The case for T-bills and patience

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Good morning. We considered not writing anything until tomorrow, so we and our readers could concentrate full time on worrying about the CPI report. Undoubtedly, the biggest threat to risk markets is the possibility that, despite everything, we are all too sanguine about how much the Fed will have to tighten. The inflation report, once a month, threatens to bring that dragon roaring to life. But CPI isn’t everything, so here’s your newsletter. Email us: robert.armstrong and ethan.wu.

Buy the short end, and wait?

Maybe we should all just ignore Bill Gross at this point? The one-time bond king and current bond Ozymandias has been retired for a few years and has admitted (in the FT) to being desperate for love and attention. Maybe sustained press neglect would be good for his soul. But he threw out a chunk of chum yesterday that really brought out the shark in me (and others). Starting with his conclusion:

Bonds are at levels which represent diminished risk but little reward. Don’t buy them. Stocks must contend with future earnings disappointments and are not as cheap as they appear. Don’t buy them just yet. Commodities are out of gas. Alternatives? … Be patient. 12 month Treasuries at 2.7 per cent are better than your money market fund and almost all other alternatives.

Gross’s argument for this position goes like this:

There has been massive misallocation of capital to wildly speculative assets since the end of the great financial crisis, caused largely by artificially low rates.

The Fed has to get interest rates back to neutral in order to contain inflation, this has already created a bear market, whacking those speculative assets, and is likely to cause a recession.

The fed funds rate that would risk only a “mild” recession while bringing inflation down is about 3.5 per cent, “but get there ASAP”.

The implication — I think — is that the fast move to 3.5 per cent, and the market/economic ructions it will cause, are not yet priced into bonds or stocks. So collect your 2.7 per cent (it’s higher now, actually) and see where we are next summer, when presumably we will be mid-recession and more bad news will be priced in.

Gross’s rates forecast (“to 3.5 and fast”) is exactly what the Fed says it is going to do and exactly what the Fed funds futures market is pricing in — it has the Fed at 3.44 per cent by December. So Gross’s point has to be that the Fed knows what it needs to do, and the futures market knows what that is, but the stock and bond markets don’t understand the severity of the implications of that.

Unhedged agrees that neither stock prices nor credit spreads price in even a mild recession. As we have argued repeatedly, valuation multiples on stocks are still too high, given that the earnings estimates that form the denominator of those multiples have not fallen meaningfully. Spreads have widened a lot, and there may be more value in credit than stocks, but more widening would be no surprise. The market still thinks there is a solid chance of a soft landing.

The interesting question is whether the best response to this is to sit at the short end of the Treasury curve, taking limited duration risk and no credit risk, collecting 3ish per cent, and waiting. We are not entirely sure that Gross’s argument doesn’t point the other way: towards sitting at the long end of the Treasury curve, collect 3ish per cent, and waiting. The argument for doing that would be that the recession that Gross seems to be quite certain of will invert the yield curve and drive long yields down, and you’d make some real money.

What say you, readers? Is the long or the short end the better bet on a 12-month horizon? No wimpy barbell strategies, please.

Recession without unemployment?

Is it possible to have a recession and a tight labour market at the same time? That is, can significant declines in production be consistent with something resembling full employment? It sure sounds odd, but in a certain sense, it seems to be happening right now. In the last quarter, GDP came in at -1.5 per cent. And it looks like this quarter might be negative, too, satisfying the crudest definition of recession. Meanwhile, the unemployment rate is 3.6 per cent (very low!) and 380,000 jobs (a lot!) have been created a month, on average, over the past four months.

These facts are hard to fit together. Yes, the labour force participation rate and employment/population ratios are a percentage point or two lower than they were pre-coronavirus pandemic. But while that may help to explain why job growth is not even stronger, it doesn’t help explain how so many jobs can be added while GDP falls.

We spoke with our favourite Wall Street economist, Don Rissmiller of Strategas, about this yesterday. He thinks that the reason that we’ve never had a high-employment recession before is because it makes no sense. If output is falling, then even if labour is scarce, there is going to be a lot of moving between jobs, as people move from the shrinking bits of the economy to the growing ones. Just the friction of these transitions ought to bring employment down (and we may be seeing some of this in the gentle uptick in jobless claims, which are something of a leading indicator).

So what’s going on? Rissmiller had a few possible explanations:

One ugly possibility is that the strong jobs creation data are just wrong, and will be revised down. This would be bad, because the incorrect unrevised numbers could trick the Fed into tightening policy even as the economy is cooling rapidly.

It could be that the new jobs that are being created now are low-productivity service jobs that add little to output. If this is so, the hiring should tail off soon (after all, unemployment is a lagging indicator).

We could be experiencing a productivity shock, for example because working from home turns out to mean pretending to work from home. This seems unlikely, but can’t be ruled out.

Rissmiller’s main worry, though, is that what is happening right now — whether you want to call it a recession or not — is not enough to “reset the cycle” and allow the Fed to back off. If the lower output we are seeing now does not create slack in the labour market, or more workers don’t enter the workforce, then wage growth will remain hot, inflation expectations will not subside, and the Fed will have to keep on tightening. The result could be an extended or double-dip recession. This is the sense in which good news about the labour market could be bad news for the economy.

This is roughly what happened in the early 1980s. One recession was not enough to crack inflation. Here is Strategas’s chart of GDP and inflation then:

We’re hoping, instead, for one recession, and a short and shallow one at that.

One good read

The bank protests in Henan province look like the kind of thing that happens in the early stages of a financial crisis. Or are we being too alarmist here?