2024 Is Starting To Look A Lot Like 2022
Inflation, energy prices and the path of interest rates all look like they're on the same trajectory. That's bad news for stocks and bonds.
Over the past week, things have kind of started to fall apart. We’ve had signals that this is the way things were trending for a while, but it seemed to come to a head with this week’s inflation report.
I’ve noted recently in this space that the re-acceleration of inflation was becoming a larger issue than investors were giving it credit for. The street is still trying its hardest to believe that Powell and the Fed are still going to cut rates later this year, but it’s becoming harder and harder to make the case. Every higher than expected inflation number further prices out those rate cuts and the markets reacted hard on Tuesday.
The S&P 500 held up by losing “only” 1% on the day, but rate-sensitive asset classes really took it on the chin. Utilities underperformed by a fair margin. Real estate was down around 4%. Small-caps, which are more reliant on debt to finance growth, lagged large-caps badly. Treasuries predictably saw yields shoot higher and this is a trend that may not be over by a long shot for multiple reasons. More on that in a moment.
While the 1st quarter of this year was all about unbridled optimism around U.S. economic growth, disinflation and an imminent rate cutting cycle from the Fed, the last few weeks have unwound a lot of that narrative. Now, we’re potentially entering a new phase that wasn’t at all what investors had expected or are prepared for.
When you take everything into account, 2024 is beginning to look an awful lot like 2022.
Let’s break down the catalysts one by one.
Inflation Is Re-Accelerating & We Don’t Know Where The Terminal Rate Will Be
This is right out of the 2022 playbook, although it actually started in 2021.
Inflation in the post-COVID reopening boom fueled by a mountain of liquidity spiked and was, at times, increasing by more than 1% month-over-month. The Fed was way behind in responding then and it still doesn’t have it back under control now.
Inflation isn’t nearly running at the pace that it was then, but it’s also nowhere near the Fed’s 2% target.
The headline inflation rate is currently rising by 0.4% month-over-month and last month’s increase was fueled by higher energy prices. The core rate, however, which doesn’t take into account food or energy prices, has risen by 0.36% in each of the past two months. Translation: the short-term annualized rate of inflation is still 4%.
If inflation was trending lower, you might be able to make the argument that the Fed can take its foot off the gas. It’s not though. At best, it’s trending sideways, but if you look back at the data over the past 6 months, inflation is trending higher.
That’s nowhere near the conditions where the Fed should be considering cutting rates, much like it wasn’t in 2022 when investors tried to talk themselves into a Fed pivot multiple times, only to be rejected by Powell each time. They’re trying to talk themselves into it again now, but the odds are looking longer every day.
Speaking of energy prices…
Energy Prices Have Been Rising Rapidly & $100 Oil Is Not Out Of The Question
In 2022, WTI crude started the year at around $78 a barrel. By June, it was trading at $120.
Entering 2024, crude was at $74. Today, it’s at north of $85, having touched the high $80s just days ago.
The backdrop is similar. In 2022, all of the liquidity getting pumped into the system was fueling an anticipated boom in demand and travel. In 2024, rates are still high, but the Fed has been managing liquidity in the system to make sure things are still flowing nicely. There’s the sense that we might be seeing an uptick in manufacturing supporting the energy price boom this time around, but we’ve also got a fairly volatile geopolitical backdrop. If rumor is to be believed, Iran is ready to attack Israel at any moment and that will almost surely send crude oil prices higher again.
I don’t think oil prices are done rising, which means I don’t think inflation is done rising either.
Then there’s that pesky issue with the yen in Japan.
The Bank of Japan Could Do A Lot Of Damage To U.S. Treasuries In The Process Of Saving The Yen
The yen has been falling pretty consistently against the dollar since the beginning of 2023, save for a brief rally in the 4th quarter of last year that seems like it happened years ago. Just this week, the yen set a 34-year low against the dollar, sinking to more than 153.
This is important because the BoJ has intervened in the past to save the yen and they’ve done so around the 150 level. We’re well above that level now and the BoJ has already indicated they’re watching the situation closely and are prepared to move to defend the currency. Given the backdrop, I believe an intervention by the BoJ is imminent and that could send the yen sharply higher for a short period of time at least.
Here’s where I think it gets concerning for U.S. Treasuries.
The Japanese government is sitting on more than $1 trillion of U.S. Treasuries. If it wants to defend the yen, it needs to buy the yen. Where is the most obvious source of funding if you want to buy a lot of yen? Start selling off a bunch of those Treasury notes.
If inflation is already putting upward pressure on Treasury yields, the Japanese government dumping a boatload of U.S. government securities into the marketplace (following a Treasury bond auction that already demonstrated the demand for these securities is weak) could easily start pushing the 10-year yield towards the 5% level.
I probably don’t need to tell you that Treasury yields were soaring throughout 2022 and resulted in one of the biggest bear markets in bonds in U.S. history. Given where we’re starting, I think it’s quite unlikely we’ll see a repeat of that, but another calendar year of losses in Treasury bonds seems more likely than not at this point.
What Does This Mean For 2024?
The U.S. economy may be chugging along and the labor market may be tight, but inflation and the Fed have been controlling the narrative since pretty much all the way back to 2021.
History has shown us that when inflation is rising, the Fed adjusts its plans accordingly and stock & bond prices retreat. The difference this time around is that 1) the market is trying to talk itself into the idea that inflation really isn’t re-accelerating and 2) the market is trying to talk itself into the idea that rate cuts are still a possibility. I think this is a big reason why the S&P 500 is still trading near all-time highs even though volatility is picking up and the potential tails in this environment are getting fatter.
I think the markets will soon find that inflation and the Fed are about to head on the same trajectory that they did in 2022. Does that mean I think we’re facing another 20-30% drawdown in stocks & bonds? Not at all. If it were to happen, I think it would be more likely to occur in stocks because they’re still priced for perfection. Valuations are still high and high yield spreads are still near historic lows. There’s a lot of room to fall based on those two factors alone.
But there’s certainly double-digit downside risk in Treasuries as well. A 50 basis point increase in long-term yields would translate to roughly an 8-9% in the iShares 20+ Year Treasury Bond ETF (TLT) and I don’t think it’s out of the question that the 10-year yield is on a path to blow through 5% if inflation keeps trending the way it has been. If the BoJ piles on, we could get to that level quickly.
Talking oneself into the Fed rate cut narrative here might be more comfortable, but realizing that the Fed, the Bank of Japan and inflation hold all of the cards right now is more realistic.