The Mother of All Pain Trades

This article was originally published on @DissidentThoughts Telegram in this post.

Trillions of dollars are effectively betting, some directly (in rates/swap markets) but most incidentally (they expect to refinance debt), that the Fed will be able to strike down inflation to their 2% target and quickly pivot back to ZIRP (Zero-% Interest Rate Policy).

This comes after first denying the existence of elevated inflation, then decrying it as "transitory", and finally embarking on an unprecedented blitzkrieg of monetary tightening catch-up that has hardly put a dent into core PCE and core CPI — the two metrics the Fed pays attention to as they are less directly influenced by volatile commodity pricing in the energy market.

Most explanations of the current inflationary environment have been poor. The least serious types will blame the Fed, while the more serious commentators will point to the epic, two-year COVID stimulus. But the 'Economic Impact Payments' (stimulus checks) are done, eviction freezes are over, and SLR relief (which was designed to induce emergency re-inflation) has ended.

Yet, inflation is still here. What comes next?

The Fed and most academic literature firmly believe in the Phillips Curve which, as you might recall, would imply that the Fed cannot effectively reduce inflation absent a rise in unemployment (i.e., a recession). Academic consensus holds that an acceptable rate of inflation around 2% is correlated with an unemployment rate of 6%. As of the latest non-farm payrolls reports, we have bounced between 3.4-3.7% unemployment since early 2022. The stubbornness is due to a high job vacancy rate.

Today, we are on the cusp of a depopulation-bomb coupled with a competence-bomb that risks entrenching unacceptable, economy-unwinding inflation absent a pivot back to a more aggressive monetary tightening strategy.

What would it take? It'd have to destroy an entire cluster of wealth caught on the wrong side and, as a consequence, create a deep recession that includes unemployment, defaults, and pain.

It will be The Mother of All Pain Trades:

Deep Pain, Deep Recession

To take core PCE (inflation) down to their 2% target (the most recent print is at 4.6%), the Fed must steepen (raise above zero) the long-end of the yield curve without cutting the overnight rate.

This means long-term yields, like the 10-year, must rise above short-term yields, like the 3-month (image) or overnight rate. This is called a bear steepener, and the Fed has known since the early 1980s that it is the only way to achieve non-negative real interest rates and crush inflation.

It will induce a deep, painful recession, and be the cause of widespread unemployment, but we know that such pain is needed for price stability and for inflation to return back to target.

The chart above is a 10-year/3-month yield curve (10-year yields minus 3-month yields). Like every yield curve as of this writing, it's inverted (negative; 3-month yields are greater than 10-year yields). In an otherwise healthy economy, yields are greater over the longer term due to unknown risks with time (all else being equal, it's riskier to make a 10-year bet than a 3-month bet).

Recall that yield curve inversions signal borrowing conditions are very tight for the private sector, depressing the economic outlook over the longer term. As the Fed hikes the overnight rate (which influences short term rates, like the 3-month in this example), credit becomes unaffordable for many and spending falls, which in theory reduces inflation. The long-end of the yield curve (10-year yield, etc.) reflects weaker future growth prospects by falling below the short-term yields, creating the inverted curve.

Yield curves can remain inverted for many years. Off the chart to the left, in the late 1970s through early 1980s, the inverted curve lasted for almost three years. There's no urgency for it to steepen on its own.

Curve inversions are a great leading indicator for weakness in the labor market, and thus are reliable recession signals when they begin to steepen.

This time will be no different.

Mechanics of the Curve

Today, the market is pricing in 175 bps of rate cuts by the end of 2024. The reason is simple: over the last 30 years, the Fed has steepened the yield curve by cutting the overnight rate (purple) to zero or near-zero as the recession becomes imminent, called a bull steepener. It would take 150 bps of cuts to steepen (un-invert) the curve today. But unless the Fed's preferred inflation gauge (core PCE) is down to 2% (for context, core PCE hasn't budged AT ALL this year), they risk losing control over price stability and sending distorted signals to the market with premature cuts.

Both examples of yield curve steepening (bull & bear steepener) are depicted on the chart above.

Fed's Powell, meanwhile, has repeated the same message for months: to not expect interest rate cuts until at least 2025 and/or when inflation is back down to its target of 2% core PCE.

What could provoke the steepening? In other words, what might prompt the 10-year Treasury (UST) yield to climb above 6%? It will take prolonged Treasury market volatility, most likely induced by Japan unwinding its YCC. While next year's Treasury buybacks will provide some liquidity, it will be incapable of suppressing a meltdown. If yields were to (for some reason) violently oscillate as they did in early March 2020, the Fed may restart some iteration of Reserve Management Purchases.

What would act as the ceiling on 10-year yields? The long end of the yield curve (10-year, 30-year, etc.) is not within the Fed's immediate control, but instead based on what the market prices for debt. The Fed would have to start YCC and commit to buy whatever amount of 10y USTs the market wants to supply at its target price. Because bond prices are inversely related to their yields, buying bonds puts upward pressure on their price (downward pressure on yields) and allows for the Fed to cap yields at some target.

The mechanics of QE resembles YCC, but that it focuses on quantities, while YCC focuses on prices (yields) of bonds.

Benchmark Rate

Importantly, the 10-year US Treasury yield (red) is considered the risk-free benchmark rate: a lender would never loan into the economy for a yield below what's offered risk-free from Uncle Sam. Yields on private debt are often denominated as the 10-year rate plus some premium. This is the same logic which underpins the reverse repo facility: the floor on global interest rates.

Consider the example above, plotting average 30- and 15-year fixed mortgage rates (blue & green) consistently just above the 10-year Treasury yield (red). Fixed rate mortgages (FRMs) are one common example, but lenders follow a similar APR structure mimicking Treasury rates for small business loans, student loans, auto loans, credit card plans and other debts.

Most loan structures will follow the 10-year UST benchmark rate or the overnight Fed Funds rate (lenders follow what's called the Bank Prime Loan Rate, which is Fed Funds + 300 bps). Student loans are an example of the latter, and auto loans an example of the former.

The point: Treasury yields do not only affect Treasury investors, but all debt holders subject to interest, as Treasury rates act as the risk-free benchmark used by lenders. US Treasuries price all debt and, therefore, all assets.

Now imagine Powell holds the overnight rate at its peak of at least 6% through December 2024 (as the Fed insists) and the market is totally wrong to price in cuts: as the curve un-inverts, and the 10-year rate (red) crosses above the overnight rate (purple), this is now over 6% on 10y USTs – and 9-10% on a mortgage at least! We last saw these rates 30 or 40 years ago.

The same rise in rates will be observed in all other categories of debt, along with the same consequences.

Debt

Crucially, global private and public debts were comparably low 30-40 years ago, during the prior inflation era when rates were in that elevated range. As much as Powell wants to be Paul Volcker, who famously crushed inflation in the 1980's, one can't ignore the fact that Volcker was jacking rates into a planet with about $200trn less debt.

Higher interest rates will pose a special risk to the sovereign debt held by emerging markets (smaller economies), as many like Pakistan are drowning in debt/GDP ratios that make the US appear fiscally average. But coupled with a strong dollar (one that will likely return within 12-36 months), the sovereign debt problem is exacerbated manyfold.

Powell will have to be agnostic to the debt and retain the focus of a fighter pilot as the political pressure to cut rates grows. Debt holders cannot be shown mercy, and many will sell their assets and/or default on said debt when they can no longer keep up with high interest payments. Their pain will be key to returning inflation back down to 2%.

Not only will interest on private debts mount until the Fed can create enough bankruptcies to break the labor market, but interest payments on the Feral debt ("national debt") will continue to climb to $1trn and higher annually, forcing US domestic policy to turn towards austerity of raising taxes and cutting Federal spending.

Much of the debts taken on during and since COVID are predicated on the idea that, by the time the loan rolls over in two-to-five years, interest rates will be back to zero, and the loan can be refinanced cheaply. And even if the Fed does keep rates higher for longer, they will drop them back down to zero once the recession arrives. And finally, that they will have to drop rates to zero eventually for the US government to remain solvent.

This logical coping is the crux of what will be The Mother of All Pain Trades.

Maturity Wall 2025

A maturity wall is simply the period during which many existing debt arrangements come due or approach maturity and must be paid down or refinanced. Borrowers often seek to extend their loan maturity further by refinancing their debt. For that reason, it's also called a refinancing wall.

Some 60% of today's $300trn debt load - in the form of home mortgages, corporate/personal loans, sovereign debts, etc. - was taken on over the last 15 years while interest rates were low, if not while they were at zero. Consider the US Federal debt, which added $24trn since 2009 when rates hit zero. Borrowers were consistently able to enter into debt and refinance at low interest rates, which had the effect of cheapening the money, so to speak.

It's not only $1.6trn in commercial real estate (CRE) debt (a trillion in office real estate alone), but $5.3trn in all debt categories, that's expected to mature as soon as the end of 2025.

When debt maturity comes, borrowers will face four options:

➙ 1) Continue paying elevated interest on the debt (which in many cases will require selling other assets/downsizing to shore up enough capital).

➙ 2) Sell the asset (house; car; unprofitable business), likely at a deep discount or a loss as they're no longer able to remain solvent at high rates.

➙ 3) Default on the loan.

➙ 4) Businesses & landlords can pass along the higher costs downstream to the consumer (which is an inflationary option).

Option #2 is the Fed's preferred case scenario, as selling, of course, puts downward pressure on prices and is therefore disinflationary. This is "the pain", and the hallmark of all recessions. Debt holders who can't tangibly afford their assets will be forced to sell and/or downsize the lifestyle that, for the last 15 years, had been financed on "cheap money".

This 'Great Debt Unraveling' will be the crux of the pain, but also the key to breaking inflation.

Timing

Timing the yield curve steepening - the beginning of the next recession - will be difficult but is not out-of-reach. We can cite a few pieces of information and historical precedent to estimate:

Like we said, and as evidenced by in the late 1970s through early 1980s, the yield curve can remain inverted for several years. Likewise, Treasury volatility can climb and hold, without necessarily causing a March 2020-like shock. MOVE - a proxy for illiquidity in the Treasury market - has been hovering at and above the 2020 highs for 16 months now. We will likely need to see concerted central bank-selling of USTs before such stress is enough to raise yields, steepen the curve, and dismount inflation. The effects of the BoJ unwinding its YCC could be the trigger.

The Fed has not officially paused yet and, with a lack of progress on inflation, may continue hiking for the remainder of the year. In general, yield curves do not steepen during the hiking cycle, but once the cycle is complete, so we can omit 2023 as a likely candidate for the recession.

For 2024, the labor market will likely remain tight as the number of Boomers eligible for retirement will see its greatest surge. The Fed would likely see this as related to inflation remaining stubborn and elevated.

One important and potentially relevant date in 2024 is of course the US Presidential election. A debt crisis and recession during an election cycle (today through end-2024) seems unlikely to me, though Obama was elected in November 2008 - by which point the stock market had already fallen 40% and unemployment hit 6.8% (it would peak at 10% one year later).

Shmita, the last year of a seven-year cycle in the Jewish calendar, has several times in the past coincided with immense financial hardships in the world during or after, and so has an interesting calendar effect. The next Shmita, September 2028 through September 2029, is probably too far off to be relevant. More likely by this point would be bond market depression resulting from Fed YCC, itself a consequence of The Deep Recession. Fed YCC would destroy the $27trn US Treasury market in the same way that the BoJ's YCC has destroyed Japan's debt market.

It's well known that the autumn-winter period has a calendar effect associated with peak financial meltdown (October specifically), often manifesting in at least one stock market crash (a decline of –10% or more over a few days).

For now, we think H2 2025 is most likely when the curve will steepen above zero and signal the beginning of The Deep Recession. If true, it would mean that the next US Presidential administration will be saddled with this dumpster fire.

All that being said, The Deep Recession will arrive within the next two or three years and may itself last for several years. If we are correct and it does arrive in the second half of 2025, it will likely peak in 2026 or 2027.