Making Hay Monday
High-level macro-market insights, actionable economic forecasts, and plenty of friendly candor to give you a fighting chance in the day’s financial fray.
Charts of the Week
Despite that some of the smartest people I know believe that recession still equals a U.S. Treasury (UST) bond bull market, visuals such as the above lead me to conclude that this time really is different. Considering the enormity of UST debt maturing over the next two years, the red line is a shoo-in to go higher… probably, much, much higher. As a result, it is almost inevitable that the Fed will need to restart its Magical Money Machine, formally known as quantitative easing (QE). To believe this will happen without reigniting inflation, seems to me a classic case of putting hope over experience.
My concerns about the longer maturity segments of the Treasury bond market are a key theme for this Making Hay Monday. However, I readily concede there is currently an abundance of negativity toward long duration T-notes and T-bonds. This for sure has the potential to trigger periodic rallies. However, I expect them to be fleeting given the supply onslaught and the shortage of interested buyers beyond near-term maturities. When it comes to the attitude toward stocks, it’s a diametrically opposed situation, as shown above. Twenty-four years ago, when traders were as bullish on stocks and bearish on bonds as they are today, it was on the eve of one of the worst equity bear markets. Conversely, bonds were poised to produce several years of strong performance. It will be a tough act to follow, though, since long-term Treasurys were yielding over 6% in 1999 versus sub-4% today. It’s also hard to believe today that in the late 1990s the federal government was running surpluses. That’s another total opposite versus current conditions.
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Is It Time To Go Long On Long Bonds?
“The US will need to refinance almost half of its national debt in less than 2 years. As a reminder, interest rates were at 0% just 15 months ago.” -Crescat Capital’s Kevin Smith and Tavi Costas in their July 21st letter to investors, Monetary vs Fiscal Dissonance.
“This is the most confusing and confused Federal Reserve in modern history.” -Economist par excellence David Rosenberg
Note: As this piece runs a bit on the longer side, we’ve bold-fonted especially pertinent passages to facilitate a quicker read for those who would prefer as much.
Last week was a memorable one for me. On Tuesday, I was invited by David Lin, one of my favorite interviewers, to be part of a panel discussion with someone I’ve held in high esteem for almost 20 years. To longtime Haymaker readers, it’s no surprise that this person is a third David, as in Rosenberg, arguably (but not much) Canada’s most famous economist. We somewhat facetiously – and, hopefully, not fatuously – referred to this show as David Cubed.
My first experience with David Rosenberg, often known as Rosie, was in the lead-up to the collapse of Bubble 2.0. In my view of the world, that second bubble was the great housing price inflation of the first seven years of this century. It followed in the wake of the explosive demise of Bubble 1.0, the most extreme example of stock market speculation in American history. The epicenter of that was, of course, tech; that formerly screaming sector had crashed by almost 80% from early 2000 to the fall of 2003. This led influential folks, such as Nobel Prize-winning economist, Paul Krugman, to exhort the Fed to create a new bubble – preferably in housing – to offset the drags from the tech-wreck. This was despite that the recession in 2001 was one of the mildest on record.
It was during that period that I began to regularly read Rosie’s daily notes. At the time, he worked for “Mother Merrill”, as its chief economist for North America. This was before it was acquired under duress by BofA, thereby becoming BofA Merrill Lynch. Ironically, it was the bursting of the housing and sub-prime mortgage bubble that brought Merrill to its knees. (Frankly, BofA was buckling back then, as well, and almost certainly survived solely because of the highly controversial Troubled Asset Relief Program, or TARP).
My concern in joining the David Cubed panel was that it would be an agreement-fest. It was a fear I expressed early in our conversation but I also knew there were at least two points of pronounced disagreement. One was on the probable long-term trend of inflation.
The other, closely related to that, pertains to our views on the appeal, or not, of long Treasury bonds. Paraphrasing that old joke about Germans, I knew going in that you can always tell an economist, you just can’t tell them much. Accordingly, I had low expectations that David R. would consider my opposing outlooks on those critical topics. My anticipations turned out to be spot-on. (We’ve linked the episode at the end of this MHM edition so you can hear for yourself that I wasn’t off the mark in this regard.)
Before delving into our divergent opinions, I should note that this isn’t the first time I’ve had opposing views to Rosie’s. However, in the past, I haven’t had the chance to directly convey my disagreement. The first major parting of the ways was after the Global Financial Crisis and Great Recession about which Rosie so presciently forewarned. (Though I think, like me, the severity caught even him off guard.) In early 2009, as I was exhorting my newsletter readers at the time to invest in almost everything but cash – which triggered a lot of blowback, by the way – David had a far more bearish mindset. He felt we were in the midst of a new Depression, akin to the 1930s (that decade will come up again shortly).
Despite the stock market having been cut in half, he was unimpressed with the prices on offer and felt there was much more downside ahead in stocks, notwithstanding the carnage that had already occurred. In my case, I was struck by the number of value stocks that were trading at throwaway prices. This included financial shares which, for obvious reasons, had been utterly nuked. Once it became apparent that TARP had put a floor under them, and the Fed was beginning its first round of QE, it was off to the drag races for this detested sector.
In fairness to Rosie, he did see great value in some corners of the yield market. As I wrote at the time, while the stock market was undervalued in early 2009 – with some areas like financials priced for extinction – corporate income securities were at 1932-type levels. At that point, junk bonds were yielding over 20% and some mid-stream energy infrastructure entities (MLPs) had yields in excess of 30%. Even investment-grade corporate bonds yields briefly touched 10%, at a time when U.S. government bond rates had crashed.
Unfortunately, as I observed at the time, the Fed directed the massive buying power of its first QE at one of the most overvalued debt securities on the planet back then, U.S. Treasury bonds. The interest rates on those had collapsed due to the extreme flight to safety at the time.
My second major viewpoint-split with Rosie happened in the second half of 2020. It would run until early 2022. During that period, he supported the Fed’s contention that inflation was transitory. In my case, I wrote repeatedly that since the U.S. government had resorted to outright Modern Monetary Theory (MMT) – essentially, enormous deficit spending financed by the Fed; aka, debt monetization – inflation was likely to surprise on the upside. It was also my belief that it would be much harder to get under control than popularly believed. (Lest you think my calls back then were flawless, I was wrong about the U.S. dollar, which I felt was on the verge of a major breakdown. Instead, it rocketed, at least against currencies like the yen and the euro.)
Again, to be fair to David R., he stayed adamant that inflation would eventually cool, which, of course, it has done, particularly this year. However, I think he would admit that it took a lot longer, and went much higher, than he thought it would in early 2021. What really matters now, though, is whether he’s right that inflation is going to recede close to the Fed’s dream target of 2% and, more importantly, stay there. On the first part, my reaction is maybe and, on the second, not likely.
One of my main reasons for being dubious about inflation staying subdued for years to come has to do with what some are calling “State Capitalism”. Among the more articulate advocates of that condition is Russell Napier. In David Cubed, I brought up Russell’s name and commented that he had long been, like Rosie and me, in the disinflation camp. (For newer Haymaker readers, over the first 40 years of my 44-year career, I was a believer that both interest rates and inflation were in long-term downtrends. My stance didn’t change until America stumbled into MMT during Covid and the yield on 10-year T-notes collapsed to ½% in the summer of 2020.)
Russell Napier has been warning bond bulls for at least a year that the U.S. government is not just spending vast sums on efforts like the green energy transition and reshoring industrial production; it is also providing huge loan guarantees for favored projects. Since this is not direct spending, it’s kept off budget. (As we shall soon see, despite this budgetary legerdemain, the sea of federal red ink is shocking.) To rebut this aspect, David R. cited the 1930s and FDR’s New Deal programs that gave our country great and lasting assets like Hoover Dam, Grand Coulee Dam, and the Golden Gate Bridge.
His point was that this unprecedented build-out didn’t lead to inflation, even by the late ‘30s, and that it also didn’t do much to help the economy. He further noted it was only WWII that pulled America decisively out of the Great Depression, and I won’t quibble with that one. However, when it comes to inflation, I think the comparison is highly questionable. Unemployment in the 1930s reached roughly 25%. Today, it is under 4%. The type of monster construction we are now seeing, much of it with little regard for ultimate return on investment, and in such a tight labor market, has a high likelihood of being inflationary. This is particularly the case with politically favored projects where the supposed total costs often end up being a de facto down payment.
Another one of my inflation concerns I expressed pertained to wars and the related global-defense spending surge. History is clear that wars are inflationary, but David R. deflected my worries with what happened after WWI. He correctly observed that inflation exploded for a few years over a century ago. It rose from 1% in 1915 to almost 8% in 1916. It then soared to 17% in 1917 and was still in the mid-teens in 1920. However, deflation emerged in 1921 and 1922, with prices falling by 10.5% and 6.1%, respectively.
Thus, even a global war, followed by a pandemic (the Spanish flu), didn’t produce lasting inflation. Despite the Roaring Twenties, the highest inflation got during the rest of that decade was 2.3% in 1925. Yet, the dissimilarities with then and now are stark. The U.S. government’s debt had risen to 32% of total economic activity (GDP) by the end of WWI. However, by 1929 it was down to 16%. Today, it is approximately 125% of GDP… and rising fast.
There was also a mass migration from farms to cities and, similarly, from agricultural jobs to industrial. This created the ideal conditions for a disinflationary boom due to surging productivity and wages. Per-capita income rose from $6,460 to $8,016. The electrification of the country also fed the rapid growth while keeping inflation under control. There was no welfare state with all of its negative impacts on productivity, though the lack of a safety net created profound social strife once the boom turned to bust. That was largely due to the bursting of what was the biggest stock market bubble in U.S. history, at least prior to the late 1990s. The banking collapse that followed 1929 was the coup de grace and almost destroyed American capitalism.
Basically, I think taking comfort in the examples of the 1920s and 1930s is ill advised. Further, I don’t believe the playbook that worked from 1981 through 2020 of buying long-term government bonds going into a recession is feasible, either. Yet, Rosie is advocating that approach. Ironically, it could well be that the recession he and I both still see coming could be the catalyst for a bond bear market rather than the usual rousing bull move.
Presently, there is little doubt that the consensus view is that a recession is not nigh. Yet, as I mentioned in this episode, we’re already in a profits recession, an industrial recession, and a Gross Domestic Income (GDI) recession. Additionally, we’re also in government tax receipts recession, a point I didn’t make but should have. Federal revenues YOY are down 10%, with personal income tax receipts crashing by 21% vs the first nine months of fiscal 2022. (There are unusual factors in play, particularly in California, that may be distorting tax collections currently.) As a result, the government deficit is up by almost $900 billion compared to last year. As I’ve written previously, and mention in this podcast, that is inexcusable and almost inconceivable at a time of sub-4% unemployment.
Along the inexcusable lines, the Congressional Budget Office (CBO) warns that this horrible budget performance is despite a drop-off in Covid-related spending. These have come down by $265 billion versus last year. One prime reason why is that cost-of-living adjustments (COLAs) on entitlements like Social Security and Medicare are boosting federal outlays by roughly $250 billion. The long-deferred consequences of unfunded entitlements are now upon us.
As the bright folks at Crescat Capital wrote this month:
In a healthy economic growth environment tax revenues typically increase while government spending tends to decline. However, today’s situation is a complete reversal of this trend.
In this regard, during our interview, I brought up that it’s hard to reconcile the currently popular belief in how resilient the economy supposedly is with the reality that it’s taking federal budget deficits of 8% of GDP to produce nominal (i.e., including inflation) growth of 7%. Frankly, I was surprised Rosie showed little interest in my reasoning, but it could be a classic case of “consider the source”. After all, he’s the world-renowned economist and I am a guy with a degree in cinema studies and filmmaking.
Despite that acknowledgment, I think Rosie’s wrong in not being open to the idea that this time is truly different when it comes to the next recession’s impact on federal finances and the Treasury bond market.
Again quoting the Crescat Capital team:
To sustain the current government spending deluge, we believe it is inevitable that the Fed and other monetary authorities reassume their fundamental role as the primary financiers of government debt.
Therein lies the problem for U.S. government debt. With nearly half of all Treasury bills and notes coming due in the next two years, merely refinancing that $13 trillion or so will be a staggering challenge. Raising $2 trillion to fund the budget blowout makes it much more daunting. Factoring in the Fed’s sale of around $1 trillion (quantitative tightening or QT), falls under the heading of “mission impossible”.
It continues to be my belief that Jay Powell will resign rather than once again be the primary financier of federal debt that is otherwise unfundable, at least at interest rates the government can afford. My “4F” scenario – a federal fiscal funding fiasco – remains one of my big fears for this year’s second half. If so, bulls on long-term Treasury bonds could be badly gored. After all the help David Rosenberg has been to me over the years, it will sadden me if he’s among them.
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