Strategist Who Nailed S&P Last Cycle Talks ‘Altogether New Regime’

“Our view has (always) been that crossing an imaginary red line can’t be a sufficient reason to pay attention,” Deutsche Bank’s Aleksandar Kocic said, in a note comparing and contrasting the Fed’s fledgling tightening campaign with the last hiking cycle.

He was referring to the four-decade downtrend in US 10-year yields. Thursday’s pre-holiday session found 10s cheapening back to levels consistent with a breach (figure below).

Earlier this week, I gently suggested that the real story in 2022 is the worst losses for Treasurys in decades, not the crossing of any purported “thresholds.”

Whether that visual presages a denouement for disinflation and/or the end of financial repression is a question that won’t be answered for years.

Looking back on the last cycle, Kocic noted that if you “plot the same history from the late-2018 perspective and adjust the channel to pre-2018 history,” a similar break above the disinflationary channel shows up. That was a false dawn. Yields subsequently resumed their downward trek. By August 2019, the global stock of negative-yielding debt was near $17 trillion.

But the macro circumstances and, as a consequence, the Fed’s reaction function, are dramatically different from the last cycle.

Kocic, some readers may recall, had perhaps the most accurate S&P “target” on Wall Street in 2018. It wasn’t really a “target,” per se (Kocic is a rates derivatives strategist), but rather a suggestion for where US equities might end the year based on his assessment of the dynamics around the Fed’s effort to re-emancipate markets after a decade of martial law imposed in the wake of the financial crisis.

I wasn’t the only one who documented Kocic’s prescience in 2018. Bloomberg celebrated the same prediction in an article which began with this sentence: “There’s one sell-side analyst who managed to predict this year’s volatile markets and he doesn’t come with a wizard nickname.” (The analyst was Kocic, and the wizard allusion was to JPMorgan’s Marko Kolanovic.)

In his latest, Kocic revisited that call. Urgency tied to inflation wasn’t behind the 2016-2018 hikes. Rather, tightening was aimed at freeing markets and allowing for the return of price discovery, as the Fed sought to cut its addiction liability “and preemptively find a more comfortable position in case inflation materialized,” Kocic wrote, noting that it all “played out against a generally benign inflationary background.”

Despite the Fed’s best efforts to be transparent and predictable, the market eventually rebelled — against its own emancipation. “The market, used to excess liquidity and easy policy, continued to voice its resistance against the Fed resolve focusing its debate on the strike of the Fed put and challenging its lower bound,” Kocic said this week, noting that in the end, “the market won that debate.”

Jerome Powell’s January 4, 2019, pivot, unveiled during a joint speaking engagement with Janet Yellen and Ben Bernanke, is remembered by many as a surrender (figure below).

This time around, the dovish pivot isn’t imminent. The inflation problem is “acute,” as Kocic put it, and the Fed must now choose between reestablishing its credibility as an inflation fighter and jeopardizing growth.

Several days ago, I noted that even with the historic selloff in bonds, yields are nowhere near consistent with where history says they “should” be given inflation realties.

The familiar figure (below) underscores the point. The red squares represent recent inflation prints.

A simple interpretation suggests 10-year yields should be somewhere in the neighborhood of 9%.

“The 100bps selloff in 10-year yields, while massive by all accounts, is still insignificant compared to the size of dislocation between the underlying rates/inflation and can be only taken as a symbolic gesture towards recovering the traditional dynamics of the past,” Kocic went on to say.

Considering near total ambiguity around the long run macro picture, uncertainty around the path of long-end yields is likely to persist, supporting higher term premia, Kocic wrote, raising the odds that the breach of the disinflationary channel could “become even more extreme,” ushering in “an altogether new regime.”

“Unlike the previous cycle, the Fed is no longer consulting the markets, but merely informing them, and the issue of the Fed put doesn’t even enter the discourse,” he added.

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4 thoughts on “Strategist Who Nailed S&P Last Cycle Talks ‘Altogether New Regime’

  1. So it sounds like we have entered a second “Taper Tantrum,” but with a strong inflationary backdrop and real QT in the near future. What spared us in 2013 was that inflation was under control, and the government eventually resumed QE. What could possibly save us this time? War in the Ukraine truly complicates things as well. At the moment, I feel like I have money with no place truly safe to put it.

  2. The disconnect between low yields and high inflation may resolve with inflation dropping or yields rising.

    Or it may not resolve, if it isn’t actually a disconnect.

    High inflation is too much (real economy) money chasing too few goods and/or services.

    Low yields is too much (financial economy) money chasing too few assets.

    High inflation would be incompatible with low yields if UST were competing with other assets purely on the investment merits. But is it really? There is so much money that “has” to be invested in UST. Bank capital rules, US trade deficit, USD reserves, safety, liquidity, all force it. Even with the Fed out of the game, there is a lot of structural demand for UST.

    We could see UST yields stay much lower than seems consistent with inflation, and lower than other govt yields.

    But if Treasury issuance pushes UST supply substantially above the structural demand, so that marginal UST has to compete for investment flows with other assets, then things could get very messy.

    1. “There is so much money that “has” to be invested in UST. Bank capital rules, US trade deficit, USD reserves, safety, liquidity, all force it . . ”

      This is a good point and I’m curious how it compares to say pre-GFC times. I would guess this is a related problem to the repo funding issues of fall of 2019–Fed needed a lot more reserves than they may have thought.

  3. Gotta believe the burgeoning economic slowdown will provide a near term cap on the dramatic increase in treasury rates …
    …we shall see…

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