Macro View: 2024–2025

Where and when to place my bets

Last Update: 12/13/2023

Financial markets in 2024-2025 — just like in 2023 — will be determined by Fed rate cuts, on which the Fed had sent contradicting messages all through Q1, 2024 (indicating it is uncertain on the perfect timing to engineer “soft landing” in an election year to avoid regional bank failures from commercial real estate exposure and balance sheet impairment from duration exposure just in time):

Interest rates are, of course, highly correlated with (real and expected) inflation:

The famous early 20th century English economist/philosopher John Maynard Keynes had this to say about inflation: “By a continuing process of inflation, Governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. While the process impoverishes many, it actually enriches some.”

There are actually two kinds of inflation, —economic inflation and monetary inflation.

Monetary inflation, aka currency debasement, comes from growth of money supply without commensurate economic growth. Done to the extreme, this type of inflation is of the hyperinflation nature, well into the double, triple digits or even beyond, — as in the case of the Weimar Republic and currently Argentina and Venezuela. It reflects a solvency problem of the currency-issuing institution (usually the central banks) in the face of the foreign exchange market. Put another way, hyperinflation is an expression that nobody in or out of a country wants its currency (such is the case of Argentina right now) because of its over-abundance (from excessive currency debasement). By implication, it is an expression of loss-of- confidence in the issuing institution (the country’s central bank)’s effectiveness in managing the currency in the foreign exchange market.

For 15 years now, the Federal Reserve has been printing money out of thin air in ever larger quantities, totaling $7T, to recapitalize its owners — the GSIB banks — at the wake of the 2008 Global Financial Crisis, and later to fund Biden’s stimulus program during the Covid shutdown:

Up till 2020, the money printed was kept within the banking sector as collaterals and out of circulation in the general economy. The financial elite closest to the banking sector gained access of this money (e.g. via REPO transactions and borrowing against collaterals, etc.) to invest/speculate in assets per the Cantillon Effect. Accordingly, monetary inflation (new liquidity injected) showed up only as asset (equity and real estate) bubbles leading up to 2024. Gold and Bitcoin joined the “monetary inflation parade” in Q1, 2024 (note how monetary inflation expressed as global liquidity in gold FAR exceeds economic inflation expressed as CPI increase in dollted black at the bottom):

The rationale is simple: Investors increasingly realize that debt will always help grow the physical economy, leak into the financial sector (inflate financial assets), and debase the underlying currency. They are deploying newly injected liquidity into alternative currencies that are not debased.

Economic inflation, on the other hand, comes from demand exceeding supply in physical goods and services. For four decades from the 1980s to 2020, The U.S. enjoyed a “Great Moderation” period whereby globalization brought about a surge of cheap labor supply from China, and low interest rates (especially after the Fed kept interest rates artificially zero-bound in response to the 2008 Global Financial Crisis) brought about abundant near-free capital. During this period, we actually had economic DIS-inflation. But all that money printing and near-free money importantly sowed the seeds for inflation to come later.

The moment Biden sent out $5T of stimulus checks to households in 2020 (see chart above), it created instant and enormous incremental demand (surge of Amazon shopping by a bored populace sheltered at home) in the real economy (i.e. money was no longer bottled up in the banking sector). No commensurate supply was created, however. Thus the seeds of monetary inflation sprouted into economic inflation. Meanwhile, there was supply chain disruption from global economic shutdown. So prices rose sharply. This was initially thought to be transitory. But it became clear that the global COVID shutdown changed the world forever. Global supply chains are now being “re-shored” out of China and “work from home anywhere” has become a permanent work culture. De-globalization is in progress and we will never return to 2019 “normal”. Economic inflation will now stay elevated in a new regime for decades to come.

The single most important characteristic of the “Great Moderation” period is that the U.S. government was like a kid stealing from the neighbors (borrowing from foreigners via ever more bond issuance at artificially low interest rates) to finance his ever worse drug addiction (ever higher deficit spending). The Japanese had been one such “good neighbor” (see chart below). But now, rising domestic inflation is forcing the Japanese savers to redeploy their savings into better inflation hedges than UST — gold, crypto etc. So the Japanese are getting out of the game.

As well, in a new bipolar world (the U.S. led “West” vs the China-led Global South), foreigners are no longer held hostage by the U.S. dollar (via the Petrodollar system), — having to recycle their trade surpluses through the U.S. Treasury market (a piggybank for future purchases of commodities — especially oil — with U.S. dollars). So the Chinese are also getting out of the game. Now, the kid has to steal from his own parents (financially repress U.S. citizens via increasing monetization of new debt issuance) to finance his addiction. The end result is lower standard of living via secular economic inflation.

Then, in the name of fighting inflation, the Fed rapidly raised interest rate from 0% to >5% within a short year (Mar 2022 to Apr 2023). All else being equal, higher interest rates in the U.S. attracts foreign investors to U.S. assets (especially U.S. Treasury bonds), driving up the U.S. Dollar (foreigners must first purchase USD before purchasing U.S. assets). When the USD goes up, commodities price in USD goes down (it takes less USD to purchase the same amount of commodities). Inflation thus eased over the course of 2023.

However, the unprecedented 500% hike in interest rates dramatically increased the cost of capital, making it difficult to finance/refinance businesses. Increased cost of capital also results in higher interest expense for government, enterprises, and households. This squeezes operating margins of businesses, — causing them to preemptively lay off employees to protect profitability. It also causes liquidity — and ultimately solvency — problems (aka “Minsky Moments”) for government, enterprises, and households alike.

This high inflation/high interest rate cocktail is toxic under the best of circumstances. It is lethal with the pre-existing condition of high debt overhang (global debt = 350% global GDP). How did high debt overhang come to being? The very same money printing by the Fed over the past 15 years, — because it went to fund deficit spending by the U.S. government. The parabolic growth in post-2008 U.S. government debt is obvious by the chart below:

Taking the debt picture even further back in history, we can see that we are running wartime debt in peace time (see chart below). Our GDP used to be based on production (immediately following WW2, the US was the biggest exporter creditor of the world) but since the (financialization and globalization) 1980s, our GDP has been based on spending. And if that spending is based on money printed out of thin air, then the only way to keep “growing” is to print ever larger amounts of money out of thin air. All the developed countries, following the American model, are in the same boat.

When debt level was still within reason (pre-2008), monetary dominance reigned. That is to say, the Fed could stimulate the economy by raising the quantity and reducing the cost of borrowing. Counter intuitively, this is actually deflationary because the Fed is sending money to the top, — corporations which maximize profit in great part by reducing labor either through (offshoring or automation). All else (such as demographics) being equal, this (purely economic) policy also maximizes GDP. Conversely, the Fed could dampen the economy (read: reign in inflation) by doing the reverse. Monetary dominance is a key driver behind the Business Cycle (typically of 10 year duration). Meanwhile, in a debt-fueled economy, the amount (i.e. liquidity) and cost of debt are the only two knobs the Fed can turn to maintain the mirage of economic growth (when in fact it is only regulating debt-financed spending, — not production). These two factors alone drive all financial markets (more on this later). Valuations don’t matter anymore — overvalued stocks just get more so . “Flow” does (i.e. money has to find a home somewhere).

But with ever-growing sovereign debt, Fiscal Dominance now reigns. That is to say, the economy is trapped in a vicious cycle of the federal government issuing ever more debt to fund ever larger deficits (an increasingly bigger portion going to interest payment). One view is, this will inevitably generate ever higher monetary inflation (because the Fed ultimately has to monetize that debt — see following chart) which will eventually destroy the currency. First, the Treasury will crowd out global USD borrowing. Demand for USD will drive up USD, affecting EM (Emerging Markets) the most. EM will sell U.S. Treasuries to raise USD, driving bond yields up and dislocates the Treasury market (by creating too much supply). Then, the Fed will step in and reinstates QE (liquify the banking sector by buying Treasuries in earnest). The USD will then weaken (commodities and risk assets will rally along with bonds as yields go down). This rinse-and-repeat process ultimately leads to currency debasement because the only way to ameliorate fiscal dominance is to inflate away the debt (keeping real yield negative via yield curve control).

Gold broke its long term faithful inverse correlation with real yields in 2024. This is signaling fiscal dominance in progress and increased risk of fiscal crisis by expressing this: “Current debt level cannot tolerate positive real yields)”:

Deficit spending under discal dominance is actually stimulative for the economy because the government directs borrowed money toward targeted industries (e.g. revitalizing the chip industry) and households (e.g. sending “stimi” checks). The latter case is a redistribution of wealth which directly causes inflation (by creating more demand but not a commensurate amount of supply). “Stimi” checks (an act of “populism”) are not economically but politically motivated. They don't maximize GDP, but instead aims to mitigate social unrest. Populism (in part manifesting in central government redistributing wealth) is a hallmark of 4th Turnings. MMT proponents would argue “Demand-side economics” reigns during Fiscal Dominance in that the federal government (rather than the Federal Reserve) keeps fueling the private sector (either with “stimi” checks or high interest income) without having to rely on the banking sector as a transmission mechanism (such as the case with Monetary Dominance). This is the essence of MMT. It may risk rising inflation and currency debasement, BUT potentially it may also obviate the business cycle and thus avoid recession.

In the short run, MMT can work. Biden’s $6T of such spending in 2020 is why despite the Fed’s tight monetary policies, the long-awaited-for recession hasn’t come yet. Yes, monetary inflation (from money printing by the Fed) will result in higher interest rates but even rates have a “virtuous” side: They generate interest income for savers thus enable later spending or investment. But government directed investments have never been wise (the efficacy is low when each dollar of new money generates only say, thirty cents of economic growth). In the long run, mal-investments and capital destruction invariably result in downstream crashes. Thus, recession has merely been delayed, — not cancelled. Prolonged recession is by definition depression. If punctuated by credit events, then it is a crisis (such as the 2008 GFC). Crises are opportunities for change (to get rid of the underbrush and allow for green shoots). We missed that opportunity in 2008 (none of the malfeasant got sent to jail and no meaningful reform resulted). Hopefully we won’t paper over the next crisis.

“Liquidity experts” assert that new money injected by the Fed and other central banks (to monetize ever-increasing sovereign debt) works through the global banking and shadow-banking system to increase global liquidity:

In a world of gargantuan debt overhang, RE-financing (7X the need for new financing) will be clamoring for much of this liquidity. Liquidity (the availability of money) is more important than interest rates (the cost of money). And there seems to be plenty of liquidity (the “pig” of past money printing still passing through the “python” of the global financial system). Bountiful Money Market Funds feeding Reverse Repo pools is a good example. This liquidity will finance future Treasury issuance of bills and bonds, so the Fed may not have to print more money, and can stick to its QT course while lowering Fed Funds Rate. The Yield Curve will naturally steepen as a result, — which means 2024 will be a bear market for long bonds while 1-Y and 2-Y T notes may see some gains until Fed rate cuts are completely done. All bets are off, of course, if credit events arise. That will trigger instant recession and a bond bull market!

By the way, there are those (like Luke Grohman) who believe Bitcoin price is the single best barometer for global liquidity (because Bitcoin is a hedge against currency debasement just like gold; Fiscal Dominance ironically bootstrapped Bitcoin to now reaching “escape velocity”). So I need to closely monitor BTC-USD:

“Liquidity experts” also believe the global liquidity cycle is what drives asset bubbles and ultimate recessions (typically punctuated by credit crises):

So has the the last global liquidity cycle already troughed (without an economic recession) as the chart above suggests? Let’s look to the bond market for clues.

All through 2022 and 2023, long bond yields have been rising due to “bond vigilantes” selling Treasury bonds in recognition of secular currency debasement. It stands to reason that with more federal government debt issue (increasing supply of Treasury bonds), the higher yield is demanded by the bond market:

Sharp increase in yield caused a whopping 40% price drop in these supposedly “risk free” investments. Long bonds continue to sell off in the first 3/4 of 2023 after a brutal down year in 2022, making it the worst bond market ever in history. This is an unmistakable sign that the Fed has already lost control of the bond market (crucial “transmission mechanism” for its monetary policies).

In the current fiscal dominance regime, the enormity of further long bond issuance defies what foreigners can absorb (see later discussion on USD/UST doom loop). With the JGB getting into positive yield territory, currency hedged investment in U.S. 10-TB now yield -1% to Japanese investors. Domestic commercial banks are already loaded with long bonds with duration risk (a la Silicon Valley bank and others in Mar, 2023). Further monetization by the Fed will just worsen monetary inflation. So the burden of buying falls on the private sector, — notably pension funds and insurance companies. This exposes these giant and systemically important financial institutions to unbearable duration risk and potential insolvency such as the case of the UK Gilt crisis, whereby dramatically higher yields (caused by bond vigilantes selling gilts in protest of Liz Truss’ deficit spending policies) in September 2022 generated large mark-to-market losses for pension funds that, combined with higher volatility, triggered large margin calls. (We all know the margin calls->liquidity problems->solvency problems->market crash sequence.)

In this environment, “risk free” government bonds are anything but. Accordingly, bond vigilantes now demand higher risk premia, which in turn induces more volatility (from rapid and sharp re-valuation for lack of a clearing price) in an already illiquid secondary market (see chart below). The benchmark 10Y Treasury bond is supposed to be the bedrock of the global Eurodollar system, trading with ample liquidity within narrow spreads (see period before 2008). It is now behaving like a casino crap table (see period after 2013). This spells illiquidity — induced dislocations.

Much of this volatility stem from recognition of a “UST/USD doom loop” circling around the globe that goes like this: Foreigners accumulated a LOT of UST (U.S. Treasury bonds) during the “Great Moderation”. Now, the USD (U.S. dollar) is high, thanks to the Fed’s relentless rate hikes in 2022/2023. Foreign central banks have been selling UST to fund FX intervention (buy and shore up their own currencies). This causes Treasury yields to rise and the USD to further rise with it. A doom loop was now in motion.

Fortunately, oil prices remain tame for now (refer to earlier discussion on higher interest rates mean higher USD thus lower commodity costs). Higher oil prices would exacerbate the doom loop because on top of selling UST to defend their native currencies against a rising USD, foreigners further have to sell UST to buy oil, causing higher rates and USD.

The inevitable prospect of ever more supply of, and diminishing demand for, U.S. government debt makes for a generational bond bear market (value steadily drops as rate steadily rises) to last for decades (the previous bond bull market lasted 40 years). Substantial long bond supply also crowds out investment in the private selector (the REPO facility now serves to only lending and borrowing between financial institutions and the Fed rather than among each other). We have solidly exited the Great Moderation (see earlier chart) and are now in a new multi-decade low growth, modest profit regime where both inflation and cost of capital will stay elevated, increasingly choking off industries (especially banks) and impoverishing the lower class. Currently rich equity prices will have to reprice to discount for this regime.

Long bonds and stocks have become positively correlated in 2023. This was primarily due to liquidity and risk premia issues with long bonds:

Passive asset allocators concluded from this “60/40 allocation no longer works”, and directed inflow from 401K contributions solely to stock indices in accordance, thus driving the “Magnificent 7” to extreme heights (because of their disproportionate cap sizes weighting). As of the end of October, 2023, the SP500 index had 10% YTD return (sporting a total market cap = 160% of GDP), yet adjusted for equal weight, it would have lost 3% for the year, with more losers than winners in its mix.

Clearly this distorted index belies the truth health of equities “under the hood”. When mean reversion eventually occurs (most likely with recession in 2024), the stock market will meaningfully reprice. The Magnificent 7 (Alphabet, Apple, Amazon, Meta, Microsoft, Nvidia and Tesla), with their ridiculous valuation (see chart below) will have the most to fall:

Virtually all institutional fund managers are indexers (otherwise they get fired for under-performing the indices). Most retail investors are invested with institutional investors. 60% of global institutional investment goes to U.S. equities. 30% of that goes into the Magnificent 7 (that’s how passive indexers outperform). This extreme concentration of investment in the Magnificent 7 portends waterfall correction once correction starts (i.e. violent mean inversion) simply because there is more fat and meat to cut before reaching the bone, — irrespective of fundamentals.

But speaking of fundamentals, current S&P PE is 26. Long term median is 15. 2023 has been all about unjustified multiple-expansion, just waiting for mean reversion. As well, despite temporary abatement (mainly due to energy prices being low), inflation will come creeping back in 2024. Interest rates will therefore revert back up after temporary decline. Discounted Cash Flow dictates downward equity re-pricing from current levels.

Debt burden (particularly exacerbated by worsening demographics) is inherently deflationary. The agent of that deflation is demand destruction (i.e. recession/depression) via high rates. In other words, sharp and steep rise in long bond yields will eventually overwhelm the (earlier discussed) stimulative effect of fiscal dominance and induce demand destruction, multiple compression, layoffs, reduction of consumer spending, and recession. “Wealth destruction” via significant equity market pullback is but one necessary condition for the described sequence to play out. Another condition is an expensive USD, which hurts EM (emerging markets), thus global economy.

China and Europe are already in recession in 2023. One major reason U.S. recession has thus far been delayed — beyond the gargantuan war-time stimulus by Biden in peacetime (read: public sector deficit is private sector surplus) — is that construction and related economic activities (whose cyclical decline is the biggest contributor to U.S. recessions since the U.S. is no longer a manufacturing economy) actually picked up the slack of a stagnant used-home market (sellers are holding on to their low legacy mortgage rates like dear life, and not selling).

As well, during the “Great Moderation”, households had lengthened the duration of their fixed rate debt. But don't forget the household’s gain is the mortgage lender’s loss. Mortgage banks sitting on a pile of 3% mortgages while the going rate is 8%+ are facing the same duration problems that tanked SVB, 1st Republic etc. back in March, 2023. The multivariate “long and variable” lag thus far has shielded the economy from the brutal rate rise in 2023. But this merely means recession is postponed, — not cancelled.

The postponement is easily observable in the (liquidity induced — see second chart to follow) easing of financial conditions (blue line), contradicting the Fed’s stated intention with “higher for longer” FFR (red line). Mechanically, this happened due to “release of the Reverse Repo reservoir” to purchase T-Bills, thus enabling fiscal deficit spending which “feeds” the economy.

But as of Dec, 2023, the Reverse Repo reservoir was running dry. So I am of the “long and variable lag” camp, anticipating the blue line reverting back up in delayed reaction to the red line.

But meanwhile, Yellen skillfully bought time by draining the Reverse Repo reservoir to fund short term T-bills in her new issuance in 2023. The new issuance generated an uptick of economic growth (via the earlier discussed stimulative effect of fiscal dominance) and gives the impression that recession is averted and we have now started a new economic upcycle. I think this is an illusion.

Expressed through the lens of long Treasury bonds, I see a secular bond market accompanied by “Depression 2.0” (below-trend economic growth with sustained levels of inflation (probably around 3–4%) and interest rates (probably around 5–6%, giving a real yield of around 2%). How long this period will last depends on how soon exponential productivity growth (per my Next First Turning outlook) will take off (2030 is a reasonable estimate). Gold and cryptos will do well in this period.

But recession will happen first when the “long and variable lag” effect of gargantuan money printing (i.e. drug overdose) finally wears off in 2024/2025. Liquidity leads financial markets by 9–12 months (so the crash from the Yellen sugar-high in mid-2023 should happen at the end of Q1 or Q2, 2024, with yield curve normalization happening about 3 months prior):

Recession is inherently deflationary so inflation and interest rates will temporarily decline. In November 2023, interest rates had already substantially corrected the sharp rise in October 2023 (in part driven by the “UST/USD doom loop” and in part higher risk premia). Rates are expected to further drop with Fed rate cuts (either in response to recession or to downward adjust real-rate inconsideration of abated inflation) in 2024.

How do we know the drug overdose will wear off and the addict (the US economy) will go into withdrawal in 2024–2025? Well, of the annualized 5.2% GDP growth based on Q3, 2023 data, government spending accounted for 5.5%! In other words, had it not been for government deficit spending, GDP actually contracted by 0.3% as of Q3, 2023, — we are already in recession!

What will make this recession discernible in 2024 are credit events. What interest rate hikes do really is to encourage debtors to settle rather than roll over debt with impunity at 0% interest rate (under ZIRP). High debt level and high interest rate cannot both exist without eventually leading to illiquidity and insolvencies somewhere — at the household, enterprise, and eventually government level. Elevated interest rates have now exposed the non-refinance-able mal-investments. SVB, 1st Republic, — even the UK Gilt crisis were “opening salvos” for more of the same to follow in 2024, triggering recession. “Higher for longer” is actually paradoxical against a high debt backdrop because “higher” leads to credit events which cuts short “longer”.

Credit (aka Black Swan or default) events will come from “Zombie companies” (those whose operating income are insufficient to meet service existing debt) this time around instead of sub-prime mortgagees as in the case of 2008. The smarter zombie companies had refinanced (“termed out” their loans) the high yield bond market (underwritten by traditional investment banks) prior to 2022 (when the Fed jacked up rates from near 0 to 5%+ in one short year). Less smart zombie companies had to resort to the leveraged loan market for much higher, post-2022 floating rate loans (underwritten by insurance companies and pension funds). The dumbest and most desperate zombie companies — especially in new financing (e.g. for dividend payout or M&A) instead of refinancing — now have to tap the private credit market (underwritten by private equity firms) for floating rate loans (not marked to market) with even higher premium. All these zombie companies are praying for speedy and sharp rate drops by the Fed. “Higher for longer” will cause defaults like a domino. The domino will start with the private credit space, perhaps as soon as 2024. The high yield “maturity wall”, on the other hand, won't hit until 2025.

Historically, yield curve inversion and peaking of the FFR always signal imminent recession, whereas yield curve normalization (in this case measured by positive 10/2 spread) always accompanies recession:

But yield curve normalization lags liquidity by about 9 months:

So 2–10 normalization — thus recession, looks to be delayed. Keep a very close eye on the 2-10 spread and my Elliott Waves white board..

As of Nov, 2023, 10 different yield spreads are already simultaneously inverted, and un-inversion has already started. Buy historical records, recession will begin as soon as the un-inversion brings about positive spread.

History shows that shortly after peaks in Fed Funds Rate (FFR), recessions followed. Now that the Fed has signaled it is done hiking in 2023, recession and rate cuts (precipitated by the aforementioned credit events) are highly likely in 2024:

Another indicator is the labor domino per the HOPE framework:

1. “Higher for longer” failed to bring any systemic breakage (consumers are resilient, in part because the vast majority of them termed out their mortgages and are relatively immune to rising rates)
2. Bear-steepening because bond vigilantes demand higher interest rates commensurate with duration risk
3. Financial conditions tighten because of exhausted fiscal stimulus, credit tightening, and rising long bond rates (refi wall = lower cash flow), causing revenue decline (read: decline in discretionary consumption and AAPL’s revenue drop) which leads to multiples contraction (equities start going down). (Note that reduction of buybacks directly translates to multiple contraction! Pay attention to the Magnificent 7!)
4. Earnings contractions due to inability to pass higher costs (e.g. interests and labor) on, causing enterprises to eventually lay off employees; unemployment rises and consumer resilience finally breaks down.
5. Recession

We were solidly in step 3 as of November, 2023. Some may argue step 4 has already started with the latest round of layoffs by Charles Schwab. And the following chart gives hope that the labor domino is finally beginning to fall. Remember, corporations lay off preemptively in anticipation of profit squeeze, — not the least from increased interest expenses.

In positioning for recession to start in 2024, mutual funds and money managers (including Rosenberg) have been piling into bond funds (bond fund inflows in 2023 hit a record high). This move is motivated not only by anticipation of rate drops, but that bonds and stocks have become inversely correlated in 2020 (yellow = TLT and blue = SPX in chart below; ignore notations, — they are meant for another discussion in The Next 1st Turning), — making the 60/40 portfolio a balanced one again. This move also triggered hedge funds’ panic short covering as described in my Elliott Waves white board, causing long bond yields to rapidly drop.

As it turns out, 3% inflation is the magic threshold that determines the nature of stock and bond correlation:

As of December 2023 inflation has eased off to 3.5%. Why would we expect inflation to drop below 3%? Because inflation lacks credit impulse by 18 months. Inflation showed up in 2022, in response to Biden’s $5T credit impulse in 2020-2021. That one time (election saving) insanity has stopped. Reasonable to expect inflation to return to pre-COVID steady state levels (<2%) even with a mild recession. And when that happens, other “bond whales” than mutual funds will rush in as buyers:

Will long bond yields continue down from here, just like in 1987 (see chart below)? Yes, because the Fed — via the dot plot in their Dec 13 FOMC announcement — now projects the FFR at 4.6% by the end of 2024, 3.6% by the end of 2025, and 2.9% by the end of 2026.

2TB yields historically decline ahead of Fed rate cuts (see chart below). This is consistent with un-inversion starting before recession and normalization accompanying recession). If 2TB is moving toward 3.6% (per current dot plot for 2025), and 10TB yield settling around 4% will normalize the yield curve just in time for recession in 2024.

The long-awaited for “Fed pivot” (read: capitulation) came on December 13, 2023 when Powell announced in his FOMC speech “inflation is tamed; rate hike regime is done; and there will be three rate cuts in 2024”. In the absence of apparent need, why did the Fed volunteered rate cuts? I don't buy the argument of these being “maintenance” cuts (to keep real rates from being too restrictive in the face of declining inflation). More believable is the Fed is concerned about the Reverse Repo reservoir running dry (discussed earlier), portending liquidity problems just as corporate debt “maturity wall” approaches in the March/April timeframe, posing the specter of credit events (and 2019 like overnight lending rates spiking to double digits). Likely, the Fed is also worried about waves of layoffs finally catching up with BLS’s BS rosy labor statistics.

Treasury yields across the entire yield curve reacted to the pivot immediately and tanked alongside the USD (the currency which gained the most against the USD in 2023 is the Swiss Franc, — suggesting “flight to safety” is afoot), while gold and commodities rallied.

All the preconditions for impending recession checks off, except for stocks “misbehaving” and rallying alongside:

The stock market is obviously working off the axiom “inflation down = liquidity up = stocks up (liquidity typically leads yield curve normalization by about 9 months). Yes, liquidity and stock prices are highly positively correlated (see chart below). But risk free Treasuries at 5% plus are now vying for the same liquidity (long term return from the ugly market is 8%; why risk your capital for the extra 3%?). Thus, when interest rates dropped meaningfully in November, 2023, the stock market rallied (for diminished competition for the same liquidity). Meanwhile, liquidity looks to be going sideways since April while the stock market kept climbing (i.e. gaining altitude while running out of fuel). (The other part of liquidity is 401K contributions dance get mindlessly allocated to passive funds which drive up the magnificent 7 in turn. This will inevitably diminish rising unemployment, especially in the high paying tech sector.)

For one, private equity firms are sitting on significant unrealized losses (don’t forget, they don’t have to mark-to-market) in the face of rate hikes and slow to return capital to their mutual and pension fund investors, thus restricting recycled liquidity. PE firms themselves are dangerously over-levered and subject to margin calls, — now targeting suburban “mini-millionaires” for fresh money. This challenges “Liquidity experts”’ assertion of ample global liquidity out there (waiting to further boost already elevated stock prices). PE firms aside, short term MMF liquidity also seems anemic:

And there is no mutual fund “sideline money” buildup either:

Which all leads to a picture of over-commitment to the stock market:

Sooner rather than later in 2024, reality will catch up with reflexivity and positioning, and stock prices will downward correct. Where will stocks correct to? Let’s use the DJI as a proxy:

The bond market, on the other hand, is correctly reading the situation as “the Fed is cutting rate to support fiscal dominance and soften the blow of inevitable recession”. It is probably correct in predicting aggressive — rather than “drip drip” — rate cuts. Recession — normally deflationary — will be accompanied this time by reignited inflation (interest rate down = USD down = commodity up = inflation up). I expect this recession to last till late 2024/early 2025 (refer back to 30 year treasury interest chart). I expect rising unemployment numbers (“doctored” in 2023 with low-end part-time jobs amplified and layoffs of tech and banking jobs masked) in 2024 to be the final “wake up call” for the stock market to smell the coffee and puke. The Magnificent 7 will lead the stock market down (even though the commodity sector will do well). I'll be updating the check marks with new data as they come in.

As mentioned earlier, the Fed ‘s dot plot signals the FFR at 4.6% by the end of 2024, 3.6% by the end of 2025, and 2.9% by the end of 2026. That means I have until close to the end of 2025 before I terminate my 2TB’s before maturation and start laddering into new T-Bill’s (do not lock in more than 1 year since rates will only go up and not down from here on). Much like the 70s, the next (more ferocious) leg of the secular bond bear market will be a period of stagflation marked by supply constraints (this time spurred by Multipolar Disorder). Commodities will be the best bet on the equity side.

Referring to The Next 1st Turning, the UST/USD doom loop may have already ended in Oct 2023; if not, then with the upcoming recession in 2024. Going forward, fiscal dominance will feature high UST yields but declining USD (translating to rising oil and other commodity prices). In 2024, this decline may be exacerbated by a sharply rising Yen. By virtue of being the world's #1 funding currency, it is by definition also the most shorted currency, — subject to a vicious short covering on the slightest rise of interest rates. Find an ETF for that play in 2024.

Elsewhere, referring back to the Liquidity leads financial markets by 9–12 months chart, risk appetite tracks yield curve shape change but lags it by 15–20 months. Further, risk appetite escalates in 4 stages over the 60–70 months (5–6 years) up-cycle. So as I track that cycle, I should refer to the chart below for specific asset allocation:

Meanwhile, referring to The Next 1st Turning, gold has started a secular bull market in December 2023. so keep the NEM core position because it is not only a gold miners play upon gold breakout, but also a commodities play later. It is important to recognize that real interest rate and the USD are no longer the primary drivers of gold price. Since weaponization of the USD at the start of the Ukraine war, foreign central banks — especially the PBOC — have been steadily building up their gold reserve as a hedge for their FX holding of USD (gold price will rise to offset any decline in USD). The PBOC has a lot more gold to buy as a % of their USD holding. This will provide a sustained uptrend for gold prices. Periodic decline in real interest rate and the USD will only be “kickers” to that secular uptrend.

In sum, the sequence of events in 2024 will most probably unfold this way: equity melt-up runs out of fuel and the stock market starts correcting as early as Q1. The Fed delivers the promise three rate cuts starting in March (to facilitate — in futility — Biden’s re-election). The bond market rallies and the stock market attempts a blow-off top in Q2-Q3. Then bad earnings and probably credit events finally happened and the specter of recession finally hits, starting Bob Farrell's mean-reversion for a decade to come. Just like the stagflationary ’70s, it will be terrible to hold U.S. stocks and bonds in this decade but it will be more terrible to hold USD. It will be ALL about commodities and EM.

And THEN we’ll start The Next 1st Turning.