After last Wednesday’s pivot by the Federal Reserve, the US dollar slumped, cyclicals rallied hard, gold and precious metal miners soared, and long-bond yields around the world, but especially in the US, fell. On the following day, the European Central Bank came out and essentially said “we don’t know what the Fed is on about, but we are staying put”. This contrast in messaging was arresting, given that US equity markets have flirted with new highs, US unemployment is close to record lows and US nominal GDP growth surged in 3Q23 even as Europe’s economic performance has remained very weak. It offered up an unusual contrast which forces investors to mull over the following three possible scenarios:
1) Investors misinterpreted what Jerome Powell said and the Fed is not as dovish as they think. In this scenario, as the Fed reaffirms its “tighter for longer” mantra in the new year, the US dollar rebounds, long-dated yields probably rise and stocks most likely sell off with the possible exception of the “Magnificent Seven”, which are increasingly becoming the natural recipients of any excess US dollars that non-US investors may hold.
2) The Fed is now signaling dovish because it foresees a slowing US economy. A skeptic could argue that the Fed did not forecast the recent surge in inflation and its forecasts for nominal US GDP growth since 2020 have been way too conservative. Hence, the fact that the Fed sees a possible downside to the exceptional boom it never saw coming may cause investors to take pause. Still, even a blind squirrel occasionally finds a nut, so it may be that the Fed is rightly cautious even if the ECB board is less worried in the face of far weaker data. But then, the ECB’s track record at being late in both easing and tightening is itself pretty stellar! So if one wishes to conclude that the Fed is right to expect a slowdown, it is not that much of a stretch to again think that the ECB is “a day late and a euro short".
Essentially, the Fed knows that a recession is looming and so loading up on long-dated US treasuries makes sense. In this scenario, one should fade the commodity rally and perhaps even the dollar’s weakness.
3) The bond rally is a knee-jerk reaction by a market used to bidding up treasuries when the Fed starts cutting rates. In the past, the Fed usually waited for equities to fall, or unemployment to rise or growth to roll over, before signaling its dovish intent. In that regard, a still-hypothetical Fed easing cycle would differ from its predecessors as it would likely be driven more by politics than economics. If this is right, then a pro-cyclical US monetary policy is likely to be very bad news for long-dated bonds. Next year could well witness very decent US consumption (boosted by the recent drop in oil prices), insane fiscal policies, a very tight labor market, a weaker US dollar and pro-cyclical monetary policies. This hardly seems to be the best of backdrops for investors in long-dated US treasuries.
As the reader has likely guessed by now, I am betting on this third scenario. Assuming that the Fed is sounding dovish more for political reasons than any genuine macroeconomic concerns, the next few months should see a weaker US dollar. If, at the same time, the Bank of Japan eventually abandons its negative interest rate policies and China’s stimulus attempts start to gain a modicum of traction (and the People’s Bank of China has ramped up liquidity injections of late), we could end up with a setup that is bearish for long-dated bonds across OECD countries, most but especially in the US.
Against that scenario, what could cause a further down leg in US long bond yields, aside, of course, from a faceplant by the US economy?
Failing that, with the US dollar index below its 200-day moving average, and the slope of the index now negative, I find it very hard to get excited about the near-term outlook for US long bonds.
DISCLOSURE: Securities highlighted or discussed in this communication are mentioned for illustrative purposes only and are not a recommendation for these securities. Evergreen actively manages client portfolios and securities discussed in this communication may or may not be held in such portfolios at any given time. This material has been prepared or is distributed solely for informational purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Any opinions, recommendations, and assumptions included in this presentation are based upon current market conditions, reflect our judgment as of the date of this presentation, and are subject to change. Past performance is no guarantee of future results. All investments involve risk including the loss of principal. All material presented is compiled from sources believed to be reliable, but accuracy cannot be guaranteed and Evergreen makes no representation as to its accuracy or completeness.