Bassman: Fed ‘Backed Into A Corner’

Long-term US rates at ~2.50% are not consistent with ~5% inflation unless the Fed invokes Yield Curve Control. More bothersome is that the SPX at 4575 (and VIX at 20) is not sustainable if an inflation-cooling recession harkens. An inverted Yield Curve never ends well, and option prices are way too low for a Fed backed into a corner while the Russians are testing their nukes.

Square Pegs

A Commentary by Harley Bassman

Cognitive dissonance is often defined as simultaneously holding conflicting or inconsistent thoughts, attitudes, and beliefs.

It is a signpost of the mature mind to accomplish this feat without first securing a membership at the local dispensary.

Just as I cannot avert my eyes from a crash site, I similarly marvel at the opposing positions offered at the same time by our political class, with unreserved sincerity.

In contrast, the governors of the Federal Reserve Bank (the FED) instill confidence in our financial system by projecting certainty. Thus, the FED’s stress must be palpable as they presently try to jam the square peg of inflation into the round hole of a bond market signaling a recession.

Dr. Cam Harvey was a recent guest on our monthly “Keeping It Simple” webinar. Dr. Harvey secured his PhD (at UChicago, of course) with a dissertation highlighting the relationship between the Yield Curve and economic recessions.

The –fettelite line– spread between the two-year rate and the ten-year rate is one of the most popular relationships. As shown below, this spread turns slightly negative about 14 months before each of the recessions.

Detailed in “Dangerous Curves Ahead”, while Forward interest rates are not a prediction, they do provide useful information.

The -charoite line- illustrates how Yield Curve inversion has preceded prior recessions. Today, the one-year forward thirty-year rate is 68 basis points below the forward two-year rate; a level not seen in more than thirty years.

Most anomalous, and perhaps ominous, is that the one-year forward Yield Curve is fully inverted, where each longer rate is lower than the prior shorter rate.

Just as the -vinciennite line- Yield Curve has a clear relationship with the economy, it has also been well-correlated with -lepidolite line- Implied Volatility. Yet since my last Commentary, both have continued to move orthogonally

For a sense of scale, the -linarite line- MOVE Index recently touched 141, a level visited only twice since 2002 – during the pandemic and the Great Financial Crisis (GFC).

Regular readers know my mantra: “It is never different this time.”

Fine…let’s stipulate that the bond market has sniffed out a recession with a summer 2023 due date.

This raises two questions: Why has the Equity market bounced hard from its lows to only 4.9% under its at-time high; and why has the Equity options market not presaged a recession ?

While the -vivianite line- MOVE Index for bonds continues to elevate, the more famous -olivine line- VIX Index for equities is at 20, near its forever average.

This chart could seem strange, but I will add the caveat that interest rates have been moving violently over the past month, while stocks have calmed down with a two-week actual Volatility of only 18.

The “wrong price” is the -sandstone line- Skew, which is the difference between the Implied Volatility of an out-of-the-money put versus a call.

For clarity, assume the S&P 500 is at 4500, so a 90% put would have a strike of 4050, or 10% below the market. Similarly, a 105% call would have a strike price of 4725, or 5% above the market.

Measured here, the Implied Volatility of the call option is subtracted from that of the put option; a simple difference equation.

Notable here is a Skew well off the highs; in fact, it is below the average Skew since the pandemic jumped the entire Skew profile.

The flashing signal of a recession should expand Skews, not contract them.

A market sector that is acting rationally is Mortgage bonds. As a reminder, the -feldspar line- is the yield spread between an MBS bond priced at par (100-00) and the ten-year interest rate. This is my best measure of MBS value.

As shown, the “forever” average is about 74bp, versus a current level 111bp.

With the MOVE near 130, and the Yield Curve in flux, this level is not crazy cheap, but I will say MBS are a better “buy” than a “sell”. This is why Mortgage REITs (mREITs) have bounced off their recent lows.

Let me add a comment about mREITs, Closed-end Funds (CEFs), Business Development Companies (BDCs) and Master Limited Partnerships (MLPs).

The greatest risk for these leveraged investments is their funding cost, which is linked to the FED Funds rate. Presently, the market is pricing a peak FED rate of 2.75% to be reached in June 2023, essentially when the Yield Curve projected recession should start. To the extent this is true, you can dip your toe; but if the FED has a lot more to do, these investments will be reducing their payouts.

Macro Comments

Not to kick the “inflation is transitory” crowd when they are down, but I think we can finally agree that there is palpable CPI inflation. Moreover, I think most will agree that a continuation of at least 4% is baked in the cake, if only because:

1. Owner’s Equivalent Rent (OER), one third of CPI, lags six-to-nine-months behind Shiller’s housing price index. (Up 19% last year.)
2. The cost of energy (as an input) has yet to flow through to the many goods that require fossil carbon. (Up 54% YTD.)

The “recession is coming” pundits argue that CPI inflation exceeding wage inflation will dampen consumer demand and rapidly reduce real GDP. This seems to be what the Yield Curve is contemplating.

But since stocks are priced in “nominal” terms, not “real” terms, they can still increase in such an environment. I would not be surprised, therefore, if “real” GDP comes in flat to negative, but “nominal” GDP (real plus inflation) runs north of 5%.

This is where the rubber meets the road for long-term interest rates; and why one should not be so sanguine about longer-term rate risk.

The old rule was that -aventurine line- ten-year rates follow -azurite line- nominal GDP; and there is an entire MBA course offering fundamental support for this concept. Larry Summers has opined that the FED has stumbled into “stagflation”, where real growth is close to zero, yet inflation remains elevated.

If this is the case, the UST 10yrs should have no problem kissing the 3.25% high reached in October 2018 when nominal GDP last nudged over 5.0%.

Concluding thoughts

As I have noted (often) since the implementation of Quantitative Easing (QE), over the course of 5,000 years of human history, there is no record of the Sovereign printing the coin of the realm (shiny rocks or fiat currency) at a faster pace than the growth of the real economy without inflation.

While the timing can be imperfect, the conclusion is a certainty.

A Central Bank can create inflation if they try hard enough, and let’s be clear, there has been massive inflation over the past decade in financial assets which has widened wealth disparity and fed our disruptive politics.

The FED printed a ‘haystack’ of money, which finally met the ‘match’ of excessive Fiscal spending and set ablaze a CPI fire storm.

For whatever the reason, the FED missed the offramp for QE and ZIRP (Zero Interest Rate Policy) last year; and is now praying to not repeat 1987.

Long-term US rates at ~2.50% are not consistent with ~5% inflation unless the FED invokes Yield Curve Control (YCC). More bothersome is that the SPX at 4575 (and VIX at 20) is not sustainable if an inflation cooling recession harkens.

An inverted Yield Curve never ends well, and option prices are way too low for a FED backed into a corner while the Russians are testing their nukes.

The FED is talking tough, but it is unclear if they have the nerve to pull out their hammer and jam the square peg into the round hole; too often that breaks the entire toy.

Short convexity is always found lurking near the scene of the crime. What I can advise for sure is to cover in any explicit or implicit option shorts. Better still, seek ways to add positive convexity to your portfolio.

Remember: For most investments, sizing is more important than entry level.

Harley S. Bassman March 29, 2022

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