees.

And DON’T MISS the next piece in your inbox.December 15: mark your calendars!

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‘‘Who are the biggest whales in the bond market?’’

If you’d go around and ask this question, most people would tell you that’s either the Fed or foreign Central Banks like the Bank or Japan or the People’s Bank of China.

That’s wrong.

And the real bond market whales might develop a renewed appetite for bonds in 2024.

The chart above speaks more than 1,000 words: history shows (red boxes) how 70%+ of net buying flows in Treasury markets are attributable to pension funds, asset managers, insurance companies, and foreign investors.

These foreign investors include both institutional players (the very same pension funds, asset managers etc) and foreign Central Banks.My estimate is that foreign Central Banks account for about 1/3 of the flows in the dark green stack.

That leaves us with ~60% of the buying flows attributable to the real whales: pension funds, asset managers, banks, insurance companies.

Not the Fed.The Fed played an outsized role only in 2020-2021, but that’s an exception attributable to the huge pandemic-related QE programmes.

Recently most of the buying flows has been coming from households: 4-5% risk-free rates have become a palatable investment alternative for the first time in decades.A caveat here as well: this definition of ‘‘households’’ also include hedge funds, so take it with a pinch of salt.

My point remains: the biggest whales in the bond market are banks, pension funds, asset managers, and insurance companies.

The big question is: why do they bonds in the first place?

* Their guaranteed (real) yields are high enough to help them meet their return objectives and simultaneously hedge interest rate risk!

Insurance companies and pension funds run long duration liabilities like life insurances or pension contributions to be paid in 30-40 years.It’s good practice to immunize the interest rate risk from these long liabilities with long duration assets: 30-year bonds, for example.

On top of it these industries have to achieve long-term return targets of (at least) 6-7% to remain viable over the long term.

Today they can pretty much achieve both objectives by buying 30-year BBB corporate bonds: that’s a very solid proposition for these whales.

* Bonds (can) act as a portfolio stabilizer when risk assets take a hit

This chart from the excellent Dan Rasmussen of Verdad Capital is key.

Going back almost 200 years, it’s quite evident that the stock/bond correlation isn’t negative all the times: it’s actually often positive (!) and especially if core inflation is above 3% and particularly volatile (2022 anybody?).

That makes sense: if core inflation is high and unpredictable, Central Banks will go a long way to tighten aggressively and get things under control again.Central Bankers rule #1 is to preserve credibility and therefore be able to retain control of the game.

As they tighten aggressively, bond markets will sell off and equity valuations will simultaneously take a hit: positive correlation, poor stock/bond returns.

Instead, bonds retain their amazing negative correlation to stocks only if core inflation falls predictably below 3% (green area).

And that makes sense too: once core inflation is within the Central Bank comfort zone, big drawdown in equities or credit markets will be seen as destabilizing for the economy and Central Banks will attach more value to their growth/labor market side of the mandate and come to the rescue.If things get bad, bond makets will rally in anticipation of Central Bank easing: this is the negative stock/bond correlation institutional investors love so much.

Conclusion

Today core inflation is at 4% with the 6-month underlying trend hitting 3% already.History shows that below 3% the sought-after negative correlation between stocks and bonds might unfold once again.

If that happens, bonds will be a very palatable asset for hungry whale buyers.

The combination of a long duration asset which immunizes interest rate risk, delivers a high yield and protects portfolios in an equity drawdown is an irresistible proposition for this big bond market whales.

These whales have been dormant, but their footprint can be enormous and much bigger than the Fed.

Beware the stock/bond market correlation and the bond market whales.

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Now, back to the piece!

Forget inflation predictably floating around 1.5% as in the last decade.

Does this mean this paradigm shift will see inflation consistently print at 4% going forward? Not necessarily.

But it sure means the volatility and uncertainty around inflation will be higher – and that’s all that matters for global macro portfolios.

Let’s look together at the drivers of inflation going forward, bearing in mind there is a big difference between structural inflation (5-10 years horizon) and the inflation cycle (6-12 months ahead).

Structural drivers of inflation include amongst others demographics, globalization, the fight between labor and capital, and energy policies. The short-term inflation cycle is instead mostly driven by real-economy money printing (credit and fiscal).

1. Demographics, de-globalization and labor versus capital (structural)

There are two schools of thought: weak demographics are disinflationary (it lowers organic growth rates and consumption while it increases propensity to savings) or inflationary over the long-run (scarcity of skilled labor leads to higher wages, older people will spend more due to higher social safety nets on healthcare etc).

I think both are somehow right if you apply the right context: we live in a globalized economy.

Using that context it’s clear that the last 10-20 years have seen a perfect confluence of disinflationary forces: weakening demographics in developed countries (left chart) generated disinflationary conditions and we solved the labor scarcity issue by offshoring production to China which in the meantime was benefitting from an ample availability of cheap workers (right chart).

A great cocktail for disinflation: weak developed market demographics plus cheap Asian-outsourced labor.

But here is the problem – this combo won’t be there anymore.

Rapidly reversing Chinese demographics (red dots, right chart) and a marginal push towards de-globalization imply DM economies won’t be able to access a growing cheap pool of labour to the same extent anymore. This will force developed markets to on-shore some production and on the margin bump up wages for scarcely available domestic skilled workers: some impact is already visible.

The counter-arguments here are two:

1. Manufacturing and cyclical industries which will experience scarcity of labour represent a small proportion of the overall labour market and that’s because…

2. …we live in a technology-driven world and that trend is only going to continue.

The typical US company which needed 8 employees to generate $1 million of revenues in the 90s now only needs 2 - in the fight between capital and labour that doesn’t bode well for wage bargaining power. Today’s economy is way less labor intensive and less unionized than in the 90s.

Overall, my take here is that the magic combination of disinflationary tailwinds which we experienced over the last 2 decades won’t repeat itself going forward – on the margin that pushes structural inflation a bit higher but let’s not forget we will still live in a (somehow) globalized, technology-driven world.

In other words: inflation will be way less predictable going forward.

2. Energy Policies (structural)

The net-zero attempt (ehm…transition) will definitely be a net inflationary force for the next 1-2 decades.

It’s pretty simple: as policymakers will penalize (read: tax more) industries that produce excess CO2 the economics will somehow force countries to decarbonize – but funnily enough in the initial phase of the transition the world will still consume fossil fuels whose after-tax prices will be higher (left chart).

On top of it the net-zero transition requires a dramatically higher amount of green commodities (e.g. copper) which is an under-invested industry as shown in the right chart. Supply and investments in green commodities take time while the demand boost will be sudden: the likely outcome is that commodity prices will have to somehow adjust higher hence fueling inflationary pressures.

The counter-arguments here are that the net-zero transition will take much longer and be much milder than anticipated, and that today’s assumptions about the needed quantity of green commodities doesn’t take technology into account: we will probably find smarter ways to generate the same output needing less input.

My take here is similar to the demographics story: on the margin the net-zero transition will be net inflationary but look at the left chart – the volatility (rather than the ‘’new average’’) of inflation will be the key change.

Conclusions – Structural Inflation

The ‘’new average’’ for structural inflation over the next two decades is likely to be higher than the 1.5% we experienced in the 2010s – how high?

Very hard to say whether 3% or 5%, but I have a much higher confidence in making another call: inflation will be much more unpredictable and swing around way more wildly over the next 2 decades.

3. Money Printing (cyclical)

Central Banks don’t print inflationary forms of money: commercial banks (credit) and governments (deficits) do.

This is why years of QE did nothing to inflation but a globally concerted real-economy money printing exercise in 2020-2021 woke up the inflation beast: we printed real-economy money through massive deficits and credit creation and inflation punctually showed up in 2022. Where next?

My TMC Credit Impulse measures real-economy money printing and it predicted (18-24m lead time) big inflationary pressures in 2022 and the following disinflation trend we have seen in 2023 so far.

It now says headline inflation will trend around 1% (!) only in June next year, with core inflation annualizing around 2-2.50%: the Fed will feel like the job is done.

2% inflation seems impossible for the supporters of the ‘’new inflation paradigm’’ but that misses a key point.

We might as well have inflation averaging 3-4% in the next two decades (structural) but the higher inflation volatility could easily result in more disinflation in 2024 (cyclical).

Don’t confuse long-term structural trends with the short-term inflation cycle!

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After years of zero interest rates such an abrupt tightening is bound to break something.

The main questions are: what, when and where does something break?

When rates are low credit is cheap and so financial actors tend to lever up more aggressively. Debt levels increase and so does the coverage of government debt.

''The US government will go broke'' ''This is not sustainable'' etc

Yet the reality is that governments are the issuers of fiat money and therefore they can always nominally (!) meet their obligations by issuing more debt.That obviously has limits too: over time they depreciate the real value of the currency and relentless fiscal deficits might lead to inflation overshoots.

But my point is that governments can kick the can down the road for a long time, but you know who can't?

You, I, and in general the private sector.

If our mortgage costs as a share of disposable income move higher we can't print money to service our debt.If corporate borrowing costs soar and earnings growth doesn’t dramatically improve, companies will be quickly forced to deleverage or cut costs.

So while in general it’s a good practice to keep an eye on both government and private sector debt levels (as the chart below shows the higher total economic debt, the lower rates must be to keep the system afloat)…

…during macro shocks countries with high & rising private debt levels are more vulnerable than countries with high public debt levels!

And history shows that’s indeed the case: look at this great chart from Dario Perkins.

* Japan's real estate crisis 1990s

* Asian tiger's crisis late 1990s

* Spain's housing crisis early 2010s

* China now (?)

All these episodes had one thing in common: private sector debt was too high and it was rising too rapidly!

Funnily enough the obsession with government debt levels skews the vulnerability assessment towards the ''wrong'' countries. Countries that keep deficits super contained starve the private sector from fresh resources and so households and corporates go and lever up privately.

Take China: their official government debt levels are very contained but behind the curtain they have been aggressively leveraging up their private sector.

And if you do that too fast in an unproductive way, problems tend to occur...

Or take Canada which has made a large usage of real estate debt to spur a domestic wealth effect. Today Canada is running a higher private sector debt/GDP than Japan did just before the implosion of their own real estate market in the 90s.

Instead if you have a look at the US you'll find that their private sector non-financial debt as % of GDP today is 20 percentage points lower than in 2007. While mainstream media commentators obsess about US government debt despite the United States enjoying the privilege of issuing the reserve currency of the world (USD), private sector leverage trends in the US show a relatively benign picture if compared to other countries around the world.

What countries score the worst by this metric, you ask?

This table can help you quickly assess in which countries private sector debt is too high and it's been rising too fast over the last 10 years.

Now, obviously levels and rate of change in private sector debt are not the only variables to consider when assessing when/where/what will break in macro.We also need to consider other fundamentals, the nature of the private sector debt market (floating or fixed rate, short-term or long-term), refinancing cliffs and many other variables.

Hence this was just the appetizer of my investigation into ‘‘what will break in macro’’.The good news though is that I will be serving you the entire menu soon :)

Now, before you leave two important points:

* Learn to master bond markets!

Even if a country is particularly vulnerable to macro shocks it doesn’t mean something will break there: it’s the combination of these vulnerabilities and these crucial but sometimes hidden messages the bond market is sending that will put you on the right path!

Where do you get pro-level knowledge of the intricate and technical bond market?

I unpacked it all for you: take a look here.

The TMC Bond Market Course has added a lot of value for customers - this is the kind of feedback I can proudly say I am receiving so far :)

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Enjoy your weekend, and always stay hungry for macro!

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Hi everybody, and welcome back to The Macro Compass!

I will be in New York on Oct 2-3-4 presenting my macro investment outlook to institutional clients - if you are/represent a hedge fund PM, RIA, family office, investment firm or a finance professional and you want to arrange a meeting please send an email to [email protected].

A brief intro and why you want to meet would be appreciated.If you put pineapple on pizza I won’t accept the invitation :)

Now: back to it!

There is a rare and powerful trend occurring in bond markets.History shows that if left unchecked, it can cause serious damage to equity markets and the economy.

Over the last 3 months, US bond markets are in an aggressive and prolonged period of bear steepening of the yield curve.

Let’s cover the basics: what is a bear steepening of the yield curve and why does it matter in the first place?

Bear steepening happens when interest rates move higher but it’s long-dated yields that take the lead, hence shifting the entire curve higher but also steeper.

The chart above shows the 10-year market-implied path ahead for Fed Funds before and after bear steepening and the net change in the box below.To understand it, think of 10-year yields like a strip of all future Fed Funds for the next 10 years discounted to today.

The reason why we didn’t see 10-year Treasury yields breaching 4% until recently is that the prevailing yield curve regime was bear flattening: the Fed would impose higher yields in year 1-2 of the chart above, but the market would discount damage to growth and inflation down the road and price materially lower Fed Funds from year 3-10 with a convergence towards a ‘’neutral’’ of 3% over time.

That’s why higher terminal rates at 5%+ didn’t push 10-year yields higher than 4.00%.But over the last 3 months the music has changed with the bear steepening.

Recently instead markets priced in a mildly higher terminal rate at 5.45% and most importantly listened to the Fed’s message: no cuts anytime soon.But while in the past that meant more cuts would be priced in immediately after, the bear steepening move implies that markets believe the economy can handle higher rates for much longer (red arrow).

In a nutshell according to markets not only Fed Funds at over 5% for quarters on end aren’t going to generate a recession, but actually the economy will barely budge (?)

But why is bear steepening such a rare and dangerous occurrence?

Bear steepening regimes cause long-dated yields to rise rapidly, and this has a large and rapid tightening effect on the real economy: 30-year mortgage rates and corporate borrowing rates rise rapidly across the curve, financing becomes even tougher and negative mark-to-market effects (see regional banks) are amplified.

The last part is particularly important: a 10 basis point rise in 30-year yields is about 10-12x more powerful than the same increase in 2-year yields from a mark-to-market perspective - this is because long-dated fixed income instruments have more duration and they are way more sensitive to changes in interest rates.

All business models which make large use of long-dated instruments and leverage are vulnerable if their risk management wasn’t done properly: pension funds, insurance companies, shadow banking, real estate, and more.

The Key Point: Bear Steepening + Weakenining Economy = Damage

The key point to understand is that higher yields and bear steepening aren’t a problem per se: if the economy is running hot it’s actually healthy to have long-end rates reflect the increase in nominal growth.

That’s not the case today.

The chart above shows the underlying trend in US nominal growth (blue, LHS) against the US Treasury 2-10 year yield curve slope (orange, RHS): notice how in 2021 the yield curve steepened reflecting rapidly accelerating growth from fiscal stimulus and reopenings. No problem at all there.

But now look at today: US nominal growth is falling and yet markets are staging a prolonged bear steepening.As that’s not reflecting stronger growth, it has to be interpreted as a very late cycle attempt by bond markets to find out where the breaking point is - after all the Fed is preaching higher for longer so let’s go after it and see if it works.

Very similar macro regimes with below-trend growth but recessions failing to materialize and markets pushing a bear steepening regime as people become convinced that ‘’economies can handle higher rates’’ were seen in:

- September to November 2000

- May to June 2007

- September to November 2018

In all three cases above rapid late-cycle bear steepening trends marked the end of the ‘’this time is different’’ experiment and ended up causing severe distress to economies (2001-2008) or markets (Q42018).

I don’t think this time will be different.

History serves as a useful guide and we just need to travel back in time to 2018 for a concrete example.

The Fed was raising rates and tightening as the economy and inflation had picked up, with markets displaying the usual bear flattening...until August 2018.At that point the economy seemed to hold on well despite the tightening and the narrative was all about how the Trump tax cuts were gonna support growth for long, how Powell saw neutral rates higher, how the economy could handle higher rates.

And so the curve bear steepened (red boxes) for about 7 weeks straight until early October.

This sustained late-cycle bear steepening was ‘’it’’ for markets, with equities peaking in early October and tanking 23% in less than 3 months.No, this time wasn’t different: the economy and markets couldn’t structurally handle higher long-end rates.

You want to know why today the bear steepening is even more dangerous?

Back then inflation was 2% and the Fed could rapidly pivot in early 2019 hence repairing the damage: rates fell and the S&P500 returned over 30% in 2019.This time inflation is much higher and the Fed’s hands are tied…

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Hi all, and welcome back on The Macro Compass.

Last call: there are only 53 spots (9%) left to secure your heavy discount for the TMC Bond Market Course!

As a loyal TMC reader, there is an exclusive offer for you: using the coupon ‘‘BOND500’’ at checkout you can claim a chunky 25% off!

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The ECB Policy Mistake

The ECB hiked interest rates to 4% and I think they made a policy mistake.

Lagarde keeps throwing fuel on the fire as the European economy is already feeling the tightening much harder and faster than the US: but why?

This is a function of ECB tightening but also of the fact that the European private sector enjoyed amazingly cheap borrowing rates for so long – and hence the change of tune is felt much harder.

Have a look at the chart below which shows European BBB 10-year corporate borrowing costs from 2013 to today:

- 2013-2023 average: 1.69% (blue line)- 2016-2019 average: 1.35% (green line)- Today: 4.20% (!!!)

European BBB-rated corporates could borrow for 10-years at 1.69% (!) all-in cost on average between 2013 and today – that’s the blue line on the chart. If we focus on the pre-pandemic period, between 2016-2019 that average was 1.35% only (green line).

Today, life is much harder: borrowing costs have almost tripled (!!!) to 4.20% and most importantly they have been sitting there for almost 12 months now.That’s a serious tightening of borrowing conditions which is biting into the European economy pretty hard.

Yet the ECB keeps hiking and it also ignores another macro beast threatening Europe much more seriously than the US: refinancing cliffs!

The chart above shows the % of corporate loans and bonds maturing per each calendar year per different jurisdictions.As corporates spread out their borrowing over time, refinancing needs are not all clustered together: on average companies have to refinance about 10-15% of their entire borrowing needs each year (red line).

As you can see, Europe (blue) faces a tough task next year: European companies will need to refinance 25% (!) of their borrowing needs in 2024 and they will have to do it at borrowing rates which are much higher than what they are used to.

As the refinancing cliffs approach fast in Europe, companies have to take hard decisions: stay away from leverage and shrink their businesses altogether, or cut structural costs (e.g. jobs) to maintain a viable business despite higher borrowing rates.

The ECB just hiked in the face of an already weak economy facing sizeable refinancing cliffs: I think Lagarde just made a policy mistake.

Japan Matters for Global Bond Markets

In a recent interview, Bank of Japan governor Ueda signaled the era of negative interest rates in Japan might soon be over.As a result, currencies and bond markets were on the move.

But why does Japan matter so much for global bond markets?Japanese investors are amongst the biggest capital exporters in the world, and they have become gigantic buyers of US Treasuries, European fixed income and other foreign bond markets.As domestic yields have been depressed for so long and Japan kept accumulating savings and foreign reserves, it looked for ways to invest these abroad to generate higher returns.

For reference, Japanese investors alone own over $1 trillion of US Treasuries and some EUR 400 bn in various European bonds (mostly French and German).Now that domestic yields in Japan might be on the rise, will they stop investing in foreign bonds?

Here is the thing: they have already done that.The Japanese support for global bond markets has been fading for quarters already.

But if Japanese bond yields have just started to rise, why did this happen already quarters ago?

You see: when Japanese investors buy foreign bonds they must swap existing JPY for USD or EUR.

This means they would run FX risk too which often they don’t want – from my personal experience speaking to Japanese investors in my previous job, they hedge the FX risk between 3 and 12 months which is considered a large enough period of time to assess the risk/return of their bond investment after hedging FX risk.

The chart above shows you what a Japanese investors see when looking at investing in 10-year US Treasuries after the costs for hedging USDJPY for the next 12 months.

For Japanese investors, today US Treasuries are extremely expensive to own because FX hedging costs are super high (Fed rate hiking cycles versus no BoJ hikes) while curves are inverted and hence the yield benefit in investing in foreign 10-year bonds is dramatically reduced.

US Treasuries are the most expensive in decades for Japanese investors.They have been so for quarters now.

And the next BoJ action will be crucial to determine whether this trend continues.

Is Powell Done Hiking?

US inflation surprisingly accelerated in August: what does this mean for the Fed?

The Fed splits core CPI into:1️⃣ Goods inflation2️⃣ Housing inflation3️⃣ Services ex-housing inflation

Disinflationary forces are notoriously at play for goods: overhang in inventories (e.g. car industry) and a complete healing of supply chains point to a continued moderation in core goods prices.This is also reflected in stuff like the Adobe Price Index measuring online digital goods prices which just hit a 40-month low.

Housing inflation represents a large share of the core CPI basket and the Fed got quite some good news with this report.Rent of shelter keeps decelerating sequentially as it just lags what's happening to rent inflation on the ground: the Zillow rent growth series has dropped materially and housing inflation captured in the CPI statistics is following suit.The pace of the deceleration is great news for the Fed: the 3-month annualized housing inflation rate is now down to 4.6% from a peak of almost 10% (!) at the beginning of the year.It should continue to slow down going forward: good news for Powell!What about Powell’s preferred measure of sticky inflation - core services ex-housing?This is supposed to be the stickiest, output-gap, labor market slack related part of the CPI basket which Powell watches the most closely.

We got a 0.4% MoM print which was stronger than expected, but the chart above allows us to take a step back and look at the trend in sticky inflation: the 6-month annualized rate of change hit a new low in this cycle at 2.7% down from over 5% (!) at the beginning of the year.Sticky inflation seems to be getting under control too.

All in all, the Fed seems to be done with hiking but markets are starting to challenge this assumption: higher oil prices, pressure building in bond markets and a solid monthly print in core services ex-housing all bring questions to the table.

Calm before the macro storm?

Last call for the TMC Bond Market Course: there are only 53 spots (9%) left to secure your heavily discounted price!

As a loyal TMC reader, there is an exclusive offer for you: using the coupon ‘‘BOND500’’ at checkout you can claim a chunky 25% off!

You can watch the course and download the material anytime you want, but this exclusive offer won’t be there forever :)Not many spots left, so be quick and take advantage of it offer before it sells out!

For more information, you can visit this dedicated page.

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

Hi all, and welcome back on The Macro Compass.

Quick reminder: The TMC Bond Market Course is out, and the heavily discounted spots are running off fast!

As a loyal TMC reader, there is an exclusive offer for you: using the coupon ‘‘BOND500’’ at checkout you can claim a chunky 25% off!

The offer though is spot-limited: out of the 500 available spots only 223 are left (55% already taken in 3 days).

So: be quick and take advantage of this exclusive offer before it sells out!

For more information, you can visit this dedicated page.

Over the last few weeks bond markets have been on the move: 30-year Treasury yields have rapidly surged from below 4% to almost 4.50% catching many by surprise.

Yet understanding why and what drives bond market action is a crucial skill for macro investors, so let’s explore together an approach that will help us make sense of the recent bond market developments.

Nominal bond yields can be thought of as the interaction between:1️⃣ Growth expectations2️⃣ Inflation expectations3️⃣ Term premium

1. Growth expectationsWhen it comes to economic growth we must consider two angles: structural and cyclical growth.Structural economic growth can be generated through more people joining the labor force (good demographics) and/or through a more productive use of labor and capital (strong productivity trends).The ability of an economy to generate structural growth is an important driver behind long-dated bond yields (strong structural growth = structurally higher long-dated yields and vice versa).

Short-term economic cycles also matter for bond yields - particularly at the short-end.Cyclical growth trends are driven by the credit cycle, the fiscal stance, earnings growth, labor market trends and more - the healthier they are, the higher short-end bond yields can be pushed also as a result of a likely tightening from Central Banks that might grow worried about economic over-heating and inflationary pressures in such an environment.

What happened to growth expectations recently?

Analysts stopped revising down their 2023 earnings per share (EPS) expectations and started revising them higher for 2024 - they are now looking for a healthy 12% EPS growth for next year!

On top of this, consider that:

* The AI-mania led to speculations over big productivity gains, and therefore boosted the ‘‘higher structural growth’’ narrative';

* The stubbornness of the US economy spurred discussions on whether we can handle higher rates for longer due to stronger structural growth;

In short, long-term growth expectations were revised higher: the first item of the equation above contribute to pushing 30-year Treasury yields higher.

2. Inflation expectations

The second component driving nominal bond yields is inflation: but NOT TODAY'S inflation - instead we are referring to long-term inflation expectations.Central Banks might temporarily react to concentrated bursts of inflationary pressures by raising short-term interest rates but when it comes to long-dated bond yields investors will always pay close attention to inflation expectations.That's because consumers and borrowers will tend to make important decisions based on these rather than on volatile short-term trends in inflation.

What happened to the inflation component?

Contrary to popular belief, investors are generally not scared of sticky persistent inflation: the US 5y5y inflation break-even has traded in a 2.45-2.75% range for the last 12 months - that means investors expect US CPI inflation to float around these levels between 2028 and 2033.

In short, investors have pushed 30-year Treasury yields higher NOT because of fear over sticky persistent inflation but because of:

* Positive re-rating of cyclical growth (EPS expectations pushed higher);

* (Some) Positive re-rating of structural growth (narrative driven: AI, higher r*);

* Wait for it…

3. Term Premium

An investor looking to get fixed income exposure can do that via buying 3-month T-Bills and rolling them each time they mature for the next 10 years.Alternatively, it can decide to purchase 10-year Treasuries today.What's the difference?Interest rate risk!Buying a 10-year bond today rather than rolling T-Bills for the next 10 years exposes investors to risks – term premium compensates for this risk.The lower the uncertainty about growth and inflation down the road, the lower the term premium and vice versa.

The chart above proves the point: the higher the uncertainty (x-axis moving to the right) about future growth and inflation, the higher the term premium (y-axis moving upwards).

Per our simple equation shown earlier, a higher term premium pushes long-dated nominal bond yields higher.So, what happened to term premium?

Estimates of the US Term Premium have moved higher and they are now testing the upper side of recent ranges: in other words, there is some more uncertainty being priced in about the path ahead for growth and inflation.Investors are less confident about a future of predictably contained inflation and growth, and they expect some more volatility and uncertainty down the road.

Taking a step back though, term premium remains still very depressed by historical standards: 10 years ago we were north of 1%, and today we are barely back to 0%.

Conclusions

The recent aggressive move higher in 30-year Treasury yields is NOT driven by fears of persistently higher inflation but instead by:

* A positive re-rating of cyclical growth (2024 EPS estimates pushed higher) and some narrative-driven speculation for higher structural growth (e.g. AI effect on productivity);

* Slightly higher term premium, reflecting investors’ expectation for more unpredictable boom and bust of growth and inflation down the road.

Thanks for reading, and a quick reminder.

The TMC Bond Market Course is out, and the heavily discounted spots are running off fast!

As a loyal TMC reader, there is an exclusive offer for you: using the coupon ‘‘BOND500’’ at checkout you can claim a chunky 25% off!

The offer though is spot-limited: out of the 500 available spots only 223 are left (55% already taken in 3 days).

So: be quick and take advantage of this exclusive offer before it sells out!

For more information, you can visit this dedicated page.

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

Are we back in 2011 or what?

After the US debt ceiling drama earlier this year we just witnessed a rating agency downgrading the US exactly like in 2011 – back then S&P, this time Fitch.

Today you are likely to read plenty of scary and fear-mongering headlines.In this piece instead we’ll take a step back and rationally assess what the US downgrade means for investors and markets out there.

A few words on the reasons behind the downgrade: Fitch pointed out the prolonged discussions on debt ceiling show ‘’deterioration in the standards of governance’’ and the rating agency also sees an economic downturn ahead which is likely to weaken government finances further.

The chart below shows the US spending on interest payments nearing an annualized $1 trillion: a scary chart…if you think the US government has a constrained budget like a household.

But that’s not how it works.

The government doesn’t ‘’need to find money’’ before delivering deficit spending: the government is the very issuer of the money the private sector uses so its balance sheet doesn’t work like ours.

Deficit spending creates a hole in government’s balance sheets and increase our net wealth (it’s nice when they cut your taxes or throw cheques at you right?) – this increases bank deposits in the system.More bank deposits (liability for a bank) imply more bank reserves (assets for a bank) in the system too, and when the government issues bonds to ‘’fund’’ its deficit spending primary dealers can swap these reserves (or use the repo market) for newly auctioned Treasuries.

There are more steps and versions of how this could work, but this stylized example should help you understand the main concept: deficit spending creates money for the private sector and the government doesn’t ‘’need to find money’’ to spend money – the government creates money in the first place.

Repeating this concept is useful to demystify ‘’scary’’ charts like the one you saw before: yes government interest payments are rising but it’s not like the US needs to ‘’choose’’ between spending on interest and spending money in the real economy – its balance sheet doesn’t work like ours.

The real limitation to uncontrolled deficit spending is inflation and scarcity of resources (2021-2022 prime example) and not some budget constraints typical of a household.

Ok, but how does the Fitch downgrade affect investors and market participants?

The key point is that US Treasuries now have their second-best rating at AA+ instead of AAA given that only Moody’s preserved its top rating for the US.US Treasuries are the most widely used form of collateral in the world due to their high rating, liquidity, deep repo market and solid democratic foundations/rule of law: does the downgrade affect that?

Let’s have a quick look at the rating requirements that different institutional players must adhere to when investing in safe government bonds to explore whether a downgrade to AA+ makes the difference.

Commercial banks are huge buyers of Treasuries: they use them as regulatory liquid assets (HQLA), as collateral and also sometimes as an asset to hedge interest rate risk on their liabilities.

The Basel regulatory framework introduced 10 years ago has 0% capital requirements for government bonds rated between AAA and AA- for its standardized approach: the downgrade to AA+ wouldn’t make any difference. Most banks actually choose an internal-rating based (IRB) approach based on internal models and in that case most jurisdictions apply an exception for any investment-grade rated domestic government bond which automatically assigns them a 0% risk weight.

Bottom line: for banks this downgrade makes no difference at all.

Pension funds and insurance companies are also large buyers of Treasuries: they use them as a long duration asset to match their long liabilities (life insurances payouts, pension payouts etc) and as collateral.

For a pension fund considerations about risk/return profile are important: they not only need to hedge interest rate risk but also try to deliver long-term returns to make the pension system sustainable over time.AAA-rated or AA+ rated US Treasuries would still fall in the hedging camp or in the defensive asset allocation camp and a one-notch downgrade wouldn’t make the difference.

When it comes to collateral usage, pension funds and insurance companies are very active in the repo market: they lend their unsecured cash parked at a bank against collateral to upgrade the safety of their ‘’cash’’ deposits – does a downgrade affect the collateral status of US Treasuries?

These are the recommended haircuts that the Basel committee suggests to apply to collateral lent/received in these transactions:

As you can see, bonds rated between AAA and AA- all fall within the same bucket.Certain pension funds have stricter collateral demands and only accept AAA collateral though, but still the marginal impact of the Fitch downgrade is likely to be extremely minor.

Big buyers of US Treasuries also include FX reserve managers: Chinese or Brazil corporates selling stuff for USD will deposit these US Dollars in the domestic banking system and so the Bank of Brazil and PBOC would be in charge of investing these USDs in safe, liquid assets – you guessed it: US Treasuries.

For FX reserve managers rating considerations are important, but again most countries put AAA-AA rated governments in the same risk bucket.More importantly, as 70%+ of global transactions are still in USD there will always be structural demand to recycle these USDs in safe US Treasuries.

What’s the alternative anyway? JGBs with no free float? Europe with a smaller AAA-AA bond market? BRICS with no liquid bond market and democracy/rule of law issues?

As you can see, for most institutional players out there this downgrade has no material impact that would make them a force-seller of US Treasuries.But let’s say you want to look at one market indicator that truly signals stress around this – what would it be?

If markets were worried about the collateral quality of US Treasuries, this would be reflected in swap spreads.Swap spreads are nothing else than the differential between swap rates and Treasury yields: OIS swap yields measure the market-implied return you can make by safely depositing money at the Fed, and hence if Treasury yields rapidly deviate from that it could be because of collateral quality considerations.There are also other drivers behind swap spreads, but it’s one of the cleanest things to follow here.

In 2011, 5-year swap spreads were very volatile around the downgrade but ended up stabilizing soon after.Today, we got no reaction at all so far.

You can follow 5-year swap rates and compare them to 5y Treasuries here.

In the short-term markets can overinterpret and overreact, so it’s important to keep track of sentiment and price action but in the long-run this article covered why this downgrade shouldn’t affect markets much.

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The big Central Bank week is here: ECB, BoJ, Fed…wow!Well…if you are an institutional investor who enjoys my macro analysis, I have great news for you!

I just launched a live Bloomberg chat service and institutional research service dedicated to you!

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Yes: it costs you nothing to try!

This is one of the most popular and yet misleading charts in macro.People like simple narratives: the Fed is ''pumping money'' into the ''system'' and that's why equity markets go up.

That’s just NOT how it works - let’s explain why.

A good starting point is asking ourselves what’s ‘‘money’’ and what’s the ‘‘system’’.Let’s start from money.

Central Banks' balance sheets expand mostly through monetary operations: the most known is QE, but there are also other tools like the recently created Fed's BTFP.In any case, when the CB expands its balance sheet by acquiring assets (QE) or providing financing in exchange of collateral (e.g. BTFP, TLTRO) it also expands the liability side - it prints ''money'', but to be more precise it prints bank reserves.

Bank reserves are bank-money, not real-economy money: only banks can transact in bank reserves with each others, and these reserves can never (I repeat, never) reach the private sector.No: banks don't ''multiply'' reserves when they make loans.As the Bank of England shows, banks create new money when extending credit to the private sector and they do not ‘‘transform’’ existing reserves.

But most importantly, no: banks don't buy stocks (!) with newly printed bank reserves!

The idea behind this chart is just wrong: as the Fed creates new bank reserves (''liquidity'') there would be a mechanism for which banks deploy these reserves in financial assets hence pushing equity markets up.

But banks don't do that.What are reserves used for?Mostly to settle transactions against other banks.

They also account as a High Quality Liquid Asset (HQLA) together with government bonds and certain corporate and mortgage-backed securities: banks can use them to pay other banks if they buy HQLA assets from those, passing over bank reserves in a closed system like a hot potato.But they won't use reserves to buy stocks - they are effectively not eligible as a HQLA asset or only under extremely strict conditions.

Equity ownership as a % of HQLA buffers from big European and US banks is negligible - conditions are so strict you could say it’s almost 0%.

I know what you are thinking now: the portfolio rebalancing effect.If banks are bidding corporate bonds away from each other's HQLA buffers, spreads will tighten and this should invite a more aggressive stance from equity investors too.That's partially true, but it's a potential second-order effect which also requires fundamentals (!) to back the thesis: banks aren't gonna blindly over-allocate to corporate bonds because they have more reserves if they smell the risk of rising defaults.

See what happened in 2008: the Fed ‘‘printed’’ almost $1 trillion (orange) very rapidly and yet corporate credit spreads (blue) kept widening as default risks were increasing due to the Great Financial Crisis.

Economic conditions matter after all.

Which brings me to the main point why the original chart in this piece is misleading.

These two series trended up over the last 15 years for different reasons: Central Banks kept accommodating through QE & Co to bring inflation back to target and most importantly...

...the Nasdaq went consistently up also because earnings grew by roughly 10% on average per year (!!!).

Don’t believe me yet?Let’s do some basic math together.

Is it really true that ‘’liquidity’’ is so tightly correlated to stock market returns?We ran a simple linear regression analysis between the change in ‘’liquidity’’ (US bank reserves) and the S&P500 returns in the last 15 years – we played around with time lags, outliers, return windows...everything.

Bank reserves and stock markets both tend to go up over time and hence they look ‘’correlated’’, but analysing the rate of change of liquidity and S&P 500 returns helps with smoothing this problem away.

The result was consistently clear.

A simple linear regression exercise tells us ‘’liquidity’’ is pretty bad at predicting stock market returns: as shown by the R2 data, in the last 15 years US liquidity only explained 3-4% (!) of the variation of SPX returns.

So, yes: both series trended up over time and plotting them on a dual-axis chart looks great but stocks go up over time because earnings grow and not because Central Banks pump ''money'' in the ''system''.

Money in this case means bank reserves, and banks can’t and won’t use reserves to buy stocks - the direct relationship and simple narrative suggested by mainstream macro commentators…

…simply doesn’t exist.

The big Central Bank week is here: ECB, BoJ, Fed…wow!Well…if you are an institutional investor who enjoys my macro analysis, I have great news for you!

I just launched a live Bloomberg chat service and institutional research service dedicated to you!

I'll cover macro, Central Bank and market events daily through an interactive BBG chat and deliver institutional-focused macro research pieces - ping me on Bloomberg (Alfonso Peccatiello) or email at [email protected] for a 2-weeks FREE trial!

Yes: it costs you nothing to try!

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 compile statistics on my traders. My best trader makes money only 63 percent of the time. Most traders make money only in the 50 to 55 percent range. That means you’re going to be wrong a lot. If that’s the case, you better be sure your losses are as small as they can be, and that your winners are bigger.’’

– Steve Cohen, Point72 hedge fund founder

This is a hard truth to accept for many macro investors: we will be right only about 50-55% of the times.

If your win rate is much higher than this, I suggest you extend the sample of trades you are analyzing or assess whether you are not trading macro but rather just selling optionality – short vol/option strategies have win rates as high as 90%+, but they wipe you out completely when you are wrong.

In the last 10 years, I scored a 53% long-term win rate on my directional macro trades.Once I realized that and given that the year-end P&L formula can be written as follows:

I knew I’d better make sure the size of my losses doesn’t get out of control.

This can be achieved in two ways: sizing trades correctly and designing a system that lets your winners run.We are going to talk about my approach to both angles in a second, but first another important remark.

To step up the win rate on macro trades from 50% to say 55% over a long period of time, you need to gain some edge over other macro investors.What could that be?

* A data-driven approach with superior macro models

* The ability to assess the gigantic amount of cross-asset market signals via quantitative tools

* A particular edge in a niche market that you have learnt to navigate well over time

* Be less stupid than others

Macro models and interactive tools help, but my ‘’don’t be stupid checklist’’ adds value too - here is what I go through for every tactical trade I set up:

Points 1-3 keep my emotions in check and ground me to a more rational assessment of the trade.

Points 4-6 are about implementation.

A warning: short carry trades (and long options) are expensive to hold over time if nothing happens.A reminder: in very choppy markets, you can get quickly stopped out with linear trades even if your thesis proves to be correct – consider whether the market regime favors linear or option implementations.Don’t be stupid: check whether the trade you are about to add is not just another expression of a trade you already have on – I have seen people blow up as the 10 trades they were running were just…the same trade.

But it’s point 7 that sticks out: sizing and risk management define most of your P&L at year-end.

Here is how I approach them through a practical example.

Say you think that the S&P500 will keep marching higher over the next month: how many SPYs do you buy?

Let’s find out some smart ways to size positions and apply effective risk management…

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