Bassman Compares ‘Team Transitory’ To Reckless Gamblers

A Commentary by Harley Bassman (Twitter: @ConvexityMaven)

 

Family lore suggests that my great Aunt Vi ran the West Los Angeles sports book for Mickey Cohen (the Bugsy Siegel gang) in the 1950s. This I can neither confirm nor deny as my grandmother was the black sheep of the family who eschewed gambling.

However, in support of nature over nurture, I went to Wall Street in the early 1980s and effectively ran a legal betting site for interest rates, more commonly known as the short-dated options business. Fifty years later, as I was teaching my kids card games, they had a “eureka” moment when they discovered a foolproof gambling strategy: Keep doubling down after each loss until you win.

Facing gambler’s ruin, “Team Transitory” is going all-in — will they win?

CPI inflation first rose above the Fed’s target of 2% in March 2021 and soon touched 5% in May. This was dubbed a “transitory” increase pressured by supply chain issues related to various COVID economic policies.

A full year later, in March 2022, with CPI inflation nearing 8%, the Fed finally reversed their April 2020 zero-interest rate policy. This coincided with the first inversion of the 2s10s. (Note: I mostly use swap rates instead of US Treasury rates as most business is conducted by these measures.)

This is an important market signal since the yield curve has the best track record of anticipating recessions, and in due course the Fed soon starts cutting rates as a balm to a weak economy and the concurrent increase in unemployment.

Front-running the Fed, the spread between the June 2023 and December 2023 three-month rates inverted in March 2022. In layman’s terms, the market was betting the Fed would cut their policy rate this summer to “soft land” the economy.

A careful eye will notice that from June to October 2022, the market was pricing a 30bps reduction in the Fed funds rate, which expanded to a 50bps cut by December.

The notion that the Fed would start cutting rates this summer jazzed a 16.4% rally in the S&P 500 from the October low, but this good cheer was foiled as the Fed’s favored measure of core inflation continued to run at an annualized rate of 4.75%.

Jerome Powell has been emphatic that he’d rather his obituary compare him to Paul Volcker than to Arthur Burns, but the bond market refuses to listen. 

Over the past thirty years, rate-cutting cycles have all commenced soon after the Fed’s policy rate touched the 5-year, forward 5-year rate (the market’s “guess” as to the five-year rate starting in 2028.)

Presently, the Fed funds rate is 103bps above the 5yr-5yr rate. The Fed has bet the economy is still too strong, but anticipating an imminent “hard landing,” the market is all-in, and has pushed their stack of chips onto the table.

Who owns the casino?

The old saying on Wall Street was that we were in the “moving business,” not the “storage business.” It was not my (primary) job to have an opinion, per se, but rather to facilitate transactions between parties who had a view. I was the dealer at the card table, not one of the players.

Forwards are not a prediction, rather they are the simple mathematical discounting of the spot curve to produce an “arbitrage-free” price, no more, no less.

In a nutshell, if grandma can buy a one-year CD at 2% or a two-year CD at 3%, she would only buy the one-year CD if she thought she could buy another one-year CD next year at 4% or higher. We would call this 4% rate the one-year rate one year forward (or the break-even rate).

This (simple) math trick can be done in all sorts of ways between two dates, and this is why the yield curve is so valuable — even a civilian can have a “break-even” opinion.

The chart below shows the spread between the current two-year rate and the one year forward two-year rate. (Yes, this is a form of three-dimensional chess.)

The curve is presently so inverted that to make all the math work, the two-year rate must decline 88bps by next March — from 5.19% to 4.31%. Extrapolating into USTs, that would imply a move from 4.87% to 3.99%.

This simply begs incredulity. The Fed has all but promised at least two more rate hikes over the next two meetings, so who’s taking the other side of this bet?

I can conjure up a zillion charts that signal an economy about to go off the rails. Ignore the vectors below and just note its pure anomaly.

Notwithstanding a VIX well below its forever average of 21, the MOVE Index has been bracketing 125 for a while, foreshadowing interest rate instability.

The distress flare sent up by the yield curve has been noticed by the MBS market, where spreads have widened to levels only matched during crisis.

Explaining the inexplicable

Let me go off script for a moment to suggest perhaps there are other risk vectors besides inflation and the Fed’s policy response.

While the rotation of the yield curve does offer terrific insight into the macro-economy, it can also reflect other forces. Perhaps our rate profile has more to do with the unprecedented growth of our public debt, and less to do with the Fed’s next policy statement.

While it may take a decade for its denouement, I suspect the market is sniffing a “Thelma & Louise” financial hiccup on the horizon, especially since the “benefit absorbing” Boomer generation will not fully reach age 65 until 2029.

Dusting off the old playbook

We know that:

1. The spread between the Fed funds rate and the UST two-year rate is about 50bps.
2. The spread between the UST two-year and the UST 10-year rate is about 100bps.
3. The Fed has indicated they’ll stop hiking between 5.1% and 5.4%, which creates a positive real rate relative to their favored core PCE.

The three-month UST first crossed above the 10-year in November 2022, so mark the recession to start fourteen months hence in January 2024. (This is the original construction offered by Dr. Campbell Harvey in 1986.)

So, the Fed should start cutting rates sometime in 2024 (not mid-2023). Assuming they reduce their rate to 2%, flat to their target inflation rate, that would project a UST two-year rate of 2.5% and the UST 10-year rate of 3.5%.

What’s the wrong price?

By intent or accident, the market has bet the ranch that the US economy is going to “hard land” soon, and thus induce the Fed to cut rates as early as Labor Day (September). That is simply not going to happen. While goods inflation is calming, service inflation has not pulled back.

The reason is simple: The demand for labor can’t be met as Boomers retire from the workforce for reasons of either age or a (still) plump 401k, and immigration (legal or otherwise) can no longer plug the gap. Every window I see has a “help wanted” ad.

The 10-year is presently near 4% and using our simple bond math from discounting the yield curve, the two year forward 10-year rate is 3.65%. Above, we predicted a 10-year rate of 3.5% if the Fed cuts rates to 2%, so where is the profit of buying 10s? I see a lot of risk to make a 15bps gain (about 1 point in price).

The yield curve is way too inverted given even optimistic inflation projections relative to the Fed’s stated politics and policies.

Closing comments

Since May of 2020, I’ve warned that rising inflation would flip the correlation of stocks versus bonds so they no longer “hedged” each other.

This has come to pass. Thus, I urge caution on carrying a pure 60/40 portfolio with no diversification. Presently, 30-year rates are 171bps inverted (below) two-year rates, which is just plain nuts.

Strangely, I believe that 30-year rates could rise when the Fed starts cutting as a process to normalize the yield curve.

An obvious addition would be a payer swaption hedging strategy, which I’ve detailed frequently. One might also peek at a low-cost managed futures strategy.

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

Harley S. Bassman

March 7, 2023

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