We have finished the trading day and there has been a noticeable shift in the short-term flows for risk assets. Additionally, bonds rallied on the PCE print which came out above expectations.
In the write-up, I am going to break down the price action we saw this week specifically from the GDP print and PCE print. I will then show how this contextualizes the risk-reward of assets as we move into FOMC next week.
Side note: If you are new and trying to wrap your head around how macro works, go through the following steps:
Step 1: read ALL the articles in the research synthesis: Link. This is a comprehensive list of primers on every aspect of macro and how it connects to each asset class.
Step 2: Begin making a list of all the processes, models, or frameworks you need to build out. This will look different for each person because everyone has a different role in the market or economy. Macro impacts everyone but each person needs to determine HOW they are going to manage their exposure to macro changes. If this is daunting, check out this podcast I did on this topic: Link.
Step 3: Begin the incremental process of innovating, systematizing, and running, as I laid out in the very first article: Link. It doesn’t matter where you are at, you need to employ meta-level thinking for your actions in life so that they intentionally build on each other.
If this seems like a daunting task, that is ok. Anytime you encounter something difficult, you know that the amount of people who make it through shrinks exponentially. This is the process of acquiring specialized knowledge.
When you encounter something hard, just say GOOD and move forward with focus and intentionality.
The Big Picture:
I have consistently and comprehensively laid out the big picture for macro. You can find all of the research here:
One of the things I laid out very clearly in the macro report on June 28th was that the 2-year rate was moving DOWN (link):
I then further broke down this view in the interest rate report framing how duration was directly connected to my view on the short end:
We have moved down considerably within the risk-reward I shared:
Think about WHY this is the case? Well remember that the Fed Funds rate has been held ABOVE the inflation rate for a considerable period of time now:
The Atlanta Fed GDP-nowcast hit almost 6% in 2023 and the resilience in growth is what allowed the Fed to hold rates elevated for this long.
As we moved into the beginning of 2024, inflation came in above expectations marginally which gave them further reason to hold rates at an elevated level:
We are now in a period of time where growth is lower than 2023 but not in contraction. Additionally, inflation is decelerating and likely to hit the 2% goal of the Fed in 2025. As a result of this, the Fed is in the process of beginning rate cuts.
The main distinction you need to keep in mind surrounding this is that duration risk and credit risk are two distinct dynamics.
Duration Risk: Duration risk primarily addresses how changes in interest rates impact the present value of future cash flows from fixed-income investments. It highlights the sensitivity of a bond's price to interest rate fluctuations, reflecting the time value of money. Bonds with longer durations are more exposed to this risk because their cash flows, spread over a longer period, are more significantly discounted when interest rates rise, leading to greater price volatility.
Credit Risk: Credit risk centers on the uncertainty surrounding the actual receipt of future cash flows promised by a borrower. Unlike duration risk, which deals with the time value of money and interest rate sensitivity, credit risk is concerned with the borrower's ability to make the scheduled payments. This risk underscores the potential for default, where the anticipated cash flows may not materialize at all, impacting the lender's or investor's expected returns.
While duration and credit interact dynamically and are connected within the economic and financial system, they are fundamentally two distinct things.
Why does this distinction matter? If the Fed begins lowering interest rates, the direction of asset prices is dependent on if this taking place into high credit risk or lower credit risk.
Think about it like this, there are 4 possible scenarios for these things to take place:
Increasing Duration Risk with Increasing Credit Risk:
In this regime, both interest rates and credit concerns are rising. This situation is particularly challenging for bond investors, as the increasing duration risk means bond prices are falling due to higher interest rates, while increasing credit risk indicates a higher likelihood of default, making the bonds even less attractive.
Increasing Duration Risk with Decreasing Credit Risk:
Here, interest rates are rising, increasing the duration risk and causing bond prices to fall. However, the credit risk is decreasing, meaning the likelihood of default is lower, which can partially offset the negative impact on bond prices as the issuer is seen as more creditworthy.
Decreasing Duration Risk with Increasing Credit Risk:
In this scenario, interest rates are falling, reducing duration risk and causing bond prices to rise. At the same time, increasing credit risk suggests a higher chance of default, which can negatively affect bond prices despite the favorable interest rate environment.
Decreasing Duration Risk with Decreasing Credit Risk:
This is an ideal scenario for bond investors, where falling interest rates decrease duration risk and boost bond prices, while decreasing credit risk lowers the likelihood of default, further enhancing the attractiveness and value of the bonds.
We are in a constant state of uncertainty regarding BOTH duration risk and credit risk. Global macro is about constantly mapping BOTH of these dynamics via growth, inflation, and liquidity.
Where are we in these regimes? We are in a period of time where inflation is falling, growth is positive and the Fed is in the process of beginning to cut interest rates. This means duration risk is decreasing and credit risk remains low on a cyclical basis.
This brings us to the price action and data releases we saw this past week. Additionally, it contextualizes WHY I am running the trades I have on.
Price Action This Week / Trades:
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