When financial advisors appear in front of you with packets of data showing how they have the perfect portfolio allocation, one never bothers to ask them, how far back they went in collecting their sample set. The beauty of statistical analysis and correlations, tweak the data range, and get a different answer, one that suits the narrative. Since the 1970s, we really have not experienced any proper inflation. Since then and mostly since 2000 onwards, we have only seen bond yields and rates move lower and lower, almost down to 0.5% on the US 10 year, so these advisors can be forgiven for claiming that 60-40 is the perfect portfolio hedge. 60-40 meaning 60% equities and 40% in bonds. Throughout the last few decades this made sense, not because by some magic bonds represented a good hedge vs. equities, it is because of the type of disinflationary cycle we were in. With China's urbanization and globalization, this trend has been exacerbated since 2000's. During disinflation bonds go up, and equities can go both up and down, but with central banks printing endlessly, they can only move higher. Voila, the perfect hedge!
Fast forward to 2020, and the pandemic exposed the vulnerabilities in the economic system, now with both monetary and fiscal stimulus, the growth of broad money supply is picking up, inflation is alive and kicking. One can argue pure QE does not lead to inflation as it has a base effect of money going to the banks who then purchased risk assets. But fiscal stimulus sees actual money being flushed into the economy, increasing the velocity of money. In 2020, we have done both! And this is why inflation can and will rear its ugly head. But if that is case, despite the Fed's constant denial, then bonds as an asset class are finished.
There are still so many deflationists out there, who think this time is the same and no matter how much the Fed prints, inflation will never appear. Another factor since the pandemic has been a permanent change in supply lines and the world getting more polarized, meaning less disinflationary forces going forward as every country gets more isolationist. Bonds have fallen 15% this year and asset allocators are getting worried. The Fed may be right that yields do not seem high, but that overlooks the fact that the global market is so indebted. It is not about the level of yield which is lower than 2018 even, it is the rate of change that is more important. The move is now getting disorderly and that is where the risk lies.
The market cannot even handle a move higher in US 10 year bonds to 1.5%, let alone going to 2.5% as other measures indicate that is where "fair value" should be. As March starts in earnest, asset allocators are sitting down trying to decide how to allocate their assets going forward. Seeing their 60/40 crater over the last few weeks, perhaps there is a rude awakening. It seems soon the Fed will need to be the buyer of last resort. They cannot afford a loss of control in the U.S. bond market. Either asset prices need to fall back, or they need to do less QE, but something has got to give. The Fed should in theory stop the $120 billion in asset purchases it has been doing since last year. One wonders why the need still? But from 2018 it remembers all too well how addicted the market is to that "buying". There seems to be some support here in the bond market, with the Bank of Japan and RBA already announcing some form of yield curve control. If it falls much more from here, the Fed will have to embark onto some sort of yield curve control of their own as they cannot risk any damage to the mortgage market. The March FOMC is turning out to be a real seat grabber.
For now, the market remains torn between the reflation and the stagflation theme. As seen by yesterday's print of ISM showing manufacturing and services both slowing down, albeit robust, the prices paid index was the highest since 2008! There is no doubt that we have inflation and companies are even talking about passing through higher costs. Inflation with no growth is stagflation, which is bearish cyclicals and equities. Generalists are tick-trading, chasing the reflation trade like oils and cyclicals reopening stocks as yields tick up, but this time the effect is the opposite as it is too much too soon and hurts assets. On top of that, oil has its own physical market drivers as we enter the infamous OPEC+ decision about releasing more barrels into the market. As a reminder, we still have about 8 mbpd of oil sitting on the sidelines and prices are 25% higher. There is no shortage of it and the world is nowhere close to reopening and travelling without any restrictions anytime soon.
All asset classes here all boil down to one macro trade. The key question is will the bond market hold here or has the Fed already started working behind the scenes supporting it? It remains to be seen.
