Markets have been very bullish over the last 6 months, with stocks and bitcoin up big and even Gold having an almost 20% rally of its own. But the question now is whether or not this rally can be sustained, especially considering a few macro tailwinds that are now shifting into headwinds.
Being in such a good market, a big mistake that many investors and traders make is falling into the trap of confirmation bias. Simply put, they come to a conclusion and proceed to only look for information that validates it. On the other hand, the great investors are always thinking from a risk management standpoint.
For example, we’re currently in a bull market and we’ve seen outstanding returns since October, at this point many investors get overly excited and begin increasing their risk exposure while acting outraged at any bearishness.
We don’t want to fall into this trap, so our goal today is to analyze the risks that are beginning to poke their ugly heads, so we can vigilantly monitor any shifts into a more risk-off market structure.
The Current Macro Outlook
Over the last 6 months or so, the key drivers of this rally have been:
- Stabilizing inflation,
- A reversal in yields,
- Above-trend GDP growth,
- High expectations for 3 or more rate cuts in 2024.
The issue is that we are now beginning to see these bullish catalysts unwind themselves, along with some geopolitical tensions that have begun creating more uncertainty in the market.
Among these market risks are:
- Inflation remaining stickier than expected
- Increasing treasury yields and less favorable liquidity conditions
- Signs of a weakening labor market
This could put the market in a scenario where it is forced to recon with slowing growth on one hand and sticky inflation on the other hand. This would mean heightened volatility for risk assets.
Inflation
The disinflation trend is beginning to dwindle as the consumer price index – among other indicators – is sticky above 3.2% YoY and has even inflected up in March. With 3 hot reports in a row, the CPI is signaling a trend in the wrong direction, which could even be exacerbated by the escalating geopolitical tensions in the Middle East.
If we look at the Consumer Price Index (CPI) you’ll see that it has recently hit its historical average which has acted as an inflection point. While the rate is getting back near the Fed’s target of 2%, we are now entering the period where we need to get from 3.5% to 2%, which is going to be much more tricky and volatile than the path from 9% to 4%.
One important pattern to note is that based on every inflationary period in recorded US history, the risk of a resurgence cannot be discounted, as every other time inflation has gotten above 6% once, it was followed by multiple accelerations. That being said, the good news is that while inflation remains sticky, there currently isn’t a high probability that we will see it reaccelerate to 2022 levels.
Market Liquidity
Another risk that we’re keeping an eye on is liquidity and bond yields.
The US Government has a major debt maturity this year which they’ll have to roll over at much higher interest rates. To make matters worse, Japan and China are buying less treasury debt, and the Federal Reserve is currently still reducing its balance sheet.
To put this in perspective, the Treasury sold almost $3 trillion in debt securities in 2023, but due to the combination of debt payments, deficit spending, and over $7 trillion in maturing debt, the US is projected to sell more than $10 trillion of new debt securities in 2024, more than triple that of 2023. Unless the Fed decides to stop Quantitative Tightening, liquidity conditions from the US may see some headwinds.
To put it in more simple terms, the U.S. government will not only be selling trillions in new treasuries at higher yields but there is currently less liquidity to buy this debt. This situation could mean added upward pressure on yields.
The one positive thing to note is that China has very ambitious economic goals for 2024. This being the case they’re continuing to pump major amounts of liquidity into the global economy, which should continue to help global liquidity and could dampen the negative impacts on U.S. liquidity conditions.
A model that we’re currently using to monitor US liquidity conditions is U.S. Net Liquidity, the purpose of this model is to track how much liquidity is being injected or extracted from the financial system via the Fed and US Treasury.
To Calculate this we simply take the Federal Reserve balance sheet and subtract the Fed’s overnight reverse repo facility and the US Treasury general account.
As you can see it is currently still in a slow but steady uptrend, despite the Fed having been reducing their balance sheet. This is simply because the government has been spending so much money over the last few years that it has essentially made up for the Fed’s Quantitative Tightening.
If we begin to see this or other liquidity indicators begin to roll over that would be a factor that compels us to move forward with extra caution.
Unemployment
The Sahm Rule is an economic indicator that detects recessions based on the trend of unemployment. It works by taking the average unemployment rate over 3 months and compares it to its lowest point in the last year. Simply put if the unemployment rate over a three month period goes up by at least 0.50 percentage points from its lowest point in the past year, it indicates that the economy is either in or near recession.
Recently the Sahm Rule has been inching closer to recession territory. The good news is that it hasn’t been a definite trend as it moved down Oct – Jan. However, there are significant risks in the labor market and this is something to keep a very close eye on.
A dangerous scenario that could be playing out is unemployment continuing to rise while at the same time inflation and interest rates remain higher. This would essentially squeeze fed between their dual mandate of maximum employment and stable prices, putting them in quite a tough spot.
Do they A) cut rates to save the economy and risk causing even more inflation or B) hold rates – or even raise – rates to hopefully keep the cap on inflation which would further damage the economy.
If this situation continues trending in the wrong direction, the US economy would be in a lose lose scenario.
The Ideal Scenario
The ideal scenario for risk assets would be that the job market stabilizes with the sahm rule remaining below the 0.5 level. Inflation needs to remain stable at its current level while slowly trending towards 2% likely getting there in mid or even late 2025.
Third is continued strong growth in the economy. Importantly note that currently, economic growth is above trend. Hence, as inflation trends towards 2% territory, it won’t be concerning to see economic growth also slow slightly as it comes back towards trend.
Our Outlook
We have been in a relatively flat market structure for the last month as markets have begun to realize that they won’t get the 7 rate cuts that were originally anticipated for 2024. While the current sell-off has been partially driven by sticky inflation, the main catalyst has been uncertainty around the escalating geopolitical tensions in the Middle East.
Our current expectations are that this will be a short-term move and aside from a few hedge positions and buying the dip, we aren’t trying to trade around it much as it’s impossible to predict what will happen next. Many times these conflicts cause fast sell-offs that quickly reverse themselves. Considering how oversold the market has gotten in such a short period of time, there is a good chance of a reversal as long as the geopolitical situation doesn’t worsen.
In the medium and long term, we’re still risk-on. unless we begin to see inflation reaccelerating or economic growth and employment begin to deteriorate, the market still has room to move higher. Our long-term thesis is still that we’re in the early to middle stages of a 4-year business cycle and in the latter stages of a long-term secular bull market.
Bitcoin has essentially been range bound for about a month and a half. Our expectations are still that its short-term holder realized price continues to act as support at around 56k.
A move below STH Realized Price would signal that short-term holders are no longer defending their cost basis and that Bitcoin is back in a sideways or bearish market structure. The most likely scenarios are that Bitcoin either breaks out of the current range straight to new All-Time highs or we could see it dump to around 56k or 57k to shake out the weak hands before moving higher.