April 2024 Market Strategy (this one is important!)
The bond capitulation is finally happening. It comes at the worst time for the duration crowd. From an investment strategy perspective, this has profound consequences. Time to shift gears.
Disclaimer: The information contained in this article is not and should not be construed as investment advice. This is my investing journey and I simply share what I do and why I do that for educational and entertainment purposes.
This is an important turning point from a macro perspective. The bond/duration capitulation that I have been anticipating for so long is finally here. Ironically, it coincides with another turning point, namely the end of the fiscal impulse. This combination presents a great opportunity for a new contrarian call.
TLDR Summary
The bond capitulation is finally happening. Investors are chasing cyclical assets in droves and they are dumping defensive assets to finance that. They are doing this because inflation is echoing alongside economic resilience and accelerating corporate profits. As expected, hiding in low risk and long duration has not worked because capital returns in high risk assets are too high. The most important pain trade in recent history is finally in its last innings.
In ‘fiscal dominance’, a sufficiently large number of investors has apparently found a suitable narrative to trigger this asset rotation. They finally understand that deficit spending has been the main driver for this bull market. As a regular FA reader, you have known this for about 15 months.
Where these investors err though is that they believe fiscal deficits are a one way street. They believe deficits are consistently, inevitably and predictably rising to fuel inflation and economic growth because they don’t understand that these are just as cyclical and seasonal as many other market patterns.
Deficits reaccelerated in 2023 due to the inflation shock and subsequent interest rate shock. The former killed private sector profits (and hence tax receipts) and the latter raised federal outlays. As the inflation shock gets digested, the private sector is getting used to a higher price level which drives a normalization in profits and tax receipts. This is the initial impulse to reduce the deficit. This deficit reduction then lowers inflation and debt supply pressure that will in a second step reduce interest rates and hence federal outlays which reduces the deficit further. Nobody is talking about it, but it’s clear as day that deficit spending has left its cyclical peak behind and will decline from here.
The April 2024 tax season is giving us a taste right now of what will likely happen all year long. Fueled by $186bn in tax receipts, the Treasury generated a $161bn surplus yesterday, the largest single day fiscal drain in US history. As a result, the YTD deficit is now trailing 2023 by 34%. Again, nobody is talking about this profound tidal shift.
The 2024 inflation echo is real without doubt and it will likely keep us busy for a while. But an echo is usually weaker than the original wave, especially when we have a clear catalyst that will reign it in. We should also not get carried away with 1970s analogies. It was a very different time from various angles, incl. FX dynamics, demographics and from a public debt cycle perspective. The most likely outcome is in my opinion that CPI prints will improve in the coming months as fiscal pressure is subsiding. It will likely enable a few rate cuts to ignite a bit of a credit impulse, perhaps even more than what is priced in right now. The stock market should continue to do alright, although we do need to monitor the risk of deficits closing too quickly which may drain too much of private sector savings. If that happens, it may present an opportunity to long bonds against stocks. But not yet.
For what it is worth, I have closed my short bond bet today that has been a wonderful hedge over the past year. A hedge that has even resulted in a net profit. I don’t intend to reopen it again. Even if the bond puke continues for a little bit, the trade is over in my opinion. The next time I touch bonds, it will be long.
