Previous asset movements
In the previous week, the stock indexes ended slightly negative, mainly at the end of the week due to strong labor market data. It also impacted the front-end of the yield curve, where yields exploded. However, the back-end of the yield curve got only a very small hit. In summary, we are very successful in our strategy of being long bonds with great maturities (>10Y+) and shorting oil. Both trades played very well, and at the end of the macro report, we will reveal another trading idea and update the old ones.
Asset movements, Source: Investro Analytics Team
The jobs report will give the Fed more confidence about hiking
In the previous macro report, we also discussed the technical recession issue in the US, due to 2 consecutively negative quarterly growth in GDP. However, while we are discussing the technical recession, the employment figures indicate that there is no recession. Here are the results from the labor market:
Macroeconomic calendar, Source: Fxstreet
And each of the figures reveals some insights. Average hourly earnings for July, both MoM and YoY, implying a reason for the development of more structural inflation pressures as employees try to demand higher wages due to additional and still rising living costs. The most important data comes from Nonfarm Payrolls for July, which presents the number of new jobs created during July. The economy added 528 000 jobs, exceeding the consensus of 250 000 and 398 000 in the previous month. This number is absolutely stunning and tells us, that there are no pressures in the labor market and the unemployment rate (the key goal for Fed with inflation) also declined to 3.5%, which is exactly the number before the COVID-19 pandemic (Feb/2020).
Another strong labor market is a key condition for another hike. As we stated in the previous macro report, J. Powell said at the last meeting that additional hikes would depend on data from the economy. The stunning nonfarm payrolls and unemployment rate provide the Fed with the tool to be more aggressive in monetary tightening to combat the inflation spiral, as Fed policymakers keep a close eye on the labor market.
The market immediately reacted
The market immediately reacted in many ways after such important information. The stock market plunged as well as the front-end of the yield curve (US01Y, US02Y), but the bonds with great durations have also been slightly impacted. The one real reason was that after the job report, the market immediately priced in another rate hike till the end of 2022.
FFF, QQQ and US02Y, Source: Investro Analytics Team
The market is expecting rates at 3.485 till December 2022, but it is possible that it will go further up, thus creating a record high for 2022 rate expectations. This is absolutely bearish for high beta stocks, such as stocks from Ark Capital as well as Nasdaq or crypto from a macro perspective. As we said, the front-end of the yield curve (short-term rates) is increasing significantly due to:
- “Data” – a strong labor market and rising CPI (we believe the CPI will fall in 2-3 months, but it is the most lagging indicator, which is critical for the FOMC).
- Despite what J. Powell said, “we are close to the neutral rate” and additional rate hikes will be more “data-dependent.” It is not dovish as the market plays it. Nevertheless, there are many leading indicators showing an economic slowdown. The Fed will probably hike in a slowing economy because inflation is the primary target.
- There have been many interviews with Fed members indicating that they are not done in terms of monetary tightening and some of them want to be more aggressive.
The yield curve flattens more and more
However, this could lead to another rise in the front-end yield curve. However, the back-end is more dependent on economic growth, which is currently showing an economic slowdown and price in a technical recession. As short-term interest rates rise and long-term interest rates fall, the yield curve inverts and flattens:
The yield curve inversion (spread between US10Y – US02Y and US30Y – US02Y), Source: Investro Analytics Team, tradingview.com
However, the yield curve (US10Y-US02Y) is the most inverted since the dot.com bubble in 2000/2001, surpassing 1989 and 2007/2008. We believe that short-term rates can rise even faster as there are many signals from Fed members after the meeting. This idea is confirmed by Fed members’ talks as well as strong market data (job report). How? The probability of a 75 bps rate hike (to 3.25–3.50) significantly increased at the end of the week. At 52%, and with current circumstances, we believe that fighting the Fed right now is not the best idea.
The 75 bps rate hike probability in September, Source: Investing.com
Fed members are talking so much and still are hawkish
Now, I bring some of the latest statements by Fed members:
Neel Kashkari, president of the Federal Reserve Bank of Minneapolis (31/07/2022):
“Whether we are technically in a recession or not does not change my analysis. I am focused on the inflation data. I am focused on the wage data. And so far, inflation continues to surprise us to the upside. Wages continue to grow. We are going to do everything we can to avoid a recession, but we are committed to bringing inflation down, and we are going to do what we need to do. We are a long way away from achieving an economy that is back at 2% inflation. And that’s where we need to get to.“
St. Louis Fed President James Bullard said he expects another 1.5 percentage points or so in interest rate increases this year. If Bullard has his way, the rate will continue rising to a range of 3.75%-4% by the end of the year (CNBC -3/8/2022).
Also another interview about rate hikes from another member: Fed Governor Michelle Bowman said she supports the central bank’s recent 0.75 percentage point rate increases and believes they should continue until inflation is subdued.
The market still believes in rate cuts in 2023 as growth will be limited. It means that the inversion of the yield curve can still go deeper as we expect short-term rates (or yields) to continue to rise while long-term ones will probably stagnate or rise only slowly. However, the problem is that the market does not believe the Fed’s words and totally ignored all the interviews with Fed members until a strong job report. We believe, that the market currently underestimates the Fed’s hiking appetite right now.
We are convinced that the Fed will continue with rate hikes (more aggressively, but a little bit less than before) until there are some other insights from the market. However, the Fed totally indicated they do not care about GDP right now. It is not the first target, but hopes for a soft landing.
On the other hand, if something breaks in the economy, they will act very fast. However, the market prices a slight recession or slowdown in 2023 (with rate cuts). We currently do not know how the long-term yield curve will react, but we are still convinced that we will see a rise, mainly in short-term rates. However, we will adjust our long-term bond trade idea and slightly reduce our allocation in long-term bonds to take some profits. More in the Trade Ideas section.
We have been talking a long time about a strong labor market. Despite it now seeming great and strong, it can easily reverse at the end of 2022 or 2023 if the Fed goes much higher and above the neutral rate. However, the reason to be still bullish on longs with great maturies (but with reduced position) is recessionary, as ISM Manufacturing New Orders are still and still falling.
US ISM Services and Manufactoring Orders, Unemployment Rate; Source: Investro Analytics Team via YCHARTS
Now let’s move to our trading ideas
Long-term bonds (>10Y+)
We have achieved a successful story, as our trade mainly consisted of being very long at bonds with great maturities (10Y+) and being short on oil. Both are/were profitable trades, as we mentioned several times. However, there are still reasons to continue in such positions for both trades. However, we currently do not see such a great risk/reward profile as we saw in the previous weeks. In our case, we are still long-term bonds with great durations. However, we will halve our position (probably during this week) and take some profits.
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The risk/reward ratio is still merely appropriate, but not as before. Moreover, although we still believe that an aggressive stance from monetary policy makers could lead to slower and still reduced economic growth (which is very bullish for long-term bonds), there is a new risk associated with our strategy. We firmly believe that Fed will be more aggressive in the short-term, which should directly impact short-term yields. However, as the “economy” is still “strong”, a partially positive outcome could be spotted on long-term yields. But we do not believe it in such a manner. From this point of view, we halve our position, but we are still there, due to our narrative.
It has been approximately 3-4 weeks we still mentioned that we believe the oil would go lower as the global economic growth is significantly slowing. Mainly in Europe, but also in the USA (technical recession) and also in China. Everywhere we see negative consumer sentiment / confidence surprises, which is also bearish for oil and for common consumption.
Although we still believe that the Fed will indirectly impact oil demand (prices) with further hikes (lowered consumption and orders), we are still bearish on oil. BUT, we are aware of a possible short-term rally upside due to oversold conditions. The great risk/reward profile of oil has disappeared, and we will halve our short-position and take some profits. The narrative for us is still very bearish in the medium term from our side.
The stocks rallied in the previous weeks (2-3) and the market still do not get into more and more aggressive Fed. We slightly changed our minds and will use this “bear market rally” for a potential swing trade and will open a very defensive short. The problem is that the market still expects the Fed to ease right now (rate expectations in 2023) , but we believe that the data (unemployment, nonfarm payrolls) are great and inflation is still heading higher. Wages are also increasing. However, we will monitor the current macro situation very closely.
From this point of view, shorting high beta stocks or QQQ (Nasdaq ETF) makes sense for us. The possible great short could be spotted on Apple as well. But still the short with small position. The main narrative is that we believe that short-term yields will rise and will directly impact real yields. Rising real yields are the great enemy of high beta stocks. Real yields consist of nominal yields and inflation expectations. So, if we expect real yields to rise, we should expect a drop in high beta stocks (QQQ). More details will be revealed in the upcoming week.
High beta stocks (QQQ) vs. Real Yields, Source: Investro Analytics Team via Tradingview