Re: Inflation/Oil/Gold/Yield Curves - Revisiting Bear Steepening, Recency Bias & That 70's Show.

"Loss of Faith" narratives abound with respect to the UST and USD with the recent Bear Steepening. I argue that this was entirely predictable and driven by Macro/Cyclical factors.

Revisiting Bear Steepening

In June, 2022, I wrote a thread that proposed an “out-of-the-box” solution to the Fed’s dilemma of how to cure Inflation without potentially also creating a Credit Crisis. In short, I said that the Fed and Treasury needed to work together to engineer a Bear Steepener:

The difference between what I was suggesting (an engineered Bear Steepener) vs. what is happening now (a market-driven Bear Steepener a la the 70’s) is that my plan (had it been enacted) might have taken long yields to 6% (and thus crushed long duration Risk Assets) but might have also obviated the need to take the Fed Funds Rate (FFR) Sledgehammer to the current 5.25-5.5% (and thus may have lessened the chances of a Credit Crisis):

Now that the Fed has already availed itself of the FFR Sledgehammer, lifting us off from ZIRP to 5.25-5.5% with 11 consecutive hikes and the fact that Core Inflation remains elevated, the market is finally waking up to the reality of what true Higher For Longer (H4L) might entail and has started repricing the rest of the Yield Curve.

TO ME, THIS IS JUST BOND MATH BEING APPLIED ACROSS THE CURVE TO PROPERLY REFLECT H4L EXPECTATIONS AND NOT SYMPTOMATIC OF ANY “LOSS OF FAITH” FEARS IN THE US GOV’S ABILITY TO FUND ITSELF.

THE USD/UST ECOSYSTEM REMAINS THE SAFEST, MOST LIQUID STORE OF VALUE WITH THE ELASTICITY TO ACCOMMODATE WORLD SURPLUSES.

If you’d like to read why Elasticity is important, see this past piece:

The reason why I am deliberately conflating “Loss of Faith” arguments in the USD (De-Dollarization Bogeyman) and “Loss of Faith” arguments in the UST market (Funding/CB Selling Bogeymen) is because the USD and UST are both obligations of the US Government, separated only by the TIME dimension. So it is the same issue ultimately.

To me, the Recency Bias of DECADES of Liquidity Lottery have ossified Macro thinking into assuming that Yield Curves must always follow some prescriptive path of inverting prior to a recession and then Bull Steepening our way back out through Rate Cuts.

This was a memorable exchange last year, in which I was told with great certainty exactly how things would play out:

I remained skeptical and warned about getting too hung up on models curated over decades of Endless Liquidity Lottery:

Indeed, it looked like Eric’s playbook was right for a while as our Yield Curve massively inverted to the point where the 3M-10Y spread briefly went past -175 bps.

This is where I noticed something funny.

Given US Economic Strength relative to the RoW, why on earth should our Yield Curve be pricing in such a draconian recessionary scenario relative to the Yield Curves of other countries whose economies were in far worse shape?

Barely anyone took note of this.

For clarity, here are the individual charts:

I mentioned it again a month later.

Yawn. Again, barely anyone took notice.

Around this time, I decided to switch to 2s10s (given short end data limitations in other countries). To recalibrate to 2s10s, note that the level of YC Inversion reached -110 bps in the US in July when 3M-10Y breached -175 bps:

Note my last statement: “This is the GRC Safety Bid in plain sight.”

Frankly, I think the level of extreme inversion was excessive Safety Premium built into our long end, but as the world would soon see, Macro eventually dominates everything.

Given the resumption of shellacking in the long end in recent weeks, no one’s yawning anymore:

Again, to put things into perspective, this is just Bond Math working properly to reprice the Yield Curve to accommodate a true H4L scenario.

THE CRITICAL POINT HERE IS THAT THIS BEAR STEEPENING WAS JUST CORRECTING A MASSIVELY MISPRICED YIELD CURVE THAT HAD BAKED IN THE PLAYBOOK THAT EVERYONE GOT USED TO FROM THE RECENCY BIASES OF DECADES OF LIQUIDITY LOTTERY.

I THINK THAT THIS MOVE HAS LITTLE TO DO WITH “LOSS OF FAITH” IN THE USD OR UST AS A FUNDING MECHANISM FOR THE USA AND HAS EVERYTHING TO DO WITH THE MACROECONOMIC/CYCLICAL FACTORS MENTIONED ABOVE.

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October 6th and Flight-To-Safety

In the days after the devastating events in the Middle East that began with the October 6 Hamas attack on Israel, there has been much hullaballoo about how the traditional Safety Bid in long USTs was conspicuously absent even as Gold and Oil spiked.

To this I say:

BEWARE OF CONFLATING GEOPOLITICAL NOISE WITH ACTUAL MACROECONOMIC SIGNAL AND EXTRAPOLATING BASED ON THAT.

Take an expanded look at these same 3 charts and pay attention to the price action leading up to October 6. Bonds, Gold and Oil all literally reversed on exactly that day:

Why then did Bonds not hold while Gold and Oil continued to ascend?

Bonds notably diverged on 10/19 after Powell’s devastating remarks, stating that “rates haven’t been high enough for long enough…policy does NOT seem tight enough.”

My interpretation is that for Bonds, the Macro was already driving Bear Steepening and Powell’s comments hammered home the prospect of H4L policy. In the end, Macro dominates over short-term Geopolitical Fears.

It is for this same reason that I find the moves of Gold and Oil suspect, and the market gave tells about what the Macro conditions portended for both prior to 10/6.

For Gold, the Macro headwinds of Positive Real Rates had seemingly caught up to it, and Gold had collapsed right before 10/6. Indeed, I had been bearish Gold and caught the massive downdraft prior to 10/6 based on this thesis:

Given the 10/6 V-bottom while I was traveling, I didn’t do a great job of preserving my gains but still managed to escape with a positive PNL. I am flat Gold now and remain ambivalent about its prospects.

Gold, like its younger cousin BTC, are Chameleon Trades to me; they are at times Inflation hedges, Deflation hedges, Geopolitical hedges which also means that at different times they are none of these things. They cannot be valued, do not pay dividends/interest, and have limited Supply Elasticity, which makes them objects of Speculation — often with religious zeal. There is no intrinsic value except for what the next buyer is willing to pay. The non-falsifiable investment thesis really bothers me, and I prefer other vehicles where the investment thesis can be more clearly defined and proven right/wrong.

Oil, on the other hand, is the world’s most critical “Opex Commodity,” which I have written at length about over the last several years and have a significant long-term, self-liquidating PE interest in. Despite my long-term bullish thesis (that I’ve had since 2016), many of you know that I’ve turned bearish since April, 2022 when Oil was last $105-$110 and have cautioned about deteriorating Macro fundamentals.

That bearish call had been the right call until July, with Oil hitting the mid-60’s. Although I didn’t foresee the extent of counter-trend rally since July, I also did not advocate directly shorting Oil because of its steep Backwardation and because of the potential for OPEC+ surprises (which indeed have been the main reasons for the rally). Instead, I have been hedging my PE exposure through “out-of-the-box” hedges that I think correlate with the deteriorating Macro fundamentals for Oil: 1. Short CNH since March, 2. XOP put spreads since August.

Prior to 10/6, the double-whammy effects of the USD Wrecking Ball + High Oil Prices had also begun to take its toll, and Oil had also weakened materially before 10/6. Macro Fundamentals are far worse since my original bearish call in April, 2022, recent Geopolitical spike notwithstanding. If anything, if there is true escalation without material Supply Disruption (I see low likelihood of this), Macro Fundamentals for Oil will become even worse:

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I wrote a piece last month stating exactly why I felt that factors specific to the US were contributing to US Economic Resilience in such a way that the Fed would likely break RoW’s economies before the US Economy:

Interestingly, I was doing some due diligence on a potential idiosyncratic investment recently, and this stuck out to me, which corroborated my thesis:

Jay Powell essentially echoed these sentiments in his comments on 10/19, so it’s no wonder why Long USTs continued to crater despite these subsequent Geopolitical headlines continuing to support Gold and Oil:

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That 70’s Show

Going back to the Yield Curve now, let’s take a look at the shift from the point of maximum inversion (when 2s10s hit -110 bps in July) vs. now.

It looks quite dramatic — especially for an entire generation birthed in the cocoon of the Never-Ending Liquidity Lottery that had never seen such a fast Bear Steepening.

But this is where Recency Bias can really bite you in the ass.

For purposes of comparison, I’ve added 4 points now from 1/1/1979 to 1/1/1982.

Does the recent bout of Bear Steepening look so dramatic now?

Does the hyperventilation about this being some harbinger of “Loss of Faith” in the USD/UST system seem justified now?

NO and NO.

For one last illustration, I want to show the before (Black) and after (Dark Blue) of Volcker’s infamous Saturday Night Massacre in which he surprise-hiked Fed Funds from 11% to 12%. According to the WSJ, “Mr. Volcker's announcement, made on a Saturday night, became known as ‘the Saturday Night Massacre’ for its murderous effect on bond prices—but it also broke the back of inflation.”

Note that the initial rate shock didn’t move the long end (focus on the 10Y) much at all. The 10Y didn’t gap higher in yield until much later — in fact long after the short-end had already peaked.

See chart below from the WSJ:

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Recency Bias Can Kill You

Before closing, I just want to share a couple of past observations I’ve made over the last 2 years about the dangers of Recency Bias and how it can lead to a lack of imagination about possible Tail outcomes that can be significantly deleterious to your financial health.

I hope you get the picture and that this helps you expand your imagination to possible outcomes.

Conclusion

I’ll conclude this missive with a couple key takeaways:

• The recent Bear Steepening has happened before and is NOT symptomatic of some “regime shift” due to “Loss of Faith” in the USD/UST system as the De-Dollarization/End of Fiat Doomsday folks have been predicting for DECADES.

• Beware of extrapolating from Geopolitical NOISE versus Macroeconomic SIGNAL. In the end, Macro dominates.

• Have humility and observe the market with “Beginner’s Mind” and First Principles to avoid getting trapped in Recency Bias, which can be a real killer.

• The adage “History may not repeat itself exactly, but it often rhymes” resounds with me more than ever as this period reminds me more and more of the Stagflationary 70’s.

• To that end, maybe we need to stop talking about Wrecking Balls but focus instead on Disco Balls?