Sunday, January 12, 2025

Breakouts or Fakeouts

In the process of rewriting the next article in my series, it expanded into a 43-page whitepaper that I’m keeping private until I figure out how to proceed because I’m moving forward with it as the new direction in my life. 

In the meantime, despite my intention to not write about markets anymore, I’ve been forced into my Rethink Room by this move higher in yields to determine whether my view that a hard landing is inevitable is early or whether my entire worldview is wrong. In the process, I’ve come to the conclusion that I’m early and a soft landing is impossible, but I will point out the one variable that would make me change my mind. For the people who are like “hard landing?- we just had blowout jobs numbers - what is he talking about?” I’m referring to structural flaws akin to termites gnawing away beneath the surface. 


At the core of the hard landing question is whether or not we entered a “post Covid, post QE” new world or whether we’re still in the old world and nothing fundamentally has changed. As you will see, I believe the answer lies in whether or not there will be a gap in time before the real, game changing AI innovations cause a lasting economic boom similar to the internet. Getting that right is likely to be the key variable. 


First, if you believe we are in a new “post Covid/QE” world, then what you are saying is QE worked and it was an effective tool to bridge the broken economy of the GFC with a new economic frontier that is strong, sustainable, fully healed, and will no longer need assistance. For example, the last time we had this level of debt/GDP was post WW2, which involved a prolonged period of Fed/Treasury financial engineering followed by a sustained period of innovations that created everyday goods, produced jobs, and improved efficiency, particularly household appliances, radios, TVs etc... The financial engineering of that era was the government reaction function to keep the ship from sinking to bridge the economic hardship with the new frontier that surely awaited - they hoped (and they were right). The everyday innovation era that followed was how we organically grew our way back to a manageable level of debt relative to GDP, but the most important variable of that era was that we manufactured all those integrated-in-our lives goods ourselves. 


In our current environment, the shining ray of hope is AI and the renewal of our energy infrastructure it necessitates to process all the data. However, thus far, the only innovations out of AI have been more like an assistant for already existing products and services. Whether that and the energy transformation for the data processing is enough economic growth IS the core of the question of whether we’re in a “post Covid/QE” world or not because if it’s enough, then rising yields will be sustainable by a lasting economic boom created by the proliferation of these new innovations, therefore the deficit can be reduced without any adverse effects of hurting demand since private sector activity will rise as gov’t intervention falls and our debt/GDP can be reduced over time similar to post WW2. However, if these AI innovations are not enough, then rising yields will expose a still broken economy by squeezing the profit margins of businesses and the discretionary income of consumers as both are forced to maintain, roll, or initiate new debt at higher rates, which will cause an economic contraction that leads to declining earnings and layoffs in a downward spiral of recession. 


If the AI innovations of today are enough of an economic engine for The Great Handoff from gov’t dependency of the last 15 years to private sector flourishing, the equity market might sell off to price in a higher risk premium to compete with treasury yields, but it will stay contained to a correction. If the AI innovations are not enough to sustain The Great Handoff, then an equity market selloff will likely lead to a bear market and the deflationary effect of falling asset prices will cause more Fed and Treasury intervention and reveal that we’re still in the same pre-Covid world of QE supported markets - for now. Any notion of an in-between won’t last long - it will ultimately be one or the other. We’re either in a QE-is-still-necessary-world or we are in the early stages of The Great Handoff. 


Another consideration is that yields are not rising because we’re in the midst of the real economic expansion of The Great Handoff, rather, it’s an unwind of Yellen’s yield curve control in anticipation of Bessent’s coming attempt to normalize issuance back toward the long-end, so the question is: did Yellen shorten duration for political reasons (or whatever excuse she makes), or was there a bond auction or two that made her nervous? Meaning, it’s quite an assumption to think the long end can absorb all the issuance that’s built into mandatory spending over the next decade. What if it’s not possible to normalize duration? This too begs the question of whether we are in a new “post Covid/QE” world because if the private market can’t absorb the issuance, or they demand a yield the economy can’t handle, then we’re not in a “post QE” world because the Fed will eventually be forced to monetize that debt, which will happen as a response to a deflationary recession with falling equity prices leading to layoffs and reduced consumer spending etc.. 


This idea of the Fed being unable to save the equity markets due to inflation is only valid at the top of a bull market because this economy is so financialized, when the stock market is getting crushed, inflation expectations will be too. This is a key variable the inflationists got wrong for a decade: QE does not inflate consumer prices - it inflates asset prices. However, as Jim Bianco points out, after every recession the world changes in some way. I believe what changed this time is they figured out how to cause inflation by sending insane amounts of money directly to consumers, so if that is the form QE takes, then most likely we’ll see a repeat of the last few years, but at some point the long end is not going to fall for it, so the Fed will have to pin the long end and raise rates on the short end to dampen demand. This is too far ahead. There’s plenty that can go right to avoid this. 


The main way to avoid that recessionary scenario is if the AI innovations create enough real economic growth that it leads to rising tax receipts, real economic expansion, and an ability of the private market to absorb a normalized duration issuance (of a path of spending that goes straight up - without a recession), which will then allow deficits to be reduced as The Great Handoff lifts us to the fabled soft landing glide path higher. (btw, this is how I define a soft landing - it's a complete exodus of gov't intervention like the post WW2 era).


Here’s the key variable, though: the reason I worry about a gap in time that prevents this is because I'm assuming in order for AI innovations to have a similar post WW2 effect they’ll need to be actual everyday products in our lives like robots and robotaxis, and virtual reality devices as contact lenses etc., which requires solving AGI first. This is the crux of the issue. There’s no Great Handoff to a new “post Covid, post QE world” unless it’s driven by genuine economic innovations that allow deficits to be reduced and higher yields to be sustained broadly without adversely affecting earnings that leads to layoffs. The question is whether or not the economic activity from the evolving AI developments along the way to the everyday integrated-in-our-lives innovations of the future is sufficient, or whether there’s a gap.

 

The same applies to energy. The planned nuclear sites are solely for data processing and will still take 5 years, so is the economic activity from the investments in energy infrastructure sufficient to broadly absorb higher interest rates, even though there will likely be a greater demand on energy than available supply during the process, which should cause energy prices to rise and squeeze discretionary income etc...  I’m referring to electricity more than oil or natural gas, although, rising oil prices due to geopolitical tensions if Trump can’t end the war on day 1 certainly needs monitoring. 


I am not surprised we didn’t have a recession for the last two years because the stimulus put the consumer in good shape, but I am surprised we still have rising yields and strong jobs and increasing inflation expectations. The call of the inflationists and bond bears for a resurgence off the lows was the correct one, especially heading into the first few months of the year and possible tariffs. But now we’re back to the key question regarding inflation: is it self-fueling? And I adamantly, table poundily say it is not. The reason is because unlike a deflationary mindset that doesn’t require anything else, an inflationary mindset is meaningless without money. It requires money. If the consumer has no stimmies and they hit their credit card limits, there’s nothing left to spend. 


I wrote thousands of words on this, so I will sum it up succinctly as follows: Wall Street has co-opted the term inflation to mean rising consumer prices, which is inaccurately misleading because it combines both supply side and demand side causes into one concept, but they have opposite economic effects. I understand the horse is out of the barn on the semantics, so it’s your job when someone says inflation and they’re referring to rising prices to translate it in your head to distinguish whether they mean actual inflation which is more money than available goods that leads to an economic boom for as long as the money is flowing, or supply side causes like rising oil or interest rates or tariffs which leads to an economic contraction from squeezing margins since it lacks the monetary expansion to pay for the rising prices. 


Obviously, Trump is wrong that tariffs are a tax on the other country, but a lot of people have been calling it a tax on consumers, which assumes the business can pass it along. If you’re thinking on the level of general economic concepts, you are not operating on the transactional level where every business has different pricing power, market share, and balance sheets, so each business will have to independently decide how much they can pass along without hurting their own sales, and how much they have to absorb, which will force them to trim other expenses to make up for it. 


Since a feature of our system is the constant changing of the guard, overseas businesses can also choose to pivot to other markets or wait out the Trump presidency and NOT move back here, which is yet another assumption people are making. They're assuming a business doesn’t have other options and Trump can pull a bunch of levers and make them do what he wants when the reality is that an irreversible global system is emerging, driven by technology, and a carnival barker with an idea that would have been great in 1994 is not going to stop it. By the way, if tariffs were erected in 1994 it would have had the same effect as gold, meaning, it was only a matter of time before the pressure from companies with global ambitions pursuing their own self-interest would have broken the restraint of tariffs and we’d be in the same situation today. It’s remarkable how many people willfully choose to ignore that it's not in the best interest of these overseas companies to come back here when cheaper locations with policies lasting more than four years exist. Maybe everyone calling for deglobalization can gather the millions of people who lost their jobs and lead a rally on the Atlantic coast so you can keep promising the ships with all the manufacturing equipment coming home to restore their jobs are right over the horizon.


A global interconnected system of technology is the force in charge. 


Let’s look at some charts.  Are these breakouts or fakeouts?  


SPX is not only forming the dreaded head and shoulders pattern, it’s on the edge of breaking out to the downside. To be fair, when a technical pattern like this fails, it tends to be a great signal in the other direction, so it’s not over yet, but there’s so much uncertainty ahead and so many things that can go wrong, and this is exactly what a top would look like, so it should at least have everyone’s highest attention, especially since the first few months of the year have tended to run hot on CPI as yearly prices reset. A completion of this pattern would be the first lower low since the Nov 23’ backtest reversal off 4200 (a lower low meaning a pullback that didn’t make a new high - this one retraced 78%).


IF stocks break down, particularly if it happens on a hot CPI that causes yields to rise (that’s 2 IFs), the equity market will shift to a mindset of selling the rips and it won’t stop until the downtrend it creates is definitively broken and becomes an uptrend again. All the thoughts I just wrote about and all the thoughts in your head will evaporate into the arbiter of truth: price. If you think about the nastiest thing that could happen, it would be two days of rally back into range and then a terrible last 3 days closing the week with a clear breakdown bar. If the market isn’t ready to fall, this week needs to be a banger to the upside to shift the whole psychology of it morphing to the dark side. The question is: if Yellen’s yield curve control and Powell’s pivot allowed stocks to rally this much, what does the unwind of YCC and Powell’s pause do?  Or will optimism over the coming policies mute these concerns? Just asking questions. 





GOLD - it is exceptionally interesting that gold and silver rallied WITH yields and solid data. What this means, to me, is that either gold is not a believer The Great Handoff is underway and we’re still in the old world, so rising yields means an eventual breaking of the economy that will cause a collapse in yields and more QE, or it was a market-maker-conventiently-disappeared-for-the-morning fake out.


Gold is currently trying to break out of this triangle, but if the CPIs are hot, it could rather quickly retest the lows. If gold and silver continue ignoring hot data and rising yields, look out when they break the economy.  I'm thinking if gold gets killed on CPI, I’ll be looking for a breakout of this triangle from the bottom, or seeking a therapist if it breaks down from there.  





10-YEAR YIELD - while I expected a bounce in yields at the first rate cut in September because that’s what happens every time, I thought yields would be contained by the down trendline, which is clearly wrong, so wrong in fact that it prompted the rethink that led to this article (remember, I’m not writing these anymore). I don’t have a level that would interest me in duration, but if the combination of an economy that won’t quit + deficit spending + tariff fears + normalizing issuance somehow causes a 6 handle I don’t see why I’d ever take risk again, except for the fact that equities would be so cheap I don’t see why I’d ever own treasuries again. I’m trying to be as open minded as possible to the outcomes, given Trump’s policies. 





OIL - This is also testing an important trendline. If the economy defies all headwinds and remains strong, and oil breaks out, it will become yet another test of the economy’s resilience. Meaning, I can justify no recession when consumers and businesses had stimmies to offset rising prices, but if rising energy and rates still have no effect, then I would be forced to consider whether QE worked and the new frontier of AI innovations and The Great Handoff is here. That would be a complete letting go of the inevitability of a debt/currency crisis. I honestly cannot imagine this as possible at the moment, but that’s what it would look like. 





Anyway, those are my thoughts in the most dispassionate expression possible. The timing would be nice, but it’s not as important as understanding the forces at work and having the patience to wait for it to play out, and, of course, recognizing what will prove you wrong. I’ll put a number on it: if the SPX touches 4450, then it’s not a new world, although still debatable, but if the SPX touches a deep 3 handle anytime in the next few years, it’s the same old QE world and nothing has changed. I'm trying to be done with these, so best of luck to you.