October 30, 2023Scroll down
The CIO’s Take:
The NASDAQ and S&P 500 fell into “correction” territory last week, with both markets down significantly since long-term bond yields surged toward 5%. Ironically, the very catalyst for a stock market sell-off is being tipped by some as investors’ salvation, as skyrocketing yields show unequivocally that Fed policy—and expectations for its trajectory—are having an impact making conditions more restrictive, which could hasten the pivot to easing. In comments to the Economic Club of New York last Thursday, Fed chair Powell indicated the stress induced by rising market rates gets us closer to “mission accomplished,” though he also made it very clear there was scope for further hikes if the data don’t corroborate continued disinflation. Despite some well-known bond bears’ call for a rebound in long-term bond prices, we still don’t see this as the time to buy and expect it will take something considerably more disruptive than what we’ve seen so far to get the Fed easing: a view which supports maintaining our risk-off posture.
Powell’s speech hints at November decision
Last Thursday, Fed chairman Jerome Powell spoke at the Economic Club of New York, representing his final public remarks before the US central bank’s next policy decision, slated to be announced on November 1st. After the FOMC took a pause from raising rates at its September meeting, markets are trying to assess two things: First, does the current level of policy rates mark the end of the road for a tightening cycle that has seen the Fed Funds rate soar by 525 bps since March of last year—or are we in for more hikes? Second, when might we expect the Fed to pivot and begin easing? Cutting to the chase, our read on Powell’s speech is that November will be another pause—the “totality of the incoming data” isn’t hot enough, in our view, for the Fed to move at this meeting—but the Fed chair was absolutely explicit that macro developments “could warrant further tightening”, and we’re not ruling out another hike by early next year. We certainly don’t see rate cuts until late-2024 at the earliest.
Rising yields could stop the Fed hiking
One interesting point Powell made during his remarks to the Economic Club that we don’t believe enough investors appreciate is that financial conditions can tighten without the Fed actually raising rates. That’s because many factors beyond explicit policy actions—from expectations about future Fed moves to conditions affecting the supply of government bonds—have an impact on yields, and high market interest rates are ultimately what lead to the “downward pressure on economic activity and inflation” Powell and his colleagues are trying to achieve. As everyone’s been talking about over the past few weeks Treasury yields have surged, with the 10-year topping 5% in recent trading. Average 30-year mortgage rates, likewise, keep rising and are now closing in on 8%. Powell suggested in his speech that cripplingly high yields speed our arrival at “sufficiently restrictive” policy and could preclude further tightening.
But are conditions really tight enough?
Unfortunately, taking a look at the Fed’s own National Financial Condition Index (see below), it’s neither clear to us (a) that we’ve reached peak policy rates, nor (b) that the path to easing will be a quick one. Since the Global Financial Crisis (GFC), financial conditions have been remarkably loose. The early-2020 COVID outbreak represents but a brief spike, quickly resolved through massive monetary and fiscal stimulus. Beginning in 2022, Fed tightening got conditions on a different trajectory, with restrictiveness peaking in October of that year, jumping again around the US banking crisis in March of this year, but drifting down since then. As such, it’s easy to imagine the Fed hiking once or twice again before all is said and done or, at the very least, letting the economy stew a bit longer in the moderate level of tightness prevailing today.
Of course, there’s another scenario in which rates come down quickly: The lagged impact of past tightening continues working its way through a system rife with post-GFC and pandemic-era imbalances. Something breaks, and the Fed is forced to come to the rescue, easing quickly and putting us right back into the zero interest-rate policy trap. Clearly this is not an outcome investors would cheer—though we unfortunately see it as being quite realistic as a potential ending to this cycle, which helps to explain our cautious positioning at the moment.
Two Bills get less bearish on long bonds
Last week, two big guns in the bond market—famed hedge fund manager and activist investor Bill Ackman, along with Bill Gross, the former head of bond powerhouse PIMCO, still known as the “Bond King”—decided it was time to stop betting against long bonds. Ackman tweeted on Monday that he had closed out a short position in US Treasuries, betting yields would go way up, sending prices way down. His trade, disclosed in August, yielded a massive profit, but Ackman apparently feared there was more downside than upside for yields going forward, explaining that he saw “too much risk in the world to remain short bonds at current long-term rates.” In other words, a flight to safety might lead investors to pile into Treasuries, pushing the price up and yields down, and leading to losses for bearish trades. Gross likewise tweeted on Monday that he saw potential for long-term Treasuries to rally, though his rationale was that the US is rapidly closing in on a hard landing, with a recession he expects to hit in Q4. Perhaps taking heed of these veterans’ shifting sentiment, after briefly crossing 5% on Monday, Treasury yields slid to close significantly lower (see below).
Despite bonds’ reversal, not bullish yet
In what could be a sign of the action to come, after Monday’s drop in long-term bond yields, the rest of the week saw significant volatility, with the 10-year yield nearing 5% again on Thursday morning before falling later that day to just around 4.84%, near where it closed on Friday. Such turbulence can arise when there’s increasing disagreement among market participants, and it’s easy to see both the long and short case here: the temptation of buying long-term bonds and locking in close to 5% yield, versus an inclination to play the trend and copy Ackman’s bearish trade. It’s also not surprising to see some psychological resistance kick in at the 5% level: a very “round” number, indeed, for those keen on technicals (though if past prices tell us anything, it’s worth noting the 10-year yield has closed above 5% at some point during each rate cycle of the last 40 years). While we think sentiment and technical indicators can be especially helpful in the short-term, our long-term view is ultimately predicated on fundamentals. As long as supply-side issues we’ve discussed before put downward pressure on prices, and given the Fed’s desire to stomp out inflation, we still don’t see this as the moment to buy—though we are watching every day for a disruption that could lead us, too, to lock in those higher rates.
Chevron and Exxon get acquisitive in October
Last Monday, Chevron revealed it had entered into an agreement to buy US exploration and production company Hess in exchange for $53 billion in its stock. The acquisition expands its US oil and gas holdings, though the real rationale for the deal appears to be nabbing Hess’s stake in competitor Exxon Mobil’s discoveries in Guyana. Those fields are considered one of the most significant finds in decades, are expected to more than triple in their output over the next few years, and were recently described by a Capital One Securities research note as “by far the crown jewel in the Hess portfolio.” Earlier in October, Exxon had announced its own mega-deal, a $60 billion purchase of Pioneer Natural Resources, reinforcing its dominant position in the Permian Basin, spanning Texas and New Mexico. Against a backdrop of tight energy supplies and oil prices trending upward—developments about which we’ve been writing bullishly for some time in Perspectives—two massive mergers like this provide some validation that industry insiders see big opportunities in this space going forward.
Deals offer clues on changing industry trends
In fact, there are other interesting aspects of these deals for investors in the sector. Both sellers opted to exit with their stock prices hovering near record highs, though both also opted for all-stock transactions. There are tradeoffs in that approach, of course, as neither Chevron or Exxon agreed to a big premium, buying for 10% and 9% over Hess’s and Pioneer’s pre-announcement prices, respectively, versus an average premium of over 26% since 1998, according to Bloomberg. Moreover, an all-stock “fixed-exchange” deal exposes Hess and Pioneer investors to fluctuations in the price of Chevron and Exxon shares before the deals close, creating significant risk in coming months. These mergers also speak to changing dynamics in the oil and gas sector, which once prioritized growth and potential jackpot payoffs from successful drilling ventures, but have increasingly shifted to meet investors’ desire for a stable, profitable stream of cash flows marked by dividends and share buybacks. That could incentivize more exploration-focused players to sell out to larger, more diversified companies with integrated business spanning drilling to gas pumps. With a continued push toward ESG, lack of investment in recent years, along with plenty of geopolitical risk and upside surprise potential in global demand, we continue to view the space as quite interesting for stock pickers—as these deals illustrate.