The chart below is one I have seen before. I generally believe that history may repeat itself in the coming months, in some fashion resembling the 70s. In the past I have discussed the “whipsaw effect”, where inflation goes high, it is fought off by the Federal Reserve, and then they subsequently let off on the gas. Problem being that they ease up before inflation is fully extinguished. Ever watched a crew of fireman put out a fire? They’ll still have the axes and hoses working long after the flames look extinguished…as they know from experience that something could still be smoldering (and they don’t want to get called back!). All too often, the Fed doesn’t finish the job with the diligence of the fire department. Do I think things will be like the chart below, not exactly. But remember, we always say history doesn’t repeat itself, but it rhymes.
I think it is likely we are in the rhyme phase and we could see it play out something similar to this. Does that mean it’s not good to own bonds? Not necessarily, but owning long bonds is probably not smart at this point.
Here’s a chart of the 20+ year Treasury.
It is down roughly half from its highs in 2019 and 2020. Remember those days, where we had a pandemic and interest rates were close to zero? We pretty much have the opposite now.
According to Jim Bianco, the 10-year treasury just reported its worst 10-year return in history. Here is the chart that he is referring to from Macquarie.
It’s a little fuzzy, but the picture tells you everything you need to know. It doesn’t take a rocket scientist to figure out that when rates are close to zero, any increase in rates will cause corresponding returns to be muted or negative. Well, we have a negative return at this point. You would think that would make him very bearish on bonds, right? Not now. After being bearish for the last six years, he has now turned positive on bonds.
I have told many people that I see bonds as a very asymmetric return. What do I mean by that? It’s a bunch of bond geeky math, but here is Jim Bianco’s explanation.
So that’s asymmetric. A 2% loss contrasted with a 13% positive return. Stocks will not give you that same upside vs. downside return profile.
Is it possible for rates to go up to 6%? Sure, but one of the biggest problems we have is the size of the government debt. Interest is already $1.2 trillion. What happens if we add another 0.5-0.75% to the current interest rates? That will push interest to closer to $2 trillion a year, which will bust both the government budget and the economy.
In fact, new home sales are the same level as 1995, and existing home sales are the lowest in 12 years with mortgage rates above 7%.
Now, to those of us who have been in the housing market for more than a few minutes, 7% doesn’t seem that unusual. But for anyone under 40 years old, that 7% mortgage is unworkable – especially with housing prices still elevated as if rates were near zero. High prices and high rates are a tough combination for young buyers. That of course is changing as we speak. My neighbor’s house just went pending after a couple months on the market and a 20% decrease in price. That might be an outlier, but another neighbor’s house has been sitting since April with no action. Why? It’s priced WAY too high. That house might need to come down by 30% before the market sees it as appropriately priced.
So, speaking earlier of rocket science, the price of shipping a tanker of oil now is more expensive than launching a rocket into space.
I’m just thinking out loud, but maybe the cost of shipping oil has become too expensive (but also, hats off to SpaceX for the ways they have brought down the cost of rocket launches!).
Let’s take one final pivot before we wrap things up. It’s just something I found interesting. AI stocks are all the rage, but as I spoke about a couple weeks ago, they are taking on a tremendous amount of debt to fund these data centers. If it turns out that the demand is not there at a price where they can make a profit, the air will come out of that balloon, as consensus expectations for cash flow of hyperscalers are already to the moon!
As for the rest of the market, most stocks are in “bear” market territory (20% below highs) already. Are AI stocks likely to follow suit? Investors sure want to know!
That’s all I have for this week, as always, please let us know if you have questions or concerns. Happy to have a conversation about this or any other topic. Have a good rest of the week.