Re: Inflation-The Case for Bear Steepening/Why The Fed Won’t Pivot Soon.

Today I had a chat with @MacroAlf about various macro themes, and I presented my case for why the Fed/Tsy might/ought to consider a BEAR STEEPENER as part of its QT arsenal.

I have written several Musings in the past several months on this theme and have collated them here in an ad hoc thread:

This thread attempts to structure the argument more cogently and explain why I think a Bear Steepener might be the Fed/Tsy’s best hope of engineering a “Controlled Demolition” of asset prices WITHOUT engineering a CREDIT CRISIS.

Several weeks ago, I remarked to @JackFarley96 that the current market conditions remind me more of the Dot Com Bubble of 2000 than the GFC of 2008.

In 2000, bubblicious tech valuations resulted in high EQUITY VOLATILITY and crashed asset prices. The GFC of 2008 was very different in that the heart of the maelstrom revolved around CREDIT VOLATILITY which threatened to take down the banking system.

To me, the Fed’s best hope at curbing demand through pricking asset bubbles WITHOUT also causing a CREDIT CRISIS lies in BEAR STEEPENING of the yield curve vs. just hiking FFR (Fed Funds Rate) until something breaks.

As a caveat, I’m not a fixed-income specialist nor am I an expert on Fed policy mechanics; rather, my analysis is grounded in what I consider to be CONSTRAINTS that the Fed is facing in its inflation fight.

To set the stage, remember that QT now has to combat BOTH QE AND MMT. Giving upcoming midterms and the prospect of divided government, I don’t see a FISCAL antidote to MMT, so it all rests upon the Fed’s shoulder to use the very BLUNT tool of QT to fight inflation.

Stan Druckenmiller in a recent interview said 2 things that resounded with my own thinking. First, Stan noted that the traditional signal content from Bonds (i.e. a flat/inverted yield curve always precedes recession) is no longer as good as it once was.

Why? Because the yield curve has been MANIPULATED FOR 15+ YEARS THROUGH QE. Incidentally, it was the same manipulated quality of the CNY at 6.3 that led me to disregard its “strength” as a spurious signal.

When the Fed found itself pushing on a string with ZIRP (FFR @ 0), it overcame those CONSTRAINTS by suppressing yields all along the curve through ASSET PURCHASES.

Druckenmiller in the same interview also cited a statistic stating that “inflation > 5% could NOT be stopped without FFR > CPI."

Problem: I don’t see the FFR going >8% much less >4% without creating a major CREDIT/FUNDING CRISIS.

The full interview with Stan is here if you haven’t yet watched it:

The Fed is once again facing CONSTRAINTS with traditional FFR-focused monetary policy, and this is why I think the Fed (possibly in conjunction with Tsy) might need a creative solution to MAINTAIN tight conditions to prick asset bubbles WITHOUT creating a CURRENT FUNDING CRISIS.

Based on recent FRED data, I estimate that ~$2.7-$3T of TOTAL corporate debt (encompassing bonds and loans) of $12.2T as of Q1’22 to be FLOATING-RATE.

In addition, I estimate that ~17-20% of $15.8T of total US mortgages is in the form of ARM’s. I have no idea how much is currently floating, but even a small % of a giant absolute number would be significant.

Even if we assume a low % of floating mortgages, spiking rates on $3T of floating rate corp loans alone (typically at the top of the capital stack) will have a CASCADING EFFECT DOWN THE ENTIRE CAP STACK OF $12.2T CORPORATE DEBT AND COULD RESULT IN MASS BANKRUPTCIES.

Even worse, just hiking the short-end absent active Bear Steepening is that A FLAT/INVERTED YIELD CURVE WILL EVISCERATE BANK NET-INTEREST MARGINS AT THE SAME TIME CORPORATE DEFAULTS SURGE.

What happens when you cut off a bank’s NIM lifeblood and saddle it with loan losses at the same time? CREDIT CONTRACTION ACROSS ALL LENDING ACTIVITIES AND POSSIBLY EVEN BANK BANKRUPTCIES.

I believe the Fed is ok with a 2000-style correction but NO ONE wants a 2008-style CREDIT CRISIS that threatens the entire fabric of the financial system.

The market is already sniffing out an FFR-led QT-driven recession given the recent rout in FINANCIALS and ENERGY:

Remember that RISKY DISCOUNT RATES are comprised of 2 components: RISK-FREE RATES + CREDIT SPREADS (aka RISK PREMIUMS):

The market has already led the Fed in pricing in a Bear Steepener of RISKY RATES. The underperformance of HIGH DURATION ASSETS (both in Equities & $BTC/Crypto) suggests that LT EQUITY RISK PREMIUMS have already blown out. A thread on this:

There is also Bear Steepening in CREDIT RISK PREMIUMS, easily visibly in mortgage rates.

With avg 30-year fixed rates blowing out to 5.875% and 15-year fixed to 5.375%, the implied CREDIT SPREADS over equivalent tenor Risk-Free Rates are now 2.5% at 30-yr vs. 2.2% at 15-yr.

In other words, the RISKY YIELD CURVE is already leading the Fed in Bear Steepening, and I expect this trend to continue, with higher duration assets underperforming.

For the Fed/Tsy, Bear Steepening is potentially a "Heads-I-Win/Tails-I-Win" strategy.

Heads: curve steepens and HIGHER LONG RISKY RATES continue to discount High Duration Assets including HOUSING/RE -- the BIGGEST bubble which is just beginning to pop.

Tails: if the curve doesn’t steepen, and the ducks at the long-end are clamoring to fund our gov at 3.35% for 30 years, then FEED THE DUCKS AND TERM OUT OUR MATURITIES!

KEY POINT: BEAR STEEPENING WOULD LESSEN PRESSURE ON THE FED TO TAKE FFR TO A POINT THAT CAUSES FUNDING STRESS AND STILL IMPOSE TIGHTENING ON RISK ASSETS.

As mentioned already, Greenspan jawboned a Bear Steepening in 2000. In the current case, jawboning won’t work because the Fed is SO FAR BEHIND-THE-CURVE already.

Therefore, overt Bear Steepening (Anti-YCC? Anti-Twist?) may be required, and since the Fed doesn’t own a lot of long maturities to sell, it may require Tsy’s assistance in targeting issuance at longer tenors.

The Caveat: the DEMOGRAPHIC BID from Boomer re-allocation out of Equities and into Bonds might make it harder for Fed/Tsy to Bear Steepen, but note that because of the much higher duration of long tenors, A LITTLE GOES A LONG WAY.

Last but not least, I need to pivot to OIL, because OIL started it all. I said 15 mos ago that OIL was the key Opex Commodity to watch, and that its STRUCTURAL INFLATION would precipitate a tough time for risk assets. I explain the linkage here:

The prevailing zeitgeist then was that we had an uber-dovish Fed that many thought would never hike, much less go on the inflation warpath. That thesis was certainly rug-pulled, and NOW I think the thesis most subject to rug-pull is: "The Fed will quickly pivot."

Witness today's price action of correcting Oil prices leading to risk-on in high duration equities and $BTC/Crypto.

As I like to say, beware the “Bad Is Good” rally in a “Good Is Bad” regime.

My biggest concern in Oil up until 2 days ago was that runaway prices ($120 spot) had run far above fundamentals and were trading purely on GEOPOLITICAL SENTIMENT. Despite my LT bull thesis, I had been getting increasingly worried ST.

I’ve been worried that the factors for DEMAND DESTRUCTION (from not just Oil Inflation but an Everything Inflation) outweigh any SUPPLY DESTRUCTION (none so far, and that none would be forthcoming short of BLOCKADES of Russian seaborne routes.)

If anything, I thought that an $85/$65 Oil Forward Curve was “Goldilocks” for the LT bull thesis. The market got WAY ahead of its skis, and I view this flush as HEALTHY for the LT bull thesis.

A moderation in Oil prices now does this:

-Lessens likelihood of stupid policy actions like an EXPORT BAN
-Stymies runaway USD Wrecking Ball from creating Asian Contagion II (watch JPY, CNY, KRW)
-Gives the Fed TIME to consider alternatives to just an FFR-led QT

This STRUCTURAL SUPPLY situation in OIL took almost a decade to create and has since been dramatically EXACERBATED by runaway ESG policies. It will take >> a "garden variety recession" to derail the bull thesis, imho.

To me, a Greenspan-esque Bear Steepening is as close to a "soft landing" as we're gonna get, and NO ONE wants to see a CREDIT CRISIS like 2008, which gets increasingly likely if this QT relies solely on jacking FFR to the moon. I'll end it here.