As we come closer to the U.S. presidential election, it seems the market is more or less pricing in a Biden win. But on top of that, it's also pricing in a fiscal stimulus deal passing, as well.
The heartbeat of the market in the last few weeks has changed, as previously Joe Biden was thought to be bearish for the market in general, given potentially higher taxes. But now, he is seen as a net positive, especially with the Democrats pushing for a more than $2.2 trillion fiscal package focusing on infrastructure and other things. On this backdrop, U.S. bond yields have been rallying aggressively as bonds get sold. The U.S. 10-year yield is now trading closer to 0.82%, and the 30-year above 1.6%. These levels have not been seen since June. Any higher, and we would not have seen these levels since 2018. So, what is happening and why?
The world is still hooked onto the 60-40 portfolio, whereby a natural 60% allocation to equities and a 40% allocation to bonds should, in theory, hedge a portfolio at any given time during any cycle. This only worked in the past decade, given central bank quantitative easing and no inflation, so most think it will work going forward. Wrong.
If we have a higher inflationary environment, both equities and bonds can go down -- there goes your hedge. There is no doubt we will get inflation; the Fed will make sure of it. The only problem is will this be accompanied with solid growth? This means people need to start unwinding their long bond positions, which will cause yields to rally even further. The thing about yields is that if the move higher is slow and gradual, it is a good thing as it denotes recovery. But if it is fast, that is a bad thing, as asset classes cannot handle the move. This is called the "rate scare."
If the move in yields is fast and asset classes cannot handle it? This is called the 'rate scare.'
Right now, the market is "hoping" that we have a deal, but there is good chance that we do not get one till after the election. Strategy built on hope, but not reality, is a grave mistake. We can see even in the positioning, hedge funds have been selling technology (growth) names vs. buying energy, banks, industrials, and cyclical sensitive sectors (value) as they expect a genuine U.S. recovery in the fourth quarter. They are all teeing up for it, but what if it is delayed or uncertain?
This is not a certainty nor a fact. In fact, it is more and more likely given a second wave of lockdowns and no vaccine coming out, that the recovery is delayed. The fiscal deal is the only thing that can save the economy, and right now that is politically motivated.
White House officials and House Speaker Nancy Pelosi keep teasing the market about a 48-hour deadline to get a deal passed before election, but why would either side be motivated to do one now, pre-election? It won't be enacted before voting time, so they might as well save it for after. The Fed is on hold right now and cannot do any more QE -- and it all depends on fiscal stimulus to get the economy growing. If yields and rates move higher, the U.S. and the world economy cannot afford that as entire debt system is priced in Dollars and higher yields means higher servicing costs.
Everyone thinks it is a no-brainer to be short the dollar and long "recovery" basket, as it is a done deal. Investing is a risk vs. reward approach, for now it seems the risk is entirely ignored as everyone is short the dollar. What if, just what if, the dollar rallies from here or we get stagflation? #ouch
