Two-Year Notes in Turmoil

I was talking to someone uninitiated in finance the other day. She asked me if skyrocketing oil prices were having an effect on the stock market, and I said yes, but not in the way that you think. I told her that oil prices went up, which caused inflation expectations to go up, which caused central banks around the world (especially the UK) to get more hawkish, which caused short-term rates to skyrocket, which caused the stock market to go down. That is the more accurate version of the story.

About those short-term rates, and about the bond market—things are looking very tenuous. Around a month ago, I was writing about how quiet the bond market was. Not anymore!

Anyway, the reason I bring all this up is because novice investors are typically laser-focused on the stock market, but they generally have no clue about what is going on in other corners of the financial world. If you were trading short-term UK rates (which moved 110 basis points in a few days), you either had a very bad or very good week. I’m not much for putting charts in The Jared Dillian Letter, but the chart looks like a monstrous priapism. Are central banks really going to be hiking rates? They might. It was inconceivable just a month ago, or even a week ago.

I have a few insights on this. I think the Federal Reserve will probably not be hiking rates because Trump would have a cow. I mean, that might not stop the Fed, but the blowback would be enormous. But also, you’d have to believe that the Fed won’t hike rates with the stock market down close to 10% and the labor market wobbling, and you’d have to think that the Fed would at least wait a while to see if inflation was passing through… but yes, it is theoretically possible that it will hike rates. If it does, it will be a difficult adjustment for stocks, to say the least.

So far, the decline in stocks has been mostly orderly, except toward the end of the day on Friday when things started to get out of hand. Unlike last April, during the tariff tantrum, there hasn’t been anything resembling panic, and that’s what worries me. Volatility is a bit elevated, but like I said: pretty orderly so far. This leads me to believe that there is more downside in stocks, perhaps a lot more. Sorry. If you’ve been reading faithfully for the past few months, you know where I stand on the stock market. And once stress starts in one corner of the financial universe, it usually spreads.

There Are Other Risks

The war has done some damage to the stock market, but that is only the beginning of the problems. You have probably read about the issues in private credit, news flashes here and there about this fund gating redemptions or that fund gating redemptions. I want to communicate to you that private credit (and private equity) are systemic risks but nowhere near on the order of the financial crisis. If you were worried that a dislocation in financial markets could lead to a horrific bear market, it probably won’t happen. But it certainly won’t happen in a vacuum.

I spoke with some other initiated people last week, and they were asking me when a good time would be to buy stocks. I think that is the wrong question to ask at this point, but it is a reasonable question. If your life savings are in stocks and you don’t know about hard assets or real estate or bonds or anything else, then it’s reasonable to ask about when to buy more stocks. 

I’ll indulge the question and say that 6,300 in the SPX, 10% down from the highs, would be a good place to start, but that won’t be the ultimate low. The ultimate low will probably be around 5,600, or a 20% decline. The problem is that now, like in 2022, stocks and bonds are highly correlated, so there are no diversification benefits to investing in bonds. And to make matters worse, gold is now correlated to bonds and stocks. This has been a rough few weeks for The Awesome Portfolio. Really, the only place to hide has been in energy or a broad commodity index.

About those commodities. I can’t recall the specific issue, but I have written a bunch before about how commodities were undervalued relative to financial assets and how I thought it was probable, even likely, that we were on the cusp of a new commodity supercycle. Then gold went to $5,600 and oil went to $120, and the rest of the basket is starting to move. I was asked recently about the 1970s, and this is starting to smell like the 1970s, when nothing worked—stocks, bonds, real estate—except for commodities. We are there.

Speaking of The Awesome Portfolio, I wrote a book about it! It is coming out on September 8 of this year. I’ll do a formal announcement in the next few months, but for now, if you wanted to hunt it down on Amazon and preorder it, I won’t stop you!

Jared Dillian, MFA