Welcome to The Observatory. The Observatory is how we at Prometheus monitor the evolution of the economy and financial markets in real-time. The insights provided here are slivers of our research process that are integrated algorithmically into our systems to create rules-based portfolios.
Get key US macroeconomic and market research directly in your inbox.
Our primary takeaways are as follows:
● Bond markets continue to price in a path for monetary policy that is consistent with a recession and inflation at the Fed’s target.
● The latest inflation data suggests a stabilization of inflation, though at levels inconsistent with the Fed’s objectives. These dynamics make further hikes unlikely and will likely keep the Fed on pause.
● Nominal activity remains elevated, and liquidity conditions buoyant, which remains pressure on yields across the curve.
● As such, treasury markets continue to look mispriced relative to macroeconomic conditions, but opportunities are dwindling on the short side for slower-moving players, However, markets continue to discount a future dramatically different from the current pace of nominal activity, creating opportunities for tactical mean reversion.
● We see conditions slowly shifting to be more conducive to long bond positions in 2024, however, current market pricing remains a significant hurdle for these positions.
We show our systematic expression of these views, i.e., our Cycle Strategies, which have guided us through this inflationary period:
Our strategies have moved to remain flat on treasuries after showing modest losses in November. However, the opportunity set is shifting significantly.
We begin by decomposing price action before turning to fundamental conditions. Over December, treasury markets rose by 0.66%. Over the last year, our aggregate treasury markets have returned 2.52%. Below, we show the sequential evolution of returns:
For a more granular understanding of the most recent months’ returns, we perform an attribution of total returns coming from various maturities of nominal treasuries across the yield curve. Over December, treasury markets were positive across the board, with 20-30 Year treasuries contributing the most to strength, while 1-3 Year treasuries contributed the most to weakness. We show this below:
As we can see, there has been a uniform rally in Treasury markets over December.
To offer a bigger-picture view, we zoom out to show how aggregate treasury market returns have evolved over the last year and through history. As we can see below, over the last year, our aggregate treasury markets have returned 2.52%. The strongest component of the treasury market has been the 0- 1 Year tenors, and the weakest component has been the 20-30 Year treasuries.
To help better understand these moves in treasury markets, we decompose these returns into their constituent macroeconomic drivers. Our estimate of the weighted average maturity of outstanding treasuries is six years, making the 5-year note the best proxy to assess the impact of macroeconomic forces on the treasury market. Over the last year, growth, inflation, and liquidity have contributed -1.87%, 0.53%, and -1.53% to total treasury returns.
For a closer look at the current dynamic, we show the contributions to cumulative returns over the last year coming from our macroeconomic factors. Please note the sum of the various factors equals the total return on the 5-year note:
While our macroeconomic perspective is essential for us to understand what’s going on under the surface, mathematically, the single biggest factor that impacts nominal bonds is changes in discount rate expectations. Over the last month, short-term interest rate markets have remained unchanged. Over the last year, these markets have remained unchanged. We show the evolution of these expectations below:
To better contextualize these recent changes in policy expectations, we show the latest discount rate path priced over the next eighteen months. Short-term interest rate markets are expecting a peak in policy rates on Jan 24 at 5.33%, followed by a trough on May 25 at 3.82%. This implies approximately six interest rate cuts cumulatively over the next eighteen months. We show this path below:
For further insight into what markets are pricing for the expected policy path, we show market expectations for discount rates priced across the yield curve. Currently, 10-year notes are pricing four cuts, 5-year notes are pricing three cuts, and 2-year notes are pricing one cut:
As we can see above, interest rate cuts continue to be priced in across the Treasury curve.
Some parts of this pricing square with our assessment, and some do not. We think the recent moves in inflationary pricing in bond markets largely conform with our expected path from CPI. We share our tracking of the same before our synthesis. In November, headline CPI came in at 0.1%, surprising consensus expectations of 0%. Core CPI contributed 0.23% to this print, with food & energy contributing the remaining -0.13%. This point drove a deceleration in the three-month trend. Below, we display the sequential evolution of the data:
The primary drivers of CPI inflation are food, energy, transport, and shelter. These components have contributed 0.03% (Food), -0.16% (Energy), 0.1% (Transport), and 0.16% (Shelter), respectively. We display these contributions to the 0.1% change in CPI below:
For further perspective, we show how these areas have accounted for the majority of variation in inflation both economically and statistically. Over the last year, food, energy, transport, and housing have contributed 0.39% (Food), -0.28% (Energy), 0.49% (Transport), and 2.22% (Shelter), respectively, to the change in inflation. We display these principal drivers of inflation over time below:
We now zoom back into the most recent print. Inflation was somewhat mixed, with shelter contributing most positively and Motor fuel contributing most to weakness. We display the largest movers to the upside and downside below:
Above, we note the weakness in goods inflation along with energy.
We now zoom into our major categories of food, energy, transport, and shelter. For further perspective, we also show the evolution of food inflation over the last year, with the strongest contributors in shades of blue (Limited Service Meals & Snacks, Full Service Meals & Snacks, Other food at home) and the weakest in shades of red ( Dairy and Related Products, Food at Employee Sites & Schools, Meats, Poultry, Fish and Eggs):
Next, we turn to energy. The most recent data showed energy inflation was largely negative, with electricity showing the most relative strength and Motor Fuel showing the most weakness. We also show the contributions of these items to total energy inflation over the last year with historical context:
We now turn to transportation. The most recent data showed transport inflation was somewhat mixed, with Used Vehicles showing the most relative strength and Vehicle Fees showing the most weakness:
For further perspective, we also show the evolution of food inflation over the last year, with the strongest contributors in shades of blue (Vehicle Insurance, Vehicle Maintenance, and repair, New Vehicles) and the weakest in shades of red (Used Vehicles, Public Transportation, Vehicle Rental):
As we can see above, this area has begun to show a modest amount of reacceleration as used car inflation has begun to normalize.
We zoom in on new vs used cars below:
Transportation costs remain a swing factor for inflation relative to market expectations. Finally, we examine shelter, which is the largest driver of consumer inflation in the economy. We show the contributions of these items to total shelter inflation over the last year with historical context:
Overall, looking through the composition of inflation, along with its drivers, we see an environment where inflationary pressures have begun to abate, beginning with the price of goods:
We think it is important to recognize that it is highly anomalous to see sustained inflation in services relative to goods. If we continue to see goods deflation, we are likely to see further declines in services inflation over time. Our gauges have picked up on these pressures:
We note that they have shown modest increases in the recent past.
These dynamics lead us to believe that inflation will likely stabilize above target but lower than the current trend:
Thus, we think the decline in market-implied inflation measures squares with our observations. Additionally, our systematic expectations relative to what markets have priced show significantly less mispricing in the short-rate market than previously:
As we can see above, our gauges have gone from suggesting more cuts to be priced to now having none.
Now, while further declines in inflation and a modest expectation of policy cuts look warranted to us, the shape of the curve continues to look flat relative to liquidity conditions, driven by nominal GDP:
As we can see above, our estimates for where nominal yields need to be given the liquidity in the financial system continue to suggest a steepening is required. Below, we show our financial system liquidity measures, which continue to suggest elevated levels of liquidity:
Netting these dynamics, our systems stay flat on treasuries until we see an opportunity. This will either come via a significant shift in the path of the economy or a re-rating of what is priced into markets. We expect reality to be somewhere in between. Structural short opportunities continue to fade in bond markets, while fast-moving short-side mean reversion persists. Long positions are slowly beginning to gain attractiveness, but we wait for further signal. Time will tell. Until next time.