𝐄𝐟𝐟𝐢𝐜𝐢𝐞𝐧𝐭 𝐌𝐚𝐫𝐤𝐞𝐭 𝐇𝐲𝐩𝐞

2025 Macro Outlook – So Good it Hurts

As much as this is an outlook of the year ahead it’s a review of past views. In November, fresh off the election I wrote the following thread and not much has changed but here’s the lowdown:
1. Equity price has moved faster than earnings but remains correlated
2. Mid-year risk unwind was mechanical but underpinned by growth scare
3. June CPI ignited consensus for cuts – but Fed went big and now looks like a mistake
4. TY skew is back to negative, forward cuts are getting priced out
5. Risk of curve bear flattening less durable. I favoured bear steepening, which was right
6. HY issuance has been shortened, relying on rate cuts to materialize
7. Dollar is rate dependent for now
8. Clearing of rate vol sets it up for an expansion that could upset fincon
9. Gold like rate vol, was a hedge whose use was over post-election but I thought could still come back
https://x.com/EffMktHype/status/1856634876071686352

Since then, I can happily report that much of it was on point
1. Equity valuations and spreads have marginally weakened
2. This was driven by tighter fincon as yields rose, the curve bear steepened and vol sustained/increased
3. Dollar has continued its march higher (which tends to be an SPX headwind)
4. Gold demand has sustained as inflation concerns gained traction

So let’s look at the basic framework of
1.Why or why not do I want to own bonds
2.And depending on that, where do I want to put my money otherwise

To begin, let’s look economically. The U.S. 3Q24 GDP was 2.7% YoY and is expected to come in at 2.4% for the full year. On a quarterly basis, growth in the US has been accelerating through 2024 with 3.1% annualized in the 3rd quarter. Globally, it’s well above everyone else. In terms of inflation however, everyone is pretty in line. 
What does this mean? Assuming the trend persists, with higher growth and similar inflation I would expect the U.S. sees an overall higher level of nominal interest rates relative to its peers.

The interesting thing going on is that despite the divergences in growth among countries, nominal interest rates in the US, UK and Australia are very closely tied. While the UK is currently facing deficit-induced pain on their bonds, Australia has mostly seen higher levels of inflation and hence been less dovish than the Fed.

In my view, the general level of long term real interest rates, in the realm of persistently higher GDP should be higher in response until growth declines and cuts come into play. (Do note that shocks to growth such as in recessions initially see real rates climb due to the fall in inflation outpacing the fall in nominals.)
So my question for now is, where is growth headed and relatedly, inflation - together what does this mean for nominals?

My work on economic syncopation was never about prediction but about understanding the changes in the cycle and relationship between hard and soft data. The crux of the argument was about the secular shock to sentiment rather than a permanent shift. The conclusion was that the 2020 lockdown eliminated the lead/lag and it was about time healing mental wounds. That is why I looked at rate of change rather than outright levels. If ISM Mfg stays at 45 for a year, it is ‘contractionary’ but it hasn’t gotten worse – think of a production manager who expected a recession for a year that didn’t come, what’s he likely to think next? It is likely he becomes more in tune with the actual state of the economy.
This is the argument for why I think leading indicators shouldn’t be ignored and labelled as broken ANYMORE.

If we look at survey prices with the same lead/lag relationship (6 months lagged, 12 month Level Change) we can see how the survey levels have rebounded strongly and imply an uptick in the general expectation of prices. Unlike activity indices, the relationships here endured through the COVID crisis due to their direct impact on inflation. Viewed this way, inflation looks like it is facing upwards pressure based on the surveys.

Employment surveys have been less convincing and this was in part why the Fed felt comfortable ending the hiking cycle and pausing in anticipation for the cutting cycle. With hiring slowing, it engendered a willingness to cut rates and avoid a large downturn in the labor market. Viewed this way, it gave credence to the pivot. But the recent data betrayed them.

Let’s turn to the Fed’s input factors – the output gap, inflation and the real rate.
In terms of inflation there was substantial progress made toward 2% which has clearly stalled and even inflected higher lately. The output gap showed that as unemployment rose off the lows it narrowed the gap to the NAIRU. Disinflation and rising unemployment approaching target while nominal short rates were 200bps over inflation seemed like a restrictive enough stance. They worried it was too restrictive. Maybe they were right – after all you don’t drive 100mph to your destination and only slam on the brakes at the doorstep.

The issue seems to be that just when they felt it was time to ease up, economic syncopation was healing and sentiment was turning up to match the resilience of the economy. A mid-cycle adjustment was always going to be tricky but doing a jumbo 50bps cut to me, was the error, not the cut itself. They had all the time in the world but they rushed.
This is what caused the bear steepening we’ve seen come into the market since that cut.

So from my vantage point it looks as though the US economy is on a steady path upwards. It is very hard to deny its resilience. I believe that economic indicators have largely healed and we need to listen to what they say, up or down, and for now they point up. 
My base case for now is that growth maintains at high-2 to 3 percent and there is a risk that we see overheating leading to inflation not making any more progress. Inflation data in the face of this is hugely consequential now. How does this all translate into assets?

Let’s first look at rates and the peculiarity of this mid-cycle cut. I want to bring your attention to 3 distinct points: the dotcom and GFC cuts, the 1994-95 soft landing and the current setup.

1. The prior rate cut cycles see the curve bull steepen but notice that long end rates rise as the cuts get deeper and bear steepening occurs once FF hints at a bottom

2. The soft landing saw 75bps of cuts with mild bull steepening followed by largely range bound moves as the market sniffed out a mid-cycle HIKE. 

3. The current setup is all sorts of fucked up with rates rising at every juncture of every cut that occurred so far. It is closest to the soft-landing scenario however the timing is different. We are moving much faster to saying the Fed is done cutting – this implies that the market bias has shifted to selling bonds but the risk to positioning is to the downside in yields if data weakens.

In my opinion, the battleground of economic volatility will be expressed in the belly of the curve. The 2s5s30s can be considered to be bounded by 0 and -100 in most regimes with 0 being peak economic expansion and -100 being maximum economic contraction. 
If growth and inflation continue to print at levels that cause the Fed to hold rates or consider raising, that should feed through into the belly and push the butterfly higher. 
10s more than 5s look rich to the curve, as the market until recently has been very reticent to consider higher for longer possibilities (cue the calls for the curve being a broken recession indicator). How much cheaper it can get remains in the hands of inflation expectations and the Fed’s reaction function.

Side note: Coming off the Dec24 CPI print which printed last night, Core CPI missed by 0.1 rounded, yields declined sharply and the biggest move was in the 5s - reiterating my point above. 

Now, the tricky part. What about everything else now that the situation for bonds look challenging? US HY for the last 12 months has outperformed treasuries by over 8%, the prior by over 9%. 
This was aided by a combination of spread compression as well as declining interest rates after the painful 2022 rate hikes. Can it manage a three-peat? First, 5Y treasuries to the end of the year present a 4.4% return if rates don’t move at all, with a breakeven yield of 5.8% meaning holding 5Y paper until Dec 31st will return 0% if rates rise up to 5.8% by year end.

That requires HY bonds to return something north of 12% in order to generate similar outperformance. Of course anything more than 4.4% will outperform but where can that come from? HY duration is at its absolute lowest, around 3.10 thanks to shorter and shorter issuance and tighter spreads.

Speaking of, spreads are at their tightest as well. Can they tighten further? In a scenario where growth continues to build and pressure on rates subsides perhaps but we’re kinda pushing on a string. In reality, HY’s 7.5% yield to worst is built on 4.5% of benchmark yield and 3% of credit spread.

In order for HY to outperform treasuries by a similar amount this year it…is almost impossible. Treasury index has a duration of 6.7 so double that of HY, 5Y notes have duration of 4.4 so still higher. Any gains from falling benchmark rates will just cause treasuries to outperform on a price change basis.
So in an unchanged yield scenario any further outperformance must come from spreads compressing. But what if benchmark yields rise? Well that’s probably going to be a problem as we saw in 2022. Conversely, growth slowdowns that see inflation falling and benchmark yields declining surely see credit spreads widen. The proposition is asymmetric. 
So this year is really not about having a blockbuster year but hoping for a quiet year of carry. Things are so good it hurts.

Normalized against MOVE (rate vol), spreads are distinctly rich to where vol is trading relative to history. A market that rushes to price in changes in the path of rates will see vol spike further which almost always causes credit spreads to widen given the mechanical nature of option pricing scenarios for callables (hence Option-Adjusted in OAS).

In equities, we turn to everyone’s favourite chart(s) on valuation – earnings yield and P/E ratios. In the November thread I wrote about this a bit but I’ll reiterate some points here and add in some further context. First, yes the S&P500 12M blended forward Earnings Yield (EPS/Price) is lower than the US 10Y yield. Is this a problem? Well…not entirely.

First observe it relationship to yields pre-2000 compared to the next 20 years. 

The negative correlation between stocks and bonds has not always been negative since time immemorial – it is a 21st century phenomenon. In general, you can attribute this to the growth vs inflation drivers and the volatility within them. Inflation has not been a worry for the last 20 years until the global disruption in 2020, it was before then and it has been for the last 4 years. When inflation risk premium is the driver, stocks and bonds tend to move together, when growth is the driver they tend to move in opposite directions. This is the basis for “bonds breaking will break equities until equities breaking saves bonds”. 
This implies that for equity valuations, periods of inflationary concern tie it to the evolving path of inflation. The soft landing scenario matters for equities because it is about STABLE inflation, not the level. 
This ties back to the previous segment on HY which exhibits the same relationship to treasuries as stocks do – its yield is simplistically composed of the credit-risk-free rate (inflation risk premium) and the credit spread (growth risk premium).

The earnings yield, or P/E whichever way you wish to look at it can be fundamentally broken down into two components despite many analyzing it solely as a whole number. The 1) price and the 2) earnings per share. 2025 estimates have EPS at 272, a 14% increase from 2024 EPS which if a 24.4x P/E is to be maintained implies SPX at roughly 6640 (an 11.6% gain for the year).
To repeat a 20%+ year without expanding the current P/E further requires EPS to grow by 22% instead of 14% this year.

So assuming economic growth is steady (which I have established to be my base case thus far), any meaningful changes in valuation will be driven by either changes in the discount rate or the riskiness of returns on equity.
There is a lot of material out there on deriving the P/E ratio through the Discount Dividend Model and vice versa but in short, the Forward P/E multiple (or even FCFE multiple) is expanded by growth in payout ratio and reduced by increases in the excess cost of capital (r – g).

This framework is useful for me in thinking about the mechanics of valuation as opposed to predicting any specific value. Where it is useful is that I can now tie equity market valuation to the growth in earnings and the cost of capital.

Given my view on stable growth with inflation risk that implies that the cost of capital is likely to increase thus bringing current valuations lower for the year toward the forward PE of 21.86 (i.e. no change in price). For us to see PE fall below 21 it would require earnings estimates to decline faster than the decline in the cost of capital. 
This is why inflation expectations are such a pivotal component this year – declines in inflation that allow the Fed to lower rates irrespective of growth are bullish for stocks as it lowers “r” the cost of capital. A decline in growth however will lower valuations through a higher excess cost of capital as “g” declines in the “r-g” relationship.
Hence, current equity valuations to me are...so good it hurts. The economic bull case threatens inflationary increases in cost of capital while economic bear cases threaten a reduction in g and increase in r as riskiness increases (on top of likely lower payout ratios as corporate defend balance sheets).

On the volatility front, it is worth noting that the majority of implied volatility metrics have been stable and except for FX vol. This uptick in FX vol (G7 basket) first expanded mid-2024 due to the Yen-led carry unwind, itself driven by a fiery mixture of a US-growth scare and declining inflation against a tightening BOJ that spurred a collapse in interest rate differentials and subsequent rally in Yen against carry currencies.

This risk has not abated, in fact the current setup is not dissimilar to the path of the first half of 2024 – we began Jan 2024 with 6-7 cuts priced in the US only to price them out by June and set us up for the July-August meltdown. We are back at not expecting many cuts due to the strength in growth and re-focus in inflation.

I reiterate, the bias (read ‘trend’) is currently toward higher rates and positive economic backdrop – thus the market risk is to the other side, lower growth and lower inflation.
Like credit, the backdrop for EM assets is predicated on stability and the magical combination of moderating inflation without a material deterioration in growth. This will allow the U.S. dollar strength to moderate without causing shock imbalances in carry positioning

This is why I think 2025 is going to be like walking a tightrope without a harness while Trump has a remote controlled dildo plugged into your butt. 

It is a year in which the ideal scenario is one of long-term boredom where carry strategies can earn unhindered by material expansion in market volatility caused by economic volatility. Inflation data will be the nexus of short term market gyrations but growth metrics will determine the larger picture. 

To that, my bias is to hold TIPS over nominal treasuries as that still provides me with upside on a lower real rate component while providing a ballast if inflation rises (up to such point that hikes come into play. Given the incoming administration I would favour US over EM HY for carry especially while the Chinese recovery remains unconvincing despite its allure but at a lower weight against treasuries. Dollar seems to be the logical currency to hold while gold to me is actually a real rates story dressed as inflation. The US exceptionalism theme should continue favoring US stocks over ROW but I feel that current valuations leave me unattracted until we get more evidence inflation is cooling.

That’s why things are so good, it hurts.
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Just taking stock of things given the heightened worries about treasuries right now. 🚨🚨🚨

Starting with my scatter, I hold the view that we're shifting back to the right side (yellow dots), meaning overheating eco should see the curve bear flatten and recessionary path sees curve bull steepen but with little joy from the long end.

It's also worth noting in the above scatter that current levels are similar to 2007 and sorta-2001. Both pre-recession/bear market timeframes, with the path travelled similar as well (up and to the right followed by u-turn down). Meaning to say, the current bond market has continued to trade in a recessionary mindset.

It's jarring then, that the narrative around 30s trading at 5% has been distinctively bearish rates when the former position I laid out sounds distinctively bullish rates due to growth slowdown.

If we slice up the curve into its various curve dynamics we can see that the deepest expression of this recessionary mindset seems to be in the belly, with the 2s5s30s (bottom panel) at -81. Meaning 5s are quite rich to the rest of the curve.
The 5s30s curve on a 20wk lookback shows it's been twisting steeper with 5s lower and 30s higher.
Lastly, if we simply look at the individual tenors you can appreciate just how much the long end has risen relative to the front of the curve.

Obviously we can disentangle the risk of inflation and uncertainty in rates policy of the near term from the future, which many will refer to as term premium and as mentioned by many, TP can be mostly captured by the curve by the nature of how the models are constructed. 
Consider this premium as driven by inflation risk and volatility in the forward expected interest rates...

On the volatility side we can see that rate vol is currently pretty stable and not elevated as a whole. (I'm using SOFR swaps to replicate the MOVE Index here). Looking at the individual tenors' normalized vols in the bottom panel I also note that they are much closer currently than 2022-2023, where there was not only higher uncertainty in rates as a whole but across the tenors.
Lastly, plotting ACM TP against the spread of 10 vs 2 N-vols does show some element of relatively increasing volatility in 10y partially driving things.

If we turn to the decomposition of nominal rates we'll also note that further out the curve, real rates are higher, as are nominals, while breakevens are largely stable. Even in terms of inflation expectations, however you measure it, 5y5y, 10y ZC Inflation Swap etc, they are stable.

I.e. the curve steepness is not currently being driven by inflation expectations and a large part of the rise in the long end is driven by real rates.

If we look at long end nominal rates against the curve relative to where we are we can get a rough idea based on the last 30 year distribution what various moves entail. The blue distribution is the most recent 10 years.
The main question for me amid this seeming cyclicality is whether we bear flatten or marginally bull steepen (where 30s dont move much). The most painful scenario is to keep bear steepening from here, which I believe is what cause that slight wobble in risk assets on Wednesday when 30s broke 5% to the upside convincingly.

To the main question, why are real rates rising especially on the long end? I believe that a lot of the forces that drove rates lower over the decades are unwinding. While we could argue that long term growth prospects are rising and driving real rates higher, i think it is more an issue of the bond market anticipating a reduced supply of capital in conjunction with an increased demand for capital.

1. If manufacturing shifts back to the US away from Asia, the shift from high savings economies (Asia) to US (low savings) can impact the supply of capital
2. Boomers that have been a huge source of capital are also now drawing down and investment horizons are likely to be shorter than 30years
3. The deficit and debt ceiling issues highlighted the structural concerns around long term US fiscal health

The last point on the deficit, in my mind is playing out on the curve in the following way: As the chances that the TCJA goes through increase, the rise in the deficit and potential inflation concerns combined with investor aversion to US$ assets will cause rising yields to constrain activity that results in economic weakness at the near term. 
This cycles back into the ongoing likelihood of rate cuts from the Fed while at the same time the market places a premium on owning long term US debt.

Can this all go away easily? Quite possibly but it also may not matter. While many are fearful of a wholesale buyer's strike in the long end I think that is mostly done. 

My base case is that as long as we see activity maintain, rates at the long end are likely rangebound and the action will centre around the front/belly where we see the curve twist/bull steepen as inflation comes closer to target and lets the Fed cut.

In a slowdown, we see the curve aggressively bull steepen with little joy from the long end.
If the economy overheats and we see inflation pick up then it's the bear steepener-into-flattener that kills everyone

So I don't hate the long end, but I also don't really like it all that much either.
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