The market is overly complacent about interest rate risk
Updated
Markets Have Been Celebrating No Corporate Tax Hike
Stocks have been marching higher as the risk of a near-term corporate tax hike evaporated due to hard bargaining by centrist Democrats Joe Manchin and Kristen Sinema. Prediction markets are now putting the odds of no corporate tax hike at about 88%:
predictit.org/markets/detail/7237/What-will-be-the-corporate-tax-rate-for-2022
In fact, the single largest line item in the Build Back Better Act is actually a large tax *cut* which disproportionately benefits the highest earners. That's certainly a bullish development for markets, because it means more billionaire money chasing stocks.
But They've Been Ignoring the Risk That Interest Rates Will Rise
I think markets are ignoring interest rate risk, though. The passage of the Build Back Better act means that the US Treasury will be issuing a lot more treasury bonds over the next few years in order to fund new spending, and it will be doing so at a time when the Federal Reserve is tapering its bond-buying program. That means that private investors will have to absorb that over-supply of treasuries. And private investors are likely to demand higher interest rates than the Federal Reserve would. In other words, a supply-and-demand shock in the bond market could be about to send interest rates up.
Bonds May Have Just Flashed a Warning Sign Today
TLT (a major treasury bond ETF) made a big bearish engulfing candle today and closed below the 200-day EMA. (Bond prices move the opposite direction from rates, so rising rates = falling bonds.) The move came after the Fed's announcement that it will cut bond-buying in half this month and stop bond-buying altogether by mid-next year. I bought a TLT put yesterday and took profit on it today at the 200-day EMA for a 30% gain, but TLT actually continued downward and ended the day below the 200-day. It still has support from the 20-day EMA, so the question tomorrow is whether the 20-day will hold. If TLT doesn't hold support at the 20-day, then I think we're likely to see tech and pharma stocks follow it down. We could well be at the beginning of a significant correction for both bonds and stocks.
Rising rates would be bad for growth companies, and especially bad for cash-poor companies that finance their growth through debt. (Pharmaceuticals, for instance, could be especially hard-hit.) Rising interest rates make it harder for those companies to get financing. The Nasdaq index has recently been selling off whenever rates rise (and bonds fall). Rising rates are better for banks than for tech, and could lead to outperformance by XLF.
Smart Money Has Been Going Short Bonds for Months
For the last couple months, a lot of smart money has been going short bonds on the expectation that bond rates will rise and bonds will fall. Ordinarily I'd hesitate to pile into such a crowded trade, but sometimes the crowd is right. The put/call ratio on TLT is 1.7, a big bearish bet. And an indirect way to be short bonds is to be short tech. The put/call ratio on the tech-heavy QQQ right now is an even more bearish 2.0. If you have heavy long exposure, especially to tech and growth, now is probably a good time to put some hedges on.
Markets Have Been Celebrating No Corporate Tax Hike
Stocks have been marching higher as the risk of a near-term corporate tax hike evaporated due to hard bargaining by centrist Democrats. In fact, the single largest line item in the Build Back Better Act is actually a large tax *cut* which disproportionately benefits the highest earners. That's certainly a bullish development for markets, because it means more billionaire money chasing stocks.
But They've Been Ignoring the Risk That Interest Rates Will Rise
I think markets are ignoring interest rate risk, though. The passage of the Build Back Better act means that the US Treasury will be issuing a lot more treasury bonds over the next few years in order to fund new spending, and it will be doing so at a time when the Federal Reserve is tapering its bond-buying program. That means that private investors will have to absorb that over-supply of treasuries, and they are likely to demand higher interest rates than the Federal Reserve would. A supply-and-demand shock in the bond market could be about to send interest rates up.
Bonds May Have Just Flashed a Warning Sign Today
TLT (a major treasury bond ETF) made a big bearish engulfing candle today and closed below the 200-day EMA. (Bond prices move the opposite direction from rates, so rising rates = falling bonds.) The move came after the Fed's announcement that it will cut bond-buying in half this month and stop bond-buying altogether by mid-next year. I had bought a TLT put yesterday and took profit on it today at the 200-day EMA for a 30% gain, but TLT actually continued downward and ended the day below the 200-day. It still has support from the 20-day EMA, so the question tomorrow is whether the 20-day will hold. If TLT doesn't hold support at the 20-day, then I think we're likely to see tech and pharma stocks follow it down. We could well be at the beginning of a significant correction for both bonds and stocks.
Rising rates would be bad for growth companies, and especially bad for cash-poor companies that finance their growth through debt. (Pharmaceuticals, for instance, could be especially hard-hit.) Rising interest rates make it harder for those companies to get financing. The Nasdaq index has recently been selling off whenever rates rise (and bonds fall). Rising rates are better for banks than for tech, and could lead to outperformance by XLF.
Smart Money Has Been Going Short Bonds for Months
For the last couple months, a lot of smart money has been going short bonds on the expectation that bond rates will rise. (Bond prices move the opposite direction from rates, meaning that rising rates cause prices to go down.) Ordinarily I'd hesitate to pile into such a crowded trade, but sometimes the crowd is right. The put/call ratio on TLT is 1.7, a big bearish bet. And an indirect way to be short bonds is to be short tech. The put/call ratio on the tech-heavy QQQ right now is an even more bearish 2.0.
Inflation Numbers Will Determine Where We Go from Here
FOMC futures are currently forecasting that the Fed will hike rates 2-3 times by the end of next year, with a small chance of 4 rate hikes. As But as John Cochrane argues, FOMC futures have historically tended to be too hawkish:
johnhcochrane.blogspot.com/2019/06/futures-forecasts.html
There's a lot of political incentive in Washington, D.C. to keep rates low, so the Fed almost certainly won't raise rates until inflation forces their hand. (Raising rates is primarily a tool to control inflation.) So keep an eye on the inflation numbers as we go forward from here. Inflation over the past decade has tended undershoot expectations, and many economists still believe that the current bout of inflation will prove to be transitory. So it may well turn out that we just get one or two rate hikes, and then inflation stabilizes and everything returns to normal.
For now, I am expecting a short-term correction in both bonds and stocks, but a stabilization in the medium term. Shipping prices have been falling:
And commodities prices look like they may start to come down as well:
Hopefully these are early signs that inflation will be transitory after all.
But the last reading on the Citi Inflation Surprise Index was an all-time high, so beware. If the pandemic has taught us anything, it's that there's definitely a limit to how far and fast we can push deficit spending before inflation kicks in. Pandemic deficit spending in 2020 caused high inflation in 2021. The question now is whether inflation will run away or normalize. This is an unprecedented situation, so nobody really knows. But a lot will depend on whether the Fed and Congress can practice some fiscal discipline, or at least convince markets that they will.
Stocks have been marching higher as the risk of a near-term corporate tax hike evaporated due to hard bargaining by centrist Democrats Joe Manchin and Kristen Sinema. Prediction markets are now putting the odds of no corporate tax hike at about 88%:
predictit.org/markets/detail/7237/What-will-be-the-corporate-tax-rate-for-2022
In fact, the single largest line item in the Build Back Better Act is actually a large tax *cut* which disproportionately benefits the highest earners. That's certainly a bullish development for markets, because it means more billionaire money chasing stocks.
But They've Been Ignoring the Risk That Interest Rates Will Rise
I think markets are ignoring interest rate risk, though. The passage of the Build Back Better act means that the US Treasury will be issuing a lot more treasury bonds over the next few years in order to fund new spending, and it will be doing so at a time when the Federal Reserve is tapering its bond-buying program. That means that private investors will have to absorb that over-supply of treasuries. And private investors are likely to demand higher interest rates than the Federal Reserve would. In other words, a supply-and-demand shock in the bond market could be about to send interest rates up.
Bonds May Have Just Flashed a Warning Sign Today
TLT (a major treasury bond ETF) made a big bearish engulfing candle today and closed below the 200-day EMA. (Bond prices move the opposite direction from rates, so rising rates = falling bonds.) The move came after the Fed's announcement that it will cut bond-buying in half this month and stop bond-buying altogether by mid-next year. I bought a TLT put yesterday and took profit on it today at the 200-day EMA for a 30% gain, but TLT actually continued downward and ended the day below the 200-day. It still has support from the 20-day EMA, so the question tomorrow is whether the 20-day will hold. If TLT doesn't hold support at the 20-day, then I think we're likely to see tech and pharma stocks follow it down. We could well be at the beginning of a significant correction for both bonds and stocks.
Rising rates would be bad for growth companies, and especially bad for cash-poor companies that finance their growth through debt. (Pharmaceuticals, for instance, could be especially hard-hit.) Rising interest rates make it harder for those companies to get financing. The Nasdaq index has recently been selling off whenever rates rise (and bonds fall). Rising rates are better for banks than for tech, and could lead to outperformance by XLF.
Smart Money Has Been Going Short Bonds for Months
For the last couple months, a lot of smart money has been going short bonds on the expectation that bond rates will rise and bonds will fall. Ordinarily I'd hesitate to pile into such a crowded trade, but sometimes the crowd is right. The put/call ratio on TLT is 1.7, a big bearish bet. And an indirect way to be short bonds is to be short tech. The put/call ratio on the tech-heavy QQQ right now is an even more bearish 2.0. If you have heavy long exposure, especially to tech and growth, now is probably a good time to put some hedges on.
Markets Have Been Celebrating No Corporate Tax Hike
Stocks have been marching higher as the risk of a near-term corporate tax hike evaporated due to hard bargaining by centrist Democrats. In fact, the single largest line item in the Build Back Better Act is actually a large tax *cut* which disproportionately benefits the highest earners. That's certainly a bullish development for markets, because it means more billionaire money chasing stocks.
But They've Been Ignoring the Risk That Interest Rates Will Rise
I think markets are ignoring interest rate risk, though. The passage of the Build Back Better act means that the US Treasury will be issuing a lot more treasury bonds over the next few years in order to fund new spending, and it will be doing so at a time when the Federal Reserve is tapering its bond-buying program. That means that private investors will have to absorb that over-supply of treasuries, and they are likely to demand higher interest rates than the Federal Reserve would. A supply-and-demand shock in the bond market could be about to send interest rates up.
Bonds May Have Just Flashed a Warning Sign Today
TLT (a major treasury bond ETF) made a big bearish engulfing candle today and closed below the 200-day EMA. (Bond prices move the opposite direction from rates, so rising rates = falling bonds.) The move came after the Fed's announcement that it will cut bond-buying in half this month and stop bond-buying altogether by mid-next year. I had bought a TLT put yesterday and took profit on it today at the 200-day EMA for a 30% gain, but TLT actually continued downward and ended the day below the 200-day. It still has support from the 20-day EMA, so the question tomorrow is whether the 20-day will hold. If TLT doesn't hold support at the 20-day, then I think we're likely to see tech and pharma stocks follow it down. We could well be at the beginning of a significant correction for both bonds and stocks.
Rising rates would be bad for growth companies, and especially bad for cash-poor companies that finance their growth through debt. (Pharmaceuticals, for instance, could be especially hard-hit.) Rising interest rates make it harder for those companies to get financing. The Nasdaq index has recently been selling off whenever rates rise (and bonds fall). Rising rates are better for banks than for tech, and could lead to outperformance by XLF.
Smart Money Has Been Going Short Bonds for Months
For the last couple months, a lot of smart money has been going short bonds on the expectation that bond rates will rise. (Bond prices move the opposite direction from rates, meaning that rising rates cause prices to go down.) Ordinarily I'd hesitate to pile into such a crowded trade, but sometimes the crowd is right. The put/call ratio on TLT is 1.7, a big bearish bet. And an indirect way to be short bonds is to be short tech. The put/call ratio on the tech-heavy QQQ right now is an even more bearish 2.0.
Inflation Numbers Will Determine Where We Go from Here
FOMC futures are currently forecasting that the Fed will hike rates 2-3 times by the end of next year, with a small chance of 4 rate hikes. As But as John Cochrane argues, FOMC futures have historically tended to be too hawkish:
johnhcochrane.blogspot.com/2019/06/futures-forecasts.html
There's a lot of political incentive in Washington, D.C. to keep rates low, so the Fed almost certainly won't raise rates until inflation forces their hand. (Raising rates is primarily a tool to control inflation.) So keep an eye on the inflation numbers as we go forward from here. Inflation over the past decade has tended undershoot expectations, and many economists still believe that the current bout of inflation will prove to be transitory. So it may well turn out that we just get one or two rate hikes, and then inflation stabilizes and everything returns to normal.
For now, I am expecting a short-term correction in both bonds and stocks, but a stabilization in the medium term. Shipping prices have been falling:
And commodities prices look like they may start to come down as well:
Hopefully these are early signs that inflation will be transitory after all.
But the last reading on the Citi Inflation Surprise Index was an all-time high, so beware. If the pandemic has taught us anything, it's that there's definitely a limit to how far and fast we can push deficit spending before inflation kicks in. Pandemic deficit spending in 2020 caused high inflation in 2021. The question now is whether inflation will run away or normalize. This is an unprecedented situation, so nobody really knows. But a lot will depend on whether the Fed and Congress can practice some fiscal discipline, or at least convince markets that they will.
Note
I just noticed that five paragraphs got duplicated in this post, and I didn't catch it before the 15 minutes to edit ran out. Sorry about that. Just skip the duplicated paragraphs.Note
Obviously we rallied off support today. Undoubtedly this move upward in bonds is driven by falling commodities and shipping prices, which suggest that inflation will cool off. Keep an eye on GSG and BDI for the pullback to continue. If GSG and BDI rally, the bond rally will likely stall out.Note
Commodities have been rallying the past few days, and the plunge in shipping prices is decelerating. The US dollar index (DXY) is in a resistance area, and the producer price index (PPI) is out tomorrow and the consumer price index (CPI) out Wednesday. Gold traders appear to be positioning long in anticipation that the narrative might shift in an inflationary direction in the next few days: If PPI and CPI numbers come in hotter than expected, look for a pullback in TLT and stocks, especially tech and biotech.
Note
So obviously we got a pretty sharp pullback in TLT yesterday after the CPI number came in much hotter than expected, at 0.9% vs. 0.6% est. Core CPI was 0.6% vs 0.4% expected. Trailing twelve months inflation sits at 6.2%, the largest annual increase in 30 years. I had bought a TLT put the previous day, and I made good money on that put yesterday.HOWEVER, note that TLT rallied at the end of the day, and the PPI number (producer price index) was in-line with expectations. CPI is a lagging indicator, while PPI is more of a leading indicator. So to some extent, CPI is old news. TLT and stock indexes are up premarket today, so traders seem to be betting that this month's CPI number was peak inflation and that next month's number will be cooler.
Note that BDI (the index of shipping prices) is now rising. GSG (the broad commodities index) may be rolling over. Natural gas might rally from here, but oil might dip. So the picture on the supply chain side is very mixed.
It's possible that this morning's rally will prove to be a fakeout rally and that we'll end the day down. I'm going to be watching the price action to see if the market rallies with conviction here. I'm also going to be closely watching oil and natural gas prices, which were the largest components of CPI last month. If both oil and gas rally strongly, then the odds of today's rally being a fakeout are much higher.
Note that the Fed doesn't actually begin tapering until December, so it's fully possible that bonds and stocks rally through November. The real tell will be the price action next month.
Note
After watching the price action today, my bias for tomorrow is bearish for both TLT and QQQ. But the market seems to have no conviction here either way.Note
TLT is testing its moving average supports. This is something to keep an eye on, for sure. If this doesn't hold, things could get ugly next week. Since Nasdaq is up today, short QQQ and long TLT is a possible pair trade.Note
On the non-adjusted chart, bonds have broken below all major moving averages.On the adjusted chart, there's still support from the 200 EMA:
Below about 145.75 is the breakdown level. If we get that low, then tech is in trouble and VIX and financials may rip. In addition to financials, my defensive (utilities and consumer staples) plays are doing pretty well here.
Note
After a fakeout rally this morning, TLT looks to be confirming its breakdown, and XLF is beginning to rip.Note
Alright, so we definitely got a sharp rally in interest rates after that CPI number, BUT. Note that tech did NOT fall, and banks did NOT rally in line with rates, and now the rate rally is fading, tech is melting up, and bank stocks are collapsing. The market consensus appears to be that the worst of inflation is already behind us, and that rate hikes will be minimal or non-existent in 2022. And the market may well be right. The Baltic Dry Index of shipping prices has continued to fall, and it's now below its 2019 peak.
The broad commodities index has been weakening, with particular weakness in oil and natural gas.
I will be watching for any significant reversal of these trends, and for how bond rates respond to December taper.
Note
News cycle this week has been focused on the new Covid variant, Omicron. The news has provided support for bond prices as traders bet the Fed will want to support markets in the event of new lockdowns.Note
Mixed signals from Powell today. He mentioned that the Fed will discuss speeding up taper at the next meeting, but he also said that their models don't include the Omicron variant yet. Since we're at resistance here, I went ahead and bought a 150 put for December 3 on TLT. The next 30-year bond auction is on Thursday; we may see a significant price move after that auction.Note
Bonds are right on the verge of a big breakout higher this morning as commodity prices collapse:Shipping prices have rallied somewhat:
But overall, the risk of extreme inflation is easing, and the environment may even be turning a little bit deflationary.
Note
TLT breakout higher is rejecting in the first minutes of trading, and we still have the bond auction later today that could change the whole dynamic of the current price action.Note
TLT broke out higher Thursday and confirmed Friday.It's amazing that the very moment the Fed declared inflation isn't transitory, the bond market decided that it is. Maybe policy makers are just two steps behind, and haven't noticed yet how commodities prices and shipping prices have come down.
But the causality actually may also go the other way, with interest rates falling *because* of the Fed's hawkish talk. The Fed talks tough, so commodities traders go short and prices come down. With prices down, the Fed won't actually have to deliver on its tough talk. In a world where everyone's thinking 3-4 moves ahead, maybe inflation expectations work exactly the opposite of the way traditional economic theory says. Maybe the best way to not have to hike rates is to say you will.
My put option expired worthless, but fortunately it was a small bet. Won't be taking another position for now; just gonna happily munch my popcorn and enjoy the show.
Note
TLT pulled back a bit from its breakout due to the CPI data and the latest Fed meeting, but it's still sitting near resistance and seriously considering a continuation of its meltup.The Fed forecast 3 rate hikes this year and 3 next year, and they doubled the speed of bond purchase taper. TLT seems fairly unfazed. Tech stocks have pulled back this week, but as long as TLT holds up, tech should be able to rally from here.
Note
Important test of support coming for TLT as it is finally showing some weakness amid the Fed taper. Financials and energy generally do well in rising interest rate environments, and their strong performance today shows that traders are positioning in those sectors ahead of a possible TLT breakdown.Note
Big down day for bonds, and TLT breached support before the close.Note
Another key breakdown level in bonds:
Related publications
Disclaimer
The information and publications are not meant to be, and do not constitute, financial, investment, trading, or other types of advice or recommendations supplied or endorsed by TradingView. Read more in the Terms of Use.