PMTS

WEEK 21 2023MAY20

00:02
Good morning. This is another episode of Two Grey Beards.

00:09
Yes, it is. And I think we ought to talk about bonds first of all, and whether we are buyers of USDs at these levels or not. I agree. So last week was mostly about the bond market selling off, um, and AI stocks rallying, the bond market for me continues to have some serious headwinds in particular, once the debts will come to the debt ceiling.

00:38
debate after this, but once the debt ceiling is resolved, there is $1.2 trillion of issuance across mostly bills, but also a lot of bonds. The FDIC owns a lot of bonds from bailing out the banks it bailed out, and the banks themselves, other banks, own a lot of bonds. And so the supply side looks bad.

01:05
Absolutely. I think the post-debt ceiling, the supply will ramp up. And that is what I guess the bond market is pricing in. It’s basically front-running the supply that’s going to be coming through. And basically, what it’s saying is that whatever cuts price, you know, will be priced in by the debt ceiling resolution, the agreement isn’t going to be

01:33
enough to bring down real GDP into anywhere near negative territory. Because let’s face it, most of the cuts are going to be backloaded. They’re not going to be front-loaded. Even if you, as you said earlier, if you just take what the Republicans have proposed, all the cuts there to the spending are in years 3, 4, 5, 6, 7…

02:02
any well into the future. Therefore, the bond market, I don’t think is happy with that. And it’s basically fighting and continues to fight this negative yield curve, which makes it very, very difficult to really love bonds at these prices. Yeah. Yet. I think…

02:24
You know, we have to go back to where we were at the beginning of the year. At the beginning of the year, we said bonds are really trading instruments because while the yield curve is this negative and you have the combination of a real economy, which is still doing well, i.e. unemployment is not increasing. Retail sales are strong.

02:53
consumer spending is strong. While that happens, it’s very, very difficult to be hugely bullish on bonds. And that is why I think that something like VWOB, which we bought this week, makes far more sense. Because if you compare the yields, VWOB gives you a 5% monthly coupon, i.e. you’re not fighting the curve, you are…

03:21
you know, you are neutral on the curve, you don’t have negative funding costs. It has a seven-year yield, a seven-year duration with an over 7% yield to maturity. While if you compare that to TLT or IEF, you’re looking at, let’s call it 2.5% coupon, you are looking at, so you have 2.5% negative funding.

03:51
You are looking at something like below 4% yield to maturity, and you are looking at a similar duration in IEF. Therefore, I can’t see anyone, especially with the amount of supply that we have coming up, and that we know we’re going to have, going all guns blazing into something like IEF, let’s call that a seven-year.

04:20
or even TLT, which is a 17-year. To me, those sectors are still slowly, slowly going to come in. The really interesting question is what real level of interest rates are we interested in buying nominal bonds? Sure, let me put some numbers on that. The Republican bill that has passed has $3.6 trillion of budget cuts over the next 10 years. Again, backloaded.

04:50
and has $150 billion of budget cuts in 2024. If you just sort of assume that there’s going to be some agreement that isn’t complete capitulation to the Republicans and put a round number like a hundred billion on the budget cuts for 2024, that’s a 40 basis points of GDP hit to spending, which, you know, has an impact, probably a multiple impacts.

05:18
of a little bit more than that on growth. And so that is a bull case for bonds. That is the bull case for bonds that a debt ceiling resolution will result in a weakening of the economy, but it’s marginal at best. So then you look at real rates, which peaked at around 175 basis points on 10-year notes.

05:46
And you look at current real rates, which are 142 basis points on 10-year notes. And that probably gets you sort of both the peak and where we are at, um, for, um, real rates in the near term. And, you know, at three 75-ish on 10-year notes, four and a quarter seems.

06:11
pretty unlikely without significant changes in the economy. Not to say that we’re gonna go to four and a quarter percent, which would be about the highs of the 10-year note, but if we got there, that would be a table-pounding buy for bonds without, again, we don’t know what the future would bring, but that would be a level based on what we have today that if things were to weaken like that, everyone would bid for bonds. So now that comes to, you know.

06:40
Let’s say we drift to 150, 155 in real interest rates as the economy appears to be growing faster than the market had expected, but nowhere near the blazing rate of the peak in yields that we saw last fall. It seems like four-ish is where you might get three and three-quarters with a 5% current money yield. Seems not interesting, but…

07:09
you know, above 4%, that starts to become interesting. Yeah, I think we are unlikely to revisit the highs in real rates simply because the uncertainty at that time, i.e. when inflation would start coming down and at what speed was much greater than it is now. We now know a lot more about inflation than…

07:35
we knew six months ago that this was when real rates were at 175. We are basically now looking at something, I can’t see real rates going much above 155, 160, or something like that, simply because we know a lot more than we did then. Yeah, and I think that’s what you start to think about inflation expectations, which for 10 years are pretty low. So,

08:05
The driver, I agree the driver of real, the real rates driver would imply that inflation would have for it to go much higher than one and a half, one 55, 160. You’d really need to see, um, significant heating up of inflation. My outlook is that inflation stays high for longer, but doesn’t escalate from, you know, sort of the direction it’s heading, which is 3%.

08:35
So let’s say inflation expectations were to rise a bit because they’re very low and inflation is not, may not come in as much as expected. That’s where you could get the next phase of nominal bond yield increases above 4%. But you’d have to start seeing successive increases in the inflation data for you to make that.

09:04
move and inflation expectations really never have become unanchored. So again, I think that says that in the next month or two if bonds on this supply-demand asymmetry start yielding for and higher, those are a fairly good investment. So I think that’s pretty much where we, I think we both are.

09:33
Yes, no, I agree with you. I think anything above, you know, 4% in 10s, I think it would be, as you said, a table-pounding buy for the longer term. And we are investing here for the longer term, we’re not trading. So I think we can afford to wait for that. I see absolutely no compelling reason to step up and buy huge amounts of nominal bonds at the moment.

10:02
the yields are just not attractive enough and why fight a negative yield curve? I just don’t see the point. So that would only be the only potential for a trading spike in bond prices to me would be a complete disaster of the debt ceiling negotiation. So let’s talk about that. So the news of the week last week was debt ceiling negotiations were

10:31
you know, became a real active thing. And so that means that, in my view, the Democrats have come to the table, despite their strong view that budget cuts and the debt ceiling needed to be separated. And they probably will publicly still represent that view, but clearly there are negotiations. And those, you know, midday yesterday,

11:00
Uh, bonds spiked on the fact that the, um, Republicans left the room and then people realized that strategy, it’s a negotiation, there’s going to be ups and downs along the way. We know, um, uh, President Biden is coming back in on Sunday and may bring the room together and that can have both positive and negative and unpredictable outcomes.

11:30
In the end, June is approaching. Next week is the week before Labor Day. We enter the exit Labor Day with a few more days left in July, in Memorial Day, maybe. Huh? Memorial Day, yes. Correct. Summer’s over already. Exit Memorial Day with a few more days to play in May. My numbers suggest that the government actually can get through June.

12:00
despite the uncertainty on that, and it is uncertain, they may not get through June, but I think this gets resolved at the last minute, sometime, right after Memorial Day weekend. I think those are the odds, which leads me to believe that bonds, simply because of the uncertainty,

12:28
will not make big moves next week. I think, you know, the kind of trading that we had all week, and especially on Friday, up and down at these levels, is likely to persist the whole of next week. And that will keep equities with a lid on them. Let’s talk about equities because they’ve been doing some interesting things. Yeah, so the high-level point is…

12:56
You have to own XLK or the big six tech stocks or maybe it’s seven, maybe it’s eight, but the ones we all know anything that has AI associated with it, or you’ve lost money in equities. Yes, and that’s our situation. All our stocks basically are going sideways. And that is because bond yields are going higher and therefore all traditional stocks with traditional valuation methods.

13:26
are going to just move sideways at best. What do you know about AI? Very little. I’ve downloaded the app, but it’s not helping me much. Yeah, so, you know, this certainly has all the markings of a bubble that we’ve seen in, you know, going back to the PC when Apple created its PC, and then IBM killed it soon after.

13:56
the tech bubble in 96 and night through 2000, which really didn’t really get started until 98, the BlackBerry bubble, the real estate bubble, and the crypto bubble. You know, these things, it has all the markings of that, a new technology that is, that creates quite a bit of investor interest before.

14:27
being world-changing.

14:30
But what do all these bubbles have in common? All the ones that you mentioned are that they went far further and lasted a lot longer than anyone could have possibly predicted. Right. And so as a long-term investor, you have to think where are you going to be as a trader? You know, hop on to momentum is what George Soros said when you saw a bubble inflating, jump on. His partner, his protege, Stan Druckenmiller, bought on.

15:00
in March 2000 and rode his fund basically out of business. It’s very, very hard. And I will say that last week was interesting in my view, because we do wanna talk about current events. The current events started the week with the 13 F filings, which are the holdings of investors, hedge funds in particular focused on, that indicated that everyone you know, every hedge fund you’ve ever heard of,

15:30
bought these stocks and then Stan Druckenmiller earlier in the month promoted being very bearish on equities but thinking Nvidia wouldn’t go down. Steve Cohen became bullish at.72 became bullish equities, modestly bullish equities because he thinks there was the first wave and Paul Tudor Jones said the same thing. Now Paul Tudor Jones got into crypto near the peak.

16:00
So you have to take these words as both indicative of what they did six weeks ago and possibly not indicative of what they’re doing today. And also what the, what the people that are asking the questions want to hear about. But many people heard about them and took them, and I think it influenced the stock prices. Absolutely. Absolutely. So really the only question left for us is.

16:29
Do we want to jump on this bandwagon at this valuation? I don’t personally. What about you? Well, it would be certainly inconsistent with everything I’m doing in my alpha portfolio as I wrote calls on every one of those, those big six stocks call spreads on every one of those big six stocks for my alpha portfolio, making a small bet that they retrace and are by more viable.

16:59
in the by August after their earnings. So that’s not what we’d recommend for a long-only portfolio and we don’t go short, but I’m short so I’m not buying.

17:11
Right, so anything else that we think is indicative of what we should do about next week, because let’s face it, what do we have next week? We have some auctions in two fives and sevens, and they’re going to, you know, sort of compress volatility for the bond market to do better. So nothing to do in the bond market, as I can see. And on Tuesday, we have Services PMI, which I guess is going to still show that the economy is just fine.

17:41
And finally, we have, you know, Powell’s favorite cool PC on Friday, which again, I think is going to show that inflation is moving in the right direction, but not at the speed that would allow the Fed to start cutting anytime soon. Right. And markets are dancing around whether there’s going to be ranging from 75% odds of no cut to 50% odds of a hike.

18:10
And that’s probably what we have for June, even certainly based on the data we’re likely to see next week. There is much more important data to come. But we’ll talk about that in the following weeks. So I agree on the portfolio equities, no reason to chase bonds. We gave you our thoughts and. Still earning five percent in cash and five percent in the longer duration stuff we own seems to be.

18:40
the thing to do. I would agree. Let’s talk about the odds of the Fed doing something at the next FOMC meeting or any subsequent FOMC meeting this year. I think we are getting very close to the terminal rate, whether it’s another 25 or maybe even 50 basis points, we can argue about that till the cows come home, but we won’t know until the data shows it.

19:11
because let’s face it, the Fed from now on is going to be completely data-dependent. The one thing that I would be fairly sure about is they’re not going to cut before the beginning of next year. Yeah, five meetings left. They’re not cutting in June. There would have to be a nuclear disaster or something similar for them to cut in June.

19:37
And that leaves four meetings and the odds of a cut in four meetings, I would think are significantly lower than 25%, like one of those meetings being a cut. I think it’s much more likely that either one of the next five meetings is a 25-basis point hike. In fact, I’d go, I’d go so far as to say, and you know, you may disagree. There’s probably a 75% chance that we hike 25 basis points.

20:07
in one of the next five meetings? No, I think the odds are very good that we have another 25, but I think that that will be more or less it. Yeah. Well, the data changed, but yep. So what we are saying is that if you step in now and buy all kinds of assets, you have at least six months’ worth of negative carry to fight against.

20:35
And I don’t think the market is in the mood to do that, not with this amount of new issues that are going to happen. And therefore, you have to presume that bond yields will not be lower in four or five months’ time. Or if they’re lower, they’re going to be so marginally lower that it really doesn’t matter. And therefore, if you buy equities here or you buy bonds, i.e. you do anything but have this conservative portfolio that we have on.

21:04
the moment you are not likely to make I mean the odds are just bad that will make significant money I agree completely in terms of allocations and orders well we were filled on our 200 shares of VWOB so we are at 620 shares in total we are very well balanced between equities and

21:31
bonds and we have still 35% in cash. I think this is the right mix to have at the moment. We are just not going to chase equities because as you heard we think that bonds are going to remain stable at higher levels and therefore the risk of buying too many equities is at the moment too great. I have naturally updated the broker statement, it’s all in there, to the last penny.

22:00
And order entry, absolutely no orders for this week. So I have canceled the order in LEMB. I think we will probably get more clarity over the course of the next couple of weeks and probably be able to get it at better levels and then we will reinstate it and go higher in the allocation to bonds if and when we reach.

22:29
the nominal yields which show us that real yields are about one and a half as we indicated during the episode. Thank you very much indeed and speak to you next week.

22:45
Well, that’s a long episode. Thanks for listening. We will see you next week. See you next week.

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