The macro regime we have entered is creating a fundamental shift in WHERE capital is coming from. This falls directly in line with the sovereign debt risk that exists in the system right now. Contrary to popular opinion, sovereign debt crises do NOT mean risk assets can go up forever. When assets are denominated in a currency that is being devalued, traders will exit assets denominated in that currency entirely, because the total return is based on the asset's price appreciation AFTER it is adjusted for either domestic inflation or cross-border hedging costs.
What we will cover today gets to the very root of WHERE these flows are coming from and HOW to think about the changes in real purchasing power caused by sovereign debt risk. I have already laid out the framework for WHY these changes have taken place here. If you have been following the research, then you know why bonds are down so much right now and why it is beginning to drag on equities. My strategies signaled these risks well before Bessent tried to step in front of a market that is much bigger than him.
Let’s start by dispelling the most misleading ideas people hold on either end of the spectrum. Domestic inflation can most certainly cause equities to crash. We saw this over and over in the 70s, and it was THE driver of flows in 2022 during the inflationary bear market. There is a deceptive idea in the financial community that inflation helps equities go up, which glosses over the entire mechanism: inflation also decreases liquidity by revaluing the purchasing power of dollars. There is always a risk for every reward in the system, and it doesn't matter if it is in real or nominal terms. When an entire generation thinks that debasement is functionally free money without any risk, you know they have minimized the risks that are required for making money in markets.
The chart below shows the precarious environment that we are CURRENTLY in. The largest drawdown in recent history for total returns in bonds makes the previous 40 years look like a walk in the park. The important thing to take note of is that this shows TOTAL returns and not just outright interest rates. If we adjusted these returns for inflation, the drawdown would be even deeper.
When we look at history, low and stable inflation creates a positive environment for risk assets, but when we begin to tip into higher volatility on either the deflation or inflation side, the entire game changes: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4153468
When volatility rises on either side of the distribution, you need to make more informed and active management decisions in order to offset the drawdown. If you want to benefit from the volatility, the bar is set incredibly high, but the payout is just as high because the entire financial industry and global monetary system have been structured to be long 60/40 and short volatility. This is WHY, if you understand the drivers of volatility for both deflation and inflation, you have an incredible opportunity to benefit from these changes instead of being crushed by them.
This is why I explained in the previous report (link) that the drivers of growth and inflation are so much larger than any single action by the Fed or Treasury. Government spending and the AI capex build-out are the most significant drivers of interest rates, and the oil shock is only amplifying this.
Scott Bessent has said that the inflationary impulse is only a supply shock. This statement in itself is an attempt to misdirect people away from the real drivers of long-end interest rates:
Notice that long-end real rates (blue) are making new highs while inflation swaps (orange) remain in their range. This, along with today's CPI print, which showed core measures decelerating, indicates that we are facing a larger structural issue with interest rates that is being amplified by energy prices, as opposed to merely a supply shock that will eventually push interest rates back down to cycle lows.
These subtle rhetorical plays by Bessent have significant implications for WHERE we go in equities and HOW HIGH we can go in rates. Think about what the data says vs. the narrative Bessent is trying to subtly float (remember, the US controls oil prices right now given its role in the Strait of Hormuz).
Headline CPI and the forward swap curve for CPI are both in a very reasonable range given the inflation risks in the system. The larger question is about the growth side of the equation and what everyone refers to as “term premia” (the compensation investors require to move out the duration risk curve). Bessent is trying to focus people on short-term inflation, while the real issue is government spending and high nominal GDP.
You will notice that Bessent is taking action on the long-term rate and FX side at the same exact time Warsh and the Fed are pausing on the short term interest rate side. For the last 2 months, short-end real rates have been in a range, which shows the Fed continuing to hold an overly accommodative stance on monetary policy relative to the conditions that exist.
This overly accommodative stance comes with almost 100bps of hikes priced into the terminal rate. The chart below shows the U7 SOFR contract, which shows HOW MANY hikes are priced between now and Sept 2027. This is the highest point of the forward curve, which means the market is pricing hikes until Sept 2027 and then a pause by the Fed.
The way you want to think about the chart above is by asking: HOW MANY hikes need to be priced into the forward curve before long-term bonds find a bottom and financial conditions tighten marginally? Until the Fed tightens enough to cause this, bonds remain skewed to the downside.
This was the exact logic I laid out in the bond strategy I published last week, which explained that when the volatility regime begins to rise in bonds AT THE SAME TIME that bonds underperform crude and equities, it is a clear sign that downside is beginning to materialize. The logic for this and the TradingView model were laid out here: LINK
We now have a clear understanding of the big picture and WHAT is happening. But the more important questions are: WHERE are we moving from here, and HOW MUCH risk exists for equities as Bessent manipulates and misdirects the market?
While bonds have fallen recently, there are two important factors to understand in order to determine HOW MUCH FARTHER they can fall and the risk of a counter-trend move:
