According to todays guest expert, there is a rare and powerful trend occurring in bond markets.
Bond analyst Alf Pecatiello warns that over the last 3 months, US bond markets are in an aggressive and prolonged period of bear steepening of the yield curve.
History shows, if left unchecked, this steepening is likely to cause serious damage to equity markets and the economy.
To find out why, we’ll hear from Alf himself.
Follow Alf at https://www.themacrocompass.com/
To sign up for Alf’s Bonds course, go to https://www.themacrocompass.com/courses/#bond-market-course (and the first 50 who do can get a 20% discount by entering the code “20BOND” at checkout)
Alf Peccatiello 0:00
When long term interest rates move higher because of the much higher sensitivity to interest rates because of the higher duration in technical terms, a 10 basis point move in two year interest rates is not even comparable to a 10 basis point moving 30 year interest rates to explain the numbers, a 10 basis point move higher in third year interest rates is akin to about 10 times the magnitude of a 10 basis point move into your interest rates when it comes to the mark to market to the negative impact on your profit and loss on your business on your mark to market it is 10 times as bad. So looking at this here, long end of the curve moving higher rather than this. This is 10 times larger because of higher duration of higher interest rate sensitivity of long and interest rates.
Adam Taggart 1:05
Welcome to Wealthion and Wealthion founder Adam Taggart according to today’s guest expert, there’s a rare and powerful trend occurring in the bond markets right now. Bond analyst Alf Peccatiello warns that over the last three months, US bond markets are in an aggressive and prolonged period of steepening of the yield curve. History shows if left unchecked, this steepening is likely to cause serious damage to equity markets in the economy. To find out why we’ll hear from Alf himself. Alf thanks so much for joining us today.
Alf Peccatiello 1:38
Adam always a pleasure to be here on Wealthion.
Adam Taggart 1:41
Thank you. Always a great pleasure to have you on it’s been far too long. Thank you for joining me really interesting time for bonds. So it really couldn’t be any more timely to have you on I get a lot of questions here for you. We’re going to talk about this bear steepening that I mentioned in the intro. Real quick, I just want to flag for folks that as I understand it, you’ve actually launched a brand new course. Basically educating people on the fundamentals of bond investing, which I’ve heard from many, many people in our audience here. still tough for a lot of people to wrap their heads around. So we’ll we’ll talk about the details of that after we go through all the macro data here. But but but that’s true, correct. You’ve got a new course out?
Alf Peccatiello 2:19
It’s correct. I mean, this bond market scares people away with this jargon and technicalities. And I wanted to end that. So I created a bond market course to unpack it all.
Adam Taggart 2:29
Okay, yeah, it’s funny with bonds. They’re just a little mathy, relative to stocks. But to people, that little bit of math is almost like it’s advanced calculus, where they’re like, Oh, it’s just too mathy. I can’t do it doesn’t really require that any real advanced math, you just sort of have to understand how the components work. Right?
Alf Peccatiello 2:46
That is correct. More than the math itself. I think it’s the jargon around it is that this like this secret cloud around bond markets? And I think I just want to unpack it all make it simple.
Adam Taggart 2:58
Okay. Well, we’ll do a lot of that in this discussion. And then then I’ll let you tell everybody, anything you want to about the course itself a lot of questions for you. But if we can, let’s start where we always do with this general starter question, what’s your current assessment of the global economy and financial markets?
Alf Peccatiello 3:17
I think financial markets are testing the limits of what economists can take through two main channels, or them. The first is higher oil prices. higher oil prices are a tax on consumers. By spending more at the pump, you have less disposable income, the job market is deteriorating slowly but surely. And people have you know, I’ve seen the real incomes shrink already because of inflation, and now they’re getting an oil price rally. And for places like Europe, or the UK, which are big net energy importers, something like that is quite relevant. So the market is trying to test basically the strength of consumers. Can they take an oil rally to $100, for example, this late in the cycle, and the second way of testing is through the bond markets. Because so far, we have seen mostly front end bond yields move higher, reflecting the Federal Reserve hiking cycle, the European Central Bank hiking cycle, but long and bond yields. Were not rising that aggressively, the curve was deeply inverted. So that means that the transmission mechanism of higher interest rates to the economy was somehow dampened. But lately, instead, we have had bear steepening. So interest rates go up, and they go up faster at the long end of the curve. And when they do, it becomes really difficult for the economy and markets to handle that. So I think we are testing markets are testing this hypothesis of a soft landing of a strong economy. And the more we test, the more likely we are to break something
Adam Taggart 5:00
Okay, so just to be clear, this this new element of rising yields on the long end of the curve, that’s what you’re talking about when you refer to the term bear steepening Correct?
Alf Peccatiello 5:11
That is correct. So I think bear steepening is.
Adam Taggart 5:14
Yeah, real in real quick, before we go on there, just want to summarize what you said, because I think it’s really important, which is, you know, a couple of months ago, we could have Ian did often on this channel, you know, have a discussion about concerns of the lag effect, right of the impact of all the hiking, interest rates that the Fed has done on the short end of the curve. And all the macro data that we were looking at, that suggested a recession was was ahead and all that type of stuff. And we we had a lot of concerns at that point in time about the economy’s ability to handle this going forward. Now, what you’re saying is, from that time, we’ve had even more weight placed on the system on the back of the system, because we’ve had, we’ve had a higher cost of capital with the short end rate hikes that the Fed has done. But now the overall cost of capital is going even higher. As the long end yields catch up. You’re nodding as I’m saying this. So cost of capital is getting even heavier on the system. At the same time, we’re having input costs go back up, again, because of rising oil prices and oil prices go into practically everything. Right. So we have these twin additional weights now pulling down on the economy, the market. So that’s what you’re saying it’s being tested, which is sort of like, how heavy how many? And how heavy of straws, can we put on this camel’s back before it breaks?
Alf Peccatiello 6:36
Yes, that’s exactly where we are now. And I think to show visually, the macro lags that start from what has happened so far with frontend interest rates moving higher. And what does that do to equity returns generally with the lag. So I call this chart the macro lags visualized. And what it does is it looks at US Treasuries, total return, that’s the blue line. It takes the two year cumulative total return in Treasury bonds, okay. And it looks against it at the s&p 500 Return on a two year cumulative basis. But the trick is that the s&p 500 return is lagged by 18 months. So what are we looking at here, we are looking at what happens to the s&p 500. And to the economy 18 months after we have had a sharp move either positive returns or negative returns by the bond market. So we’re testing basically visually, Adam, whether once bond yields go down, so the blue line goes up. Remember, the relationship is inverse between bond yields and bond prices. So if Treasury returns are positive, what happens 18 months later to equity returns. And if bond returns are negative, what happens 18 months later, to equity returns, those are the macro lags effectively visualized by raising the cost of capital or reducing the cost of capital, and then waiting for about 18 months. What happens to economic growth to earnings and to the s&p 500. And now see how the relationship looks pretty good. We are going back 20 years on this chart. Adam, please you want to say something?
Adam Taggart 8:27
Just that correlation looks really tight over the past 20 years here. And I just want folks looking at the chart to take away what I think is what you’re saying off, which is that Treasury returns lead s&p returns and the delta is about 18 months, right? So we have the advantage. It’s almost like looking into the future for the stock market. Right? Okay, where did bond returns go? Okay, 18 months later, we expect s&p to go in the same direction.
Alf Peccatiello 8:54
So let’s have a look at what happened already. So equity market returns were very positive. Leading into the pandemic, just before the pandemic and leading into an after the pandemic has the Federal Reserve cut interest rates to zero effectively. And we did quantitative easing, and with forward guidance we kept, you know, the long end of interest rate curve pretty depressed. So bond yields bond returns were positive, the blue line went up. Well, with a lag of 18 months, we saw the equity market staging an incredible performance during 2021. Now since then, bond markets are now having three years, almost we’re running towards it three years of negative returns back to back negative returns. So the blue line, the leading indicator moves down.
Adam Taggart 9:49
It’s worth noting that that three years of back to back negative returns unprecedented than the data series for treasuries Correct.
Alf Peccatiello 9:56
That is pretty much Correct. Of course, the starting point was interest rates at basically zero. So some of it is just taking back the excesses that we saw during the pandemic. But nevertheless, bond markets are experiencing serious drawdowns. So what’s happening, interest rates have gone up, cost of capital has gone up. For companies, it’s more difficult to borrow for people is more difficult to get a mortgage. Well, 18 months later, the s&p 500 is already starting to return zero or negative for the last two years, the s&p 500 hasn’t gone literally anywhere, following exactly this lead time. Now, if history is any guide, because the bond market is continuing its throw down. So the cost of capital is continuing to increase and it’s been kept very high for very long, you should expect the equity markets over the next 18 months not to be able to do particularly well. And this is why I called the macro lags visualized, because the coalition looks very tight. And it is them for macro reasons, there is a lag between raising interest rates, and seeing the impact of an increased cost of capital into the economy and into equity markets. And right now,
Adam Taggart 11:10
I’m starting to wrap it again, just because you said something important there, there’s actually sort of two legs you’re talking about. There’s the move of the federal, sorry, of the of the policy for the interest rates, right, we’re going to change the interest rate, then there’s a period of time between the change in the interest rate. And then we see that manifest in the economy. And then there’s a delta between, you know, we start seeing corporate profits off and whatever. And then we see the market react to that.
Alf Peccatiello 11:37
That is true. And so now we are in the part of the lag or the lagging periods, that are more likely if you look at this chart to actually manifest into a weaker economy and into weaker equity markets. The problem is that as the expectations for a recession, at the beginning of the year, by me included, and I was wrong on the magnitude of the slowdown, the expectations are very high, or them that we would have a recession this year, as the economy has slowed, the job market has deteriorated, but not to a pace that is sufficient enough to be recessionary. Which means people are becoming frustrated. Typical late cycle, people become frustrated by the fact that you don’t get a recession, you know, it’s it’s fine, the economy can handle it. Higher rates are not a problem. This time is different software’s like no landing, no landing, soft landing, all of this exactly with the same sequence was lived back in 2006 2007, the Federal Reserve raised interest rates very aggressively in 2006. That paused, we were nine months in March, April 2007. And you can Google and you’ll find plenty of articles, saying that this time is different, that the Fed hiking cycle won’t impact the economy at all, that you won’t even get as low down. In October 2007, the Federal Reserve minutes, were expecting growth in 2008, to be over 2%. In 2008, we got the biggest financial crisis of modern era. So people get frustrated by the macro lags are the men, right? When it’s more likely that we are going to get a look at this chart, the macro lags actually come into play, people instead, throw the towel in. And markets also have a tendency to test this hypothesis of no landing soft landing. by taxing the economy more with the double whammy of higher oil prices. And Bear steepening, which we are going to explain now. And making therefore this process even more complicated. You’re in the part of the macro labs where you’re more vulnerable, yet the narrative changes. And markets try to test these hypotheses more and more, until eventually something breaks.
Adam Taggart 13:59
And when you say the markets test the hypothesis, they are basically saying you know what, the camel’s back hasn’t broken. So we’re just going to keep adding straw after straw after let’s see how many straws we can get away with. Right. And then obviously, at some point it breaks, right. And then that’s where the damage occurs.
Alf Peccatiello 14:15
And so we talked about oil prices. And I think you summarized correctly that it is indeed basically a hidden tax on consumers. So we are testing this hypothesis that consumers are resilient by basically having a late cycle rally in oil prices and making everything more expensive for them. That’s one way to do this. At the same time. We are now proceeding to do bear steepening in bond markets. That’s a very rare trend. It’s a pretty dangerous one and a very rare one. Especially if it happens when the economy’s slowing. So let me elaborate. All right,
Adam Taggart 14:51
I’m just gonna make one point just for you to address in your answer. Sure. This bear steepening is happening at a time where I at an increasing amount of debt that is held by corporations and households, I guess but for corporations mostly is going to be maturing and need to be rolled over.
Alf Peccatiello 15:11
That is indeed correct. One of the points that people fail to understand in an era where we scroll on mobile, and we expect everything to happen immediately including ratification is that people think that higher interest rates or lower interest rates should immediately produce results of some sorts. Instead, the chart I showed before shows a an 18 month lag, Adam, and also if you think about it, if interest rates rise, but you don’t have to refinance your mortgage, if a corporate doesn’t have to immediately refinance their liabilities, who cares? Right, interest rates have gone up, and this can go on for 12 for 18 months. Now, in this cycle, actually, the lags were a bit longer than usual. Because in 2020, and 2021, corporates locked in very low interest rates for an extended period of time and the same did Americans by locking in a 30 year mortgage rates, so they fixed their borrowing for a long period of time.
Adam Taggart 16:17
All right, it was the mentality there, Alf because you talk your bond analyst, you talk to a bunch of CFOs was that than just responding to market forces where they just said, Oh, my God, zip, like, we’re never gonna go lower. So load up. Now, while it’s as cheap as it can be?
Alf Peccatiello 16:32
Well, I don’t know if anybody thought that we would never go lower than that. But they surely thought that interest rates were very palatable to borrow for the long term. So we would hindsight it’s easy to say those rates were incredibly low, but even then they were objectively low. So people went on, and refinance. They locked in a 30 year mortgage rate at 3%, and corporates locked in borrowing for the next 10 years. At very low interest rates. What this means for them is that for the first 12 to 18 months, the actual refinancing needs are very, very low. It takes time for the refinancing world to hit. This has helped actually, the US economy to be shielded from higher interest rates together with fiscal deficits, which were run at an incredibly big pace for this point of the cycle. But now, the refinancing glyphs are approaching a bit faster in 2024, and 2025. But on top of it, we have moved in the moving interest rates higher as shifted from the front end to the long end of the bond markets, and that is the bear steepening that we’re talking about. So what is bear steepening? Bear steepening happens, where interest rates move higher across the curve. But they move higher faster at the long end, then they move at the short end. So you’re looking at Bear steepening, where two year yields are going higher, third year, yields are going higher. The third year yields are going higher, faster than two year yields. That’s what a bear steepening of the curve is. So in this chart, I actually plotted a stylized example of a bear steepening. So you can see the Fed Funds implied curve in orange and in blue. In blue, it’s before the bear steepening. And in orange, it’s after the bear steepening. And below in this chart, you’ll see the delta. So you’ll see what changed between this curve when bear steepening was happening. What you can see there is that the orange curve after bear steepening, it’s generally shifted higher compared to the blue one. But the majority of the shift happens at the long end. Right. So short, and yields go up, but by not much, but the long end moves up by a lot. So what does that mean? How do you interpret that from a bond market perspective, Alamo? It’s pretty simple. The market is telling you that the Federal Reserve might hike maybe one more time. And it’s telling you that over the next one to two years, rates are going to be a bit higher. But contrary to the past, the bond market is also telling you that the higher rates today, higher rates over the next one year, are not going to lead to more cuts tomorrow. They are going to be sustained over time. In other words, the market is telling you that the Fed is going to keep rates higher for longer and that the economy can handle it.
Adam Taggart 19:34
So interesting about this is that that’s what Powell has been saying for over a year now. Hey, everybody, I’m going higher for longer. The market has doubted Powell every step along the way. And it’s always had to readjust its expectations and clearly now it is here in the bond market. And obviously bonds have had been hit hard, right? We just talked about how US Treasuries have an unprecedented third year of declines It was so interesting to me, and we can talk about this later, but I’m just gonna flag it is the stock market has not adjusted for this yet? No, no, no. But it’s finally saying, Okay, I guess all last year it was pivot pivot pivot pivot is going to happen tomorrow. Now it’s like, I guess we’re going to be stuck with higher rates for a lot longer. The market still haven’t sold off on that news yet.
Alf Peccatiello 20:22
So just now as we speak, Adam, I think the stock market is starting to notice that there is something that is changing. But you’re right that we have been stubbornly resilient there. So the market is pricing. In other words, Adam, the best of all worlds, it’s pricing an economy that can handle higher rates. So the bond market is going to bear steepening higher rates are being imposed as we speak, on consumers, on corporates, on the economy, on markets. And yet, markets are pretty stable. Because yeah, of course, the economy can handle it, man, that’s not going to be a problem 30 year rates at four and a half percent, sure, growth is going to be fine. Nobody’s gonna get affected by it. That’s what the market is pricing today. That’s a bit of lala land pricing, if
Adam Taggart 21:07
it is, and and it also really validates, I think the chart that you showed earlier of how the bond returns, predict the stock market returns right when the bond market has already gotten the memo. And now we’re just waiting for the stock market to get the memo in history shows that it will.
Alf Peccatiello 21:25
So here the bond market has gotten the memo, we have gotten drawdowns on a rolling basis of 10 15% in bond markets, which, given the low volatility of this market generally are quite something the stock market is just basically starting to reverse. But in principle, one should expect from this chart that later on the equity market will also get the memo with a bit of a delay. Now, the bear steepening trend, why does it why does it really hurt? It hurts because you are taking the tightening and you’re prolonging it through time and you’re moving it towards the long end. So why the long end of bond markets is really important that this stage. Now think about it. If you are a corporate or a household with a mortgage to be refinanced, and somebody tells you, Well, Adam, you need to refinance, what in a year in two years, don’t do it now. Just wait, the Fed is gonna cut rates and you know, in in a year or two, you can refinance at much lower levels. So just wait. And you wait, and you wait, and you wait. And then it’s nine months until you need to mature. And you see what’s happening today, you see that the Fed is unlikely to cut rates, you see that rates have moved higher, and you have no place to hide anymore, until you’re getting closer and closer to your refinancing debt you’re forced to swallow much higher interest rates, they will hit you they will literally hit you. And the same goes for corporates. So when the bear steepening happens late in the cycle, the dimension of time is important. Because more people, more corporates are getting actually hit by higher refinancing rate as time goes by. So the time component matters, and also long end rates have gone higher. So there is no place to hide anymore along the curve.
Adam Taggart 23:26
And great point. And if I can just make sure I fully understand here. So obviously, as you have to refinance at a higher rate, you have a left available after you service your debt to do things, right, because your debt is taking more and more of your cash flow, right. So obviously you get hit once you refinance. But what you’re saying is even leading up to the refinance date, companies are going to start constraining their spending, because they’re going to realize, Oh, my goodness, I’ve got to start sort of saving up for this rewriting that’s coming up here. And it sounds like you’re saying, we’re now kind of in that period where the companies can see that the Fed is probably not going to ride to the rescue in time before the maturity date. And so they’re they’re at the point where they’re starting to tighten their pocketbooks.
Alf Peccatiello 24:15
That is perfectly right. So while so far, you could postpone your decisions, because the refinancing plates were far far away. Now they’re less far away. And on top of it, you watch what’s happening in bond markets, and you understand you have no place to hide anymore. Also long and bond yields have gone higher. Now, when the curve bear steepens, and you said it correctly, it’s not always the problem, because if you’re a corporate and you’re facing higher refinancing rates or them but the economy is growing fast, you’re selling more, you’re getting more profits in, that’s okay. You’re going to spend more money on that servicing but you have a bigger budget because you’re selling more stuff. So here what I did is I looked at nominal growth in the United States. by taking the series that the NBR uses to determine whether the US is in a recession or not, not just GDP guys, we need to look at the broader economy. That’s what the NBR does. So I took that series, I added inflation, so I get the goal, a gauge for nominal growth. That’s the blue line. Okay. And then I took the Treasury curve to see whether it steepens or it flattens. Right. So have a look at the red box. Do you remember early 2021 of them, reopening the boxes where their fiscal stimulus was running hot, Biden had just won the Senate as well. So everybody was extrapolating this fifth fiscal thing would last forever. But we were reopening the economy, the economy was running fast. So look at nominal growth, look at the blue line. It was running really, really hot in 2021, as we were reopening the economy. Now the curve also bear steep and back then look at the orange line. This was a bear steepening of the curve, the the equity market tank. Not at all. Because the economy was stronger, the economy could temporarily handle higher interest rates. But now look at what’s happening today, nominal growth is trending down slowly, but surely, it is trending down. So if you apply the bare steepening, you’re seeing today, if you push long and rates higher, if you price in higher for longer, while nominal growth is coming down. That is a terrible cocktail. Because a corporate cannot count on stronger sales can count on making more money, or having a larger budget to service their debt. But as you said correctly, or them, they’ll need to take a decision and very soon, the elect to ask themselves, well, I need to refinance very soon, I’ll need to pay more in that servicing costs. Where am I supposed to cut and they will start cutting labor. This is the process this is the macro lags that come into play. And it takes time until all these things happen. But we are now watching a very important development a late cycle bear steepening while nominal growth is coming down and an oil rally at the same time, which limits the ability of the private sector to face higher refinancing costs in the first place.
Adam Taggart 27:22
All right, I just want to tie what you just said, to the analysis by Michael Kantrowitz. Alpha, I’m sure you’re familiar with his hope framework, right, which basically is an acronym for the progression of how economies fall into recession. And the E in hope is employment. And basically, that’s the last last domino to fall, that really gives the green light for the recession to arrive. And at least based on the official data, you know, that that last domino EA has been surprisingly resilient. We’ll say that a lot of debate on how much we can really trust the government numbers, but still, you know, objectively, you know, we’re not seeing layoffs of the scale that we’ve seen, you know, during bad recessions, right. What you’re saying is, the bear steepening could very well be the trigger that topples that last D. Right. It’s the cost cutting that forces corporations to start having to layoff at scale.
Alf Peccatiello 28:20
The combination of higher oil prices bear steepening and refinancing glyphs. coming closer, this combination makes it so that corporates cannot delay taking harsh decisions anymore. So the reasons why unemployment has been much stronger than people thought it is weakening, of course, but it’s weakening at a more moderate pace than people thought. It’s really three things. The first is fiscal deficits, Biden threw a huge amount of money at the economy between October 22 and October 23. I have a news for you. It’s over October 2023 is the last month where the budget which was agreed upon in October 2022, is actually valid. And as we speak, these guys are even having problems passing a stopgap funding bill for a month, let alone agreeing on a budget that will print another one and a half trillion of fiscal deficits next year. I don’t think they will be able I think the Republicans will try to slow down spending as a tactical move ahead of elections. So you are not going to get the same fiscal tailwinds next year, and it’s very unlikely.
Adam Taggart 29:32
So you’re saying and I’ve talked about this in the channel a fair amount. I think the surprise of 2023 For those coming into it expecting a recession was going to happen at any moment is that they were right. The Fed and the banking system on top of it have been pushing on the economic and monetary breaks. But the administration and Congress have been jamming the gas pedal with this deficit spending and you’re basically saying that has pushed off the day of reckoning, it’s pushed off the arrival of the recession. But now their foot is getting taken off the gas, because of the expiration of the agreement, and given the political jockeying that we’re likely to see between now and the election, highly unlikely they’re gonna be able to continue doing it at the level that they’ve been doing it.
Alf Peccatiello 30:17
exactly correct. So that means one of the tailwinds that supported a stronger labor market than people thought is actually fading away. The second thing is, as we discussed, refinancing glyphs weren’t there. So even if the economy was slowing down, or them, corporates could delay, their cost cutting measures, because they didn’t need to actually face refinancing, there was not much refinancing going on. I mean, they weren’t forced to come and borrow, they could wait. Because of having locked in low interest rates for so long, that slows down the process of debt coming due to be refinanced. That was the case in 2023. But as you correctly said, in 2024, it’s already picking up. So there will be less companies, let’s say Adam, that can delay the process of cutting labor next year. And the third point is bear steepening and higher oil prices. So interest rates have now moved higher across the curve. That is a much more taxing environment for borrowing than it is if interest rates move higher only at the front end. Not only that, bear steepening highly increases the chances of something going wrong in markets. All old business models or them that rely on leverage are highly exposed now,
Adam Taggart 31:45
which just for folks watching is most business models in today’s economy, are pretty new, including the housing market.
Alf Peccatiello 31:52
Yeah, so you can go and think about highly leveraged unprofitable, small caps in the United States, housing market, credit markets in general shadow banking, pension funds, insurance companies, real estate, the list is very long. When long and interest rates move higher, because of the much higher sensitivity to interest rates, because of the higher duration in technical terms, a 10 basis point move in two year interest rates, it’s not even comparable to a 10 basis point moving third year interest rates to explain the numbers, a 10 basis point move higher in third year interest rates is akin to about 10 times the magnitude of a 10 basis point move into your interest rates, when it comes to the mark to market to the negative impact on your profit and loss on your business on your mark to market it is 10 times as bad. So looking at this here, long end of the curve moving higher, rather than this, this is 10 times larger, because of higher duration of higher interest rate sensitivity of long and interest rates.
Adam Taggart 33:11
Wow. Yeah, I think that’s something that’s it’s important for folks to know. So you have the Delta there, right of the your your orange bear steepening curve, which is the way it was before, right. So if you take that if you were to shade the area between the two lines, right, and then extend it out all the way across the yield curve duration, that basically just shows you, you know, that’s, that’s all the increasing cost of all the debt that’s out there, that’s now wasn’t going to interest service that is now going to go to incremental interest service. So it’s just all this money that comes out of production in the economy. Right now, a lot of people don’t really think of it that way. But your point, it’s a tremendous amount of value that gets taken off the table when the for yield curve moves like this.
Alf Peccatiello 34:00
And people always obsess about the United States defaulting and hey, low interest rates at four and a half percent now in the long end of the curve. So how will the US government handle this? Well, the US government can print money. It’s not a great way to handle this, but they can postpone the problem. They are the issuer of the dollar. Let me ask you a question. Can you print more dollars to pay your mortgage if interest rates have gone higher? Can a corporate print dollars? No, they can’t. So as you say that the fixed budget, the private sector as a budget, it’s the revenues we make. It’s our salaries, it’s our earnings, it’s our sales out of that pie. We will need to dedicate now much more to interest rate servicing, especially when refinancing coming due at higher interest rates and they are coming due much more aggressively in 2024.
Adam Taggart 34:56
Right And just to note, it’s even worse than that, right? So It’s the companies that have to tighten their belts because their cost of debt has gone up. But also the cost of debt has gone up for all players in the ecosystem. So consumer households, they have to cut back because their debt costs more, we’re a 70 plus percent consumer spending economy. So you know, the revenues are going to go down, because consumers are spending less, and the expenses are gonna go up, because companies are paying more on their debt service. So they’re really getting squeezed from, you know, from from those two directions. And, of course, the increase in oil prices, you know, input prices, that just makes things even worse,
Alf Peccatiello 35:34
indeed, so that comes back to this chart was shown, if nominal growth, the blue line was heading higher than at least this bear steepening would be a bit more bearable. Why because you have a larger pie, because more people are getting employed, because salaries are going up, because earnings are going up, then at least the fact that you have to pay more in interest rate spending, that’s kinda bearable. But today, you’re looking at the opposite, you’re looking at nominal growth coming down. So the pie is not even the same. If you wish, the pie might be getting smaller, and out of a smaller pie, you need to allocate more into interest rate expenditures, the obvious result will be as you say, other than that, people will spend less, companies will hire less, at some point they will be forced to fire and firing people will lead to people spending even less. And that’s a vicious circle called US recession. Now, it’s taking longer, much longer. And we have explained why. But I find it extremely funny that every time we are late cycle, and people get frustrated with the fact that the recession is taking longer, like in 2007, we start talking about there’s going to be no recession, no landing. This time is different different
Adam Taggart 36:50
this time. Yeah. You know, they say that, you know, bear, was it bull markets climb a wall of worry, bear markets slide down a slope of hope. And coming into 2023, there was a massive wall of worry, where we all everybody thought there was going to be a recession. And as some folks in this channel, Lance Roberts, probably being principal among them, was beating the drum, watch out everybody, because when everybody’s on one side of the boat, you know, they usually not all right, right, when too many people are on one trade. And he said, we’ve got this massive wall of worry. That’s what bull markets love to climb, right? That’s pretty much what we saw happen this year, you know, for the reasons you mentioned, the stimulus, the deficit spending, all that type of stuff. But now, and Lance has been beating this drum now where it’s to your point, if so many people have capitulated they’ve given up, it’s different this time, you know, we’re probably gonna have a soft landing, no landing, we now have that slope of hope. And this is what bear markets like to come, you know, tear up?
Alf Peccatiello 37:53
Well, just to describe a bit the slope of hope. Earnings Per Share expectations from analysts for 2024 are plus 12%. For 2025, or plus 15%. To give you an idea, the standard earnings per share growth of the s&p 500 Over the last few decades has been around seven to 8% on average in a year. So analysts are expecting that all these tightening, higher interest rates, everything we’re watching prolonged now bear steepening higher for longer, higher oil prices are not only going to produce positive earnings per share, but even more positive than the standard average earnings per share growth in a year of the s&p 500. That’s a slope of hope that’s analysts basically expecting not only that growth isn’t going to slow down, but earnings per share growth is going to surprise to the upside. And one interesting chart here that I want to bring is supposedly, the stock market bottomed in October 2022. The s&p 500 was at 3600. If I’m not mistaken about 3650 or so. In a bear market stocks typically would bottom nine to 10 months before earnings bottom. Okay, so you see the blue line here, that’s the price of the s&p 500. And the white line is earnings per share. You can see the price bottoms about nine to 10 months before earnings per share bottom. And that seems like what’s happened until now. The s&p 500 bottomed in October last year, earnings per share kept declining, we have had negative earnings per share growth in 2023. So earnings per share declining, declining, declining, come about now. Nine to 10 months after the bottom in s&p earnings should bottom two if this chart has to be validated, and that’s exactly what analysts are expecting. They’re expecting that we are here and therefore the s&p 500 will keep going up. earnings will keep going up. And I think all of this is wrong All of this is wrong, because earnings per share are not likely to bottom where we are now, they might stabilize for a bit. But remember, the macro lags, we are entering the period where it is more likely that the tightening we have applied 18 to 24 months ago actually plays out, not less likely, more likely, if history is any guide. And instead of respecting the macro lags or them people are getting frustrated with the recessionary call, and they’re producing a nice slope of hope, that says we have bottomed earnings per share are gonna grow double digits next year in double digits in 2025, as well, that’s a slope of hope. Yes.
Adam Taggart 40:43
All right, God, great answer. And it’s funny, because you’re going in that chart, and it’s gonna say, alpha, I’m not really sure that’s what’s setting up here. And then you said, No, it’s not. But that’s what Wall Street analysts seem to be thinking. I’ve got two questions for you, if you can one, just as a back to bear tightening of the bear steepening of the yield curve. You said that that’s the bond market, realizing that the Fed is going to go higher for longer. That’s it’s important component of that. I want to just get your reaction to some other reasons that I’ve heard for why treasury yields are going up. One is that it’s a supply issue. Right, that the US is suddenly, you know, in overdrive in issuing treasury bonds. And Janet Yellen, you know, I think right near the end of the first half of the year said, I’m going to I’m going to basically issue almost 2 trillion in fresh US treasuries in the second half of 2023. So you have that, and then other people have been saying, Hey, and if you look at, you know, foreign, sovereign countries that have been the biggest buyers of treasuries, historically, they are now selling treasuries, they’re bringing their net holdings of US Treasuries down. So you sort of have more product being pushed by the Treasury, and at least the usual suspects who would buy them not buying them. And of course, the Feds not buying them right now, either, which that was always the buyer of last resort. So how relevant are those two issues, the supply, and the buyers on strike, if you will, in in the state playing a role in the bear steepening as well.
Alf Peccatiello 42:18
So I’m very happy you bring the supply and demand to the table? It’s leads nicely into the bond market course, because it’s one of the things we talked about in there. So the demand for bonds, the demand and not the supply is one of the most underestimated and under analyzed things out there. Who are the buyers of bonds, if the Treasury is issuing more, who is buying these bonds? Right. And you mentioned foreign exchange reserve managers, so foreign central banks, they sell products in dollar, right, so a Brazilian company sells soybeans in dollars, right? They accumulate dollars, the dollar enter the Brazilian banking system, them and then the Brazilian central bank will find themselves a surplus of these dollars, and they will need to recycle them somewhere. Right? So they look for a very liquid and deep market, which is the Treasury market, obviously. So Brazil and China and all other countries will be buying a ton of treasuries, that is correct. And these guys are buying less treasuries than in the past. They are doing that for a bunch of reasons. One of it can be a geopolitical one, right? We have seen what the US has done to Russian dollar reserves. And a few countries might be wondering, well, it’s best if I diversify a bit and I buy a bit more gold, which also explains why gold has been so resilient. In the face of higher real interest rates. There is a structural demand out there, which is going on from this foreign central banks. So the supply is going up. And one of the guys that are driving the demand is fading away. But they’re not the only guys are them. What about the pension funds? What about the banks? What about the insurance companies? Those are extremely large buyers of treasuries much larger than the foreign exchange reserves out there.
Adam Taggart 44:09
Okay, that’s good to know. So they’re much larger.
Alf Peccatiello 44:11
So, to give you an idea, there are about $10 trillion of effects reserves in the world. So, this is the total pool of assets that are held by foreign central banks of these about 60% are invested in dollar assets. So that makes for a $6 trillion kind of market, okay, 6 trillion. Now, if I look at US banks alone, that because of regulation, something very important that I explained in the in the bond market course, and if I look at insurance companies and pension funds, the amount of structural buying needs from pension funds, insurance and banks because of regulation and other needs, is a multiple of that market. If you’re talking about 10 to $20 trillion worth of buying from these guys, so then you are basically you have to focus on that group as well. You can’t just cherry pick one group of buyers, which is fading away, and suddenly look at that. You also have to look at the others banks, pension funds and insurance companies
Adam Taggart 45:20
are great points. Great points. And I’m curious how, how much smaller fish are bigger fish is retail money that is currently moving out of banks. Right bank deposits are moving out of banks from money market funds, which invest in in treasuries, or just being directly invested in the bills themselves.
Alf Peccatiello 45:43
This is an excellent point. And their retail crowd is of course, much smaller than that. But we’re still looking at about a trillion to 2 trillion of money that can move from bank deposits, which are paying very little and are unsecured, the risk of a bank failing as we have seen in March of 2023, to a more secure instrument, which is a key bill which also yields more money, or yields better or a money market fund, which is guaranteed at the end of the day and invests basically in government securities anyway. So that transition is also worth a couple of trillions. My point on supply and demand is the following. It is much more nuanced than people want to make it I understand it’s a very simple narrative so people can follow it. The Treasury issues more the Fed isn’t buying, the effectors of managers aren’t buying, and therefore the yields are going higher. Well, then my question is, what are banks doing? What are insurance companies doing? What is PIMCO doing? What is Blackrock doing? Because they together are much bigger than the effectors of market itself.
Adam Taggart 46:53
Okay, well, this, folks is why you want to take your your bond knowledge from a very, you know, industry deepened and seasoned veteran, like alpha. So alpha, we’re going to talk about your course in just a minute. But before we do, let’s make this real for everybody. Okay, so I’ve got it. We got this bearish bear steepening, you’ve showed us the chart that shows how bond returns lead, s&p returns by 18 months. That looks like pretty soon we’re going to the s&p is going to, you know, catch up on the downside to the bond market. What do we do you know, are there assets right now that look particularly well positioned for for this next leg? And are there ones that you might not want to touch with a 10 foot pole right now?
Alf Peccatiello 47:43
Look, this is an environment that highly resembles late 2018. If you remember back then bond yields were going higher. And the credit market froze in late 2018, because it was too much. So we had the same story bear steepening higher neutral rate and the Fed is gonna hike but the economy can handle it. A very similar situation. And then at some point, the equity market took a draw down the credit market froze. and bond markets also couldn’t rally because the Federal Reserve was very stubborn, only for a couple of months, until they pivoted because they realized how much damage they did. And if you remember in 2019, Powell said, Sorry, guys, this was too much. And they pivoted dovish. And the SMP in 2019 made a 30% return. and bond markets rallied as well, very, very hard. So now we resemble the first part of this, where we are tightening the screws and bolts can’t rally because the Federal Reserve is projecting this higher for longer story. And we are testing whether the economy can really handle it. So we are there steepening and bonds can’t rally yet. Equity markets can’t rally either forget about it. I mean, you’re facing the tone of headwinds that we just discussed. So you can buy bonds and you can buy equities. What about commodities? Well, oil has been having a good run and it is normally something you see late cycle that the physical market, right like oil price to test the hypothesis. Yeah. But then when something breaks, oil is going to break as well. So do you want to be longer oil or maybe a bit in the portfolio, the idea is you want to be prepared for different macro environments. So for instance, I have something at the macro calm was called the Forever portfolio tries to do exactly that tries to be balanced around different macro environments, but for today, what we’re looking for the next few months, I think that the best asset you can have is dollar cash, invested in T bills, obviously instead of at the bank because you’re going to make five and a half percent. But guys in an environment where bond yields are going higher and they’re testing the hypothesis of higher for longer right when the economy is slowing If there is no place to hide, if not dollar cash invested in DBS making a secure five point 25% yield per annum, that looks like a very different difficult, difficult hurdle to beat for the next three to six months to me.
Adam Taggart 50:17
Okay, so we have the economic camel, who you are looking at and saying, all right, one of these next drawers is going to break its back. And then that’s going to really, you know, set the timer for the recession. And that’s going to finally get the memo to the stock market stock market’s going to start correcting. And meanwhile, through all that, that bear steepening will will persist, right? So you’re sort of like, it’s not a great time for any asset right now. So just getting paid or nice, real return to sit in safety? Good deal, because and this is where I want you to respond. Because when the break happens, there’s going to be a lot of interesting stuff going on.
Alf Peccatiello 51:00
Oh, yes. Oh, yes. Because I made the 2019 example. And something broke, the credit market broke. Apple had a drawdown of 25% in six to eight weeks. And the equity market was down 20% In three months. And the Fed pivoted straightaway in January 2019. Why? Because inflation was 2%. Adam back, then, try to picture the same now. Try to picture this prolonged bear steepening, which leads to an equity sell off 20% And the credit market freezing. Do you expect the Fed to pivot in a month in two months? I don’t, because inflation is still way too high, their hands are literally tied. If something like that happens. It’s a terrible setup. Because they come people to ensure they will lose their credibility until they have literally seen that a lot of damage has been done that unemployment rate has moved higher materially at that point, they can say face and tell people well, we have tightened see we have slowed inflation down the labor market, as you know, broken and we are now forced to repair but they cannot proactively people dovish like they did in 2019 they can only reactively do that. So that makes things much more complicated.
Adam Taggart 52:19
Okay, guys, let me just restate that. Because I think it’s really important. You think that when things break, as long as inflation is still elevated, and really in pounds world elevated is above 2%? Right? He’s been super clear for credibility sake, saying folks, I’m not raising two or 3% new target like, to me, it all means 2% or less, right? So that’s where his credibility is. So you’re basically saying he is going to basically sit on the sidelines, watch the market, correct? Watch the job market worsen. Until one of two things happens. Inflation is below 2%, which could happen if the destruction is bad enough, but still, it’s it? That would probably be a painful world, if that happened quickly. Or the world comes to him and begs him. Please tell. I know, you said you wanted to get to 2%. I know you said inflation was the big thing, but we are begging you pivot now. And then he’ll then have the air cover at that point to say, okay, you know, inflation is only at 2.9% or whatever. But I have to do this now because the world is begging me.
Alf Peccatiello 53:21
That’s pretty much correct. And so in the first phase, there is not much that makes a lot of money. Honestly, dollar cash is the thing that will protect your drawdowns better in that environment. In the later stage, gold is the thing that we’ll do immediately better. bond markets will timidly try to rally, but they can’t really rally because the Federal Reserve is stubbornly dis allowing them to do so. And only when the Federal Reserve really recognizes the damage that has been done. It’s when bond markets will rally viciously. So they will rally hard and they will rally last. Before that, it’s going to be very hard to be long any asset and make a reasonable amount of money adjusted for the risk you’re taking. Instead of simply taking your 520 5% risk free rate sitting in dollar cash. That’s how I see markets today.
Adam Taggart 54:20
Okay, very well said and we’re gonna have to leave it there just timewise. So because I want to have a little bit of time to explain your new course to folks before we log off here. After this has been great. You always use the term, you know, fully open the kimono. You’re very comfortable doing that with our audience. And I really thank you for that because people really appreciate the transparency and the specificity. So this has been wonderful now for folks that have watched this and said okay, great. Alphas really helping me begin to understand the bond market but I really want to get better at understanding it because I might actually want to start making direct investment in Lyons myself, we’re gonna go tell us about this new course.
Alf Peccatiello 55:04
So look at them. If people are listening to this interview, they have been asking themselves, Well, I really need to understand this bond market better because it seems to be so important. But so far, they haven’t made a step because it’s full of jargon, full of technicalities full of math, and they don’t know where to start. That ends today. I made a bond market course just to answer exactly these questions. So the idea is I’ve been there, I’ve learned stuff I’ve been in the business, I want to make sure I can share it with you in plain English. So I unpack the bond market in a course, that lasts about four hours, there is material for people to study even more, that are supporting slides. And the bond market course can be purchased at a link that we will put it in description, right?
Adam Taggart 55:54
Yeah. Do you have a? Is it a long link? Or is it a pretty
Alf Peccatiello 55:59
relatively long, so it’s well, that can go on the macro compass.com, which is my website. And there is a course dedicated section on the website where
Adam Taggart 56:08
even better, here’s what we’ll do, folks, I’ll put a link in the description below this video. But you can also just go to wealthion.com/alpha bonds, all one word, and that will redirect to the page that alphas talking about?
Alf Peccatiello 56:22
Well, that was easy. But the most important part of all of this is that I really like Wealthion. And I’d really like the wealth and audience and the job you’re doing with these guys. So I thought that to facilitate and encourage people to go and learn about bond markets through my course, I want to throw an exclusive offer that you guys at Wealthion If you allow me Adam to do that.
Adam Taggart 56:44
Absolutely, I’d be hungry if I didn’t. Okay, so for the first
Alf Peccatiello 56:47
50 people that will go and use the discount code 20 bond, so that’s two zero bond, I guess you got it, you’re gonna get a 20% of the price that you find on the website, but it’s limited. So the 51st guy that will do that will won’t be able to enjoy the discount code. So if you’re keen on doing that, go on the website, we’ll put the link in the description Adam or otherwise use Adams, the link that he just mentioned, discount code 20 Bond to zero bond.
Adam Taggart 57:19
Very generous, our thank you for doing that. I know you’re gonna get a lot of kudos and gratitude from the audience in the comments to this. Thank you, you’ve been such a great friend of Wealthion. Over the years since we started, we’re huge fans of you and the macro compass. Looks like this love affair is only getting better and better going forward. But anyways, I really do appreciate you making that special offer available to my audience here. Alright, and then beyond the course itself, if folks just want to follow you, they go to my website, chris.com. Your subject,
Alf Peccatiello 57:51
the macro compass.com is the website. So when you go in there, guys, there is anything starting from free material, I have a free newsletter. So you can find it on the website, you go on the macro compass.com You scroll and you’ll find the free newsletter as well. If you want to start from there Be my guest, we’re all here for education, there are people that want to step it up to a higher level people that want to start free. There are also of course, subscription tiers to much more in depth material, including stuff like my forever portfolio that I discussed before, which is a macro ETF portfolio that is equipped for different macro environments, the bond market course interactive tools, anything is available on the macro compass.com.
Adam Taggart 58:34
All right, great. And then you you’re active on Twitter, your handle there is remind folks
Alf Peccatiello 58:40
at macro Alf, although Elon Musk has made it a much more difficult place to use or interact and enjoy, I would say since he took over so I’m not sure it’s really the place where I’m the most active. But yes, my Twitter handle is at macro
Adam Taggart 58:56
health. Okay, great. So when we edit this alpha, we’ll put up the links there to your course we’ll make sure folks know what the discount code is to the macro compass website. And to Twitter. It sounds like you’re saying most folks should just go to your website if they want to follow you because Twitter’s been less useful to you recently, but want to make sure folks who use Twitter know that. Okay, well look, just in wrapping up here, folks. One other resource to make you aware of is the Wealthion fall online conference is still scheduled for Saturday, October 21. I won’t give the big pitch on it here because the big thing to do after watching this video is to go check out our spawn course. But if you want to get more information about the conference and register for it, while we still have the lowest price discount at our Early Bird, I think it’s 29% off discount, go to wealthion.com/conference. And if you’re an alumnus, check your email, because you’ll have a code for me that will give you an additional 15% off at that price. And just as we do in every video, I think I’ve done a great job of saying of showing us here why bonds are so important. What’s the The really difficult time we’re likely to have ahead of us in the markets for every asset, basically. And so in addition to getting educated through courses like ALFS, obviously, you want to put that into practice into action in your own portfolio. And for the vast majority of people watching this who have real lives, you know, they’re just regular people, they’ve got jobs and families to pay attention to highly recommend you do that one under the guidance of a good professional financial adviser, but most importantly, one who understands and takes into account all of the macro issues that alpha has been talking about here, that really narrows down the probability set. So if you’ve got someone who fits that narrow set, great, stick with them, but if you don’t, if you’d like a second opinion of one for a second opinion by one who does feel free to schedule a free consultation with a financial advisors that Wealthion endorses, to do that, just fill out the short firstname.lastname@example.org only takes a couple of seconds, totally free, no commitment to work with them. It’s just a public service, they offer to help as many people position as prudently as possible today in advance of the developments that elf thinks might be coming down the road. If you’ve enjoyed having us on this channel, we’d like to see him come back on again, please encourage him to do so by hitting the like button, then clicking on the red subscribe button below, as well as that little bell icon right next to it. And Alf. I just want to say again, thank you so much for just giving so generously of yourself in these videos. I’ll let you have the last word here.
Alf Peccatiello 1:01:25
Well, it’s always a pleasure to chat with you, Adam and I appreciate the educational angle that you’ve been pursuing on Wealthion. So if somebody is listening to this video and is not subscribed to the channel, what are you waiting for? Do subscribe to Adam and Wealthion. And there’s such
Adam Taggart 1:01:40
a good man. All right. Thanks, everybody. Go check out our course. And thanks so much for watching.