Sunnyside Up or Scrambled?

Plumbing:  The corners of the fixed income space are where institutions focus to see if the financial system is still working. A liquidity crisis in 2008 contributed to the equity freefall and the dislocation was illustrated by repo rates spiking. The repo market is the short-term lending window at financial institutions used to raise cash. Repo rates spike every April as people need cash to pay tax bills, and banks need to provide the necessary funds. But if the repo rates rise too quickly, it is a sign that liquidity is drying up. Last week, when fixed income investors signaled an impending liquidity crunch, the Fed had to mention they have various tools at their disposal to ensure the market doesn’t dry up, and more importantly, it caused the tariff pause announcement. We are watching that market to see if there will be more protracted de-risking in current portfolios. For now, everything seems stable, but that can change.

Asset Class Warfare

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Markets are sending out massively conflicting signals. Typically, economic data analysis lends clarity. Investors normally update their economic outlook when employment and inflation data come out, but now, such data is useless. Past data cannot be a guide to the future because it won’t impact future monetary policy. Markets must rely on investor, consumer, and business expectations for clues. Therefore, we need to focus on market prices, surveys, and insider activity. Consider the following:

·       The one month versus three-month VIX curve is inverted.

·       The inflation swaps curve is inverted from years one through three.

·       The 2-year 10-year Treasury yield curve is now the steepest it has been in over three years.

When fear rises, traders aggressively buy near-term put options on the S&P 500 Index because shorter term options are more sensitive to price changes. That pushes the level of one-month VIX futures above farther-out option maturities as a sign of investor panic. Once the inversion normalizes, it signals a market bottom is approaching. The last time the VIX curve was in this position was just before the major pandemic lows in March 2020. This is potentially a major positive.

The inflation swaps curve one year ago was basically flat from one-year through 30-year swaps, reflecting extremely well behaved 2.5% inflation expectations over a long horizon. About a month ago, one-year swaps percolated above 2.5% on tariff concerns. Since the tariff tantrum last week, one-year swaps spiked to 3.5%, with two-years swaps priced just under 3.0% and three-year swaps also above that earlier 2.5% equilibrium. That means investors expect elevated inflation through Q1 2026 and that it will take at least three years before it normalizes. Curiously, swaps of 5-year maturity and beyond have moved below 2.5%, as the market prices in slower growth in the very long term. This is the literal picture of stagflation. Unless both the short and long end of the swap curve converge back toward 2.5%, it will likely translate into depressed long-term profit forecasts that will weigh on stock prices.

The yield curve has steepened rapidly since the tariff announcement, which normally means investors expect higher growth or inflation through 2035. However, this move is different: it is being driven by fears over our deteriorating federal budget and diminished foreign demand, which will require higher 10-year Treasury yields to attract investors. Higher long-term yields also depress stock valuations.

Notably, last week’s NY Fed’s Survey of Consumer Expectations showed steady 5-year inflation expectations of 3.0%. That data will be sufficient evidence for the key trio of Powell, Williams, and Waller on the Federal Open Market Committee (FOMC) to keep rates unchanged at the March 5-6 meeting. It also helps for future decisions, because FOMC voters such as St. Louis Fed President Alberto Musalem have discussed that if a stagflationary condition arises, the Fed can only lower rates to support growth if long-term inflation expectations stay stable.

Fortunately, insider activity has been very favorable. The large companies that are reporting soon are prohibited from buying or selling their own stock before earnings, but many other companies are allowed to do so. Corporate insiders know their order books and market conditions better than anyone, and it’s a positive sign that insiders across all sectors are aggressively buying at these lower prices. 

Last week’s Pave Perspective discussed the 17-year cycle and the amazingly similar price pattern to the 2007 top. It suggested a two-week bounce that would start early last week before moving to new lows. There are enough positive signs in the market that a move below last week’s 4835 low should not be expected—therefore, if that does occur, extreme caution is warranted. Until then, there is hope that investors will join corporate insiders and start finding value.

Small Business Sandwiched

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While insiders at publicly traded companies are bargain hunting, small businesses are clearly worried about the impact of upcoming tariffs. In March’s National Federation of Independent Business (NFIB) survey, the net percent of owners expecting better business conditions fell for the third straight month and registered the largest monthly drop since December 2020. The headline Optimism Index saw its largest monthly decline in nearly three years.

Small U.S. companies do not have the luxury of having foreign subsidiaries from which to direct Chinese goods to avoid the 145% levy. Because tariffs are regressive taxes, small business owners operating in lower to moderate income areas are the most vulnerable because tariffs will hit their customers the hardest. Bank lending is particularly important to watch because banks are the primary funding source for small business. The NFIB survey reported loan availability versus three months ago is now as tight as 2022 when inflation was 7%.

The Federal Reserve’s next quarterly Senior Loan Officer Opinion Survey will be out in early May. It will be a particular focus of ours.

Unless the tariff outlook improves, small businesses are concerned about falling revenues or profits when they are forced to raise prices. This is reflected in the reversal in Hiring Plans that rose to three-year highs after the election but reversed in March to sit just above pandemic lows. This is a problem because businesses of all sizes have not been hiring, and small business represents around 65% of the demand for new workers. Small business owners are an important GOP voting bloc; given more favorable tariff news this weekend, perhaps small business complaints will generate further movement on trade deals.

Avoiding An Own Goal

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There is growing fear in fixed income markets that the era of strong foreign demand for U.S. government bonds is over. That buying was a major contributor to low long-term interest rates that helped U.S. growth. If foreign demand is permanently lower, it not only affects interest rates, but can depress stock valuations across the board. Maintaining foreign demand is critical as auction sizes will continue to grow.

Foreign capital has been flowing out of the dollar and U.S. Treasuries, the opposite of the norm when risk premia rise globally. The reason for this anomaly is that Washington is the origin of the volatility.

Thankfully, there is a path for repair.

The first step is not Washington laying down a pathway for negotiations with China—as important as that is—but to repair our relationship with Europe. Capital will not flee our borders if Europe sees us as being a dependable ally again. Furthermore, if there is a unified front between the U.S. and the EU, there can be significant trade progress when dealing with China.

Speaking of China, their $440 billion in exports still represents over one-eighth of our total import consumption. Given that Chinese imports will be taxed at 145% plus 10% from other countries, creates a blended tariff rate north of 25%. If we begin to see progress toward better long-term U.S. relations with European allies, we expect an eventual resolution to the stagflationary scenario of high tariffs, and investors will regain a feeling of optimism.

Words of caution: While the people around the president may understand the unintended consequences of the administration’s actions, the president may not. If this is a correct depiction of the atmosphere within the White House, then we may need to see more eggs get broken before responsible action is taken. If that is our path, investors will not be patient nor optimistic.  

What to Look for This Week

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(All times D.S.T.)

1.  Wednesday, April 16 at 4:00 p.m. February Treasury International Capital Flows. January net foreign purchases of long- and short-term securities, and banking flows saw an outflow of $48.8 billion in January. Net foreign official inflows were just positive at $26 billion. Foreign official institutions recorded net sales of $59.0 billion. The amount of global dissatisfaction with Washington may be quantified by the amount of government sales recorded in February. A large outflow could see Treasury yields jump higher given the upcoming record auctions.

2.  Tuesday, April 15 at 5:00 a.m. the April ZEW Economic Sentiment Index is released for Germany. German sentiment hit NY a three-year high in March on optimism over fiscal policy expansion. The degree of the recent tariff concerns will be reflected here.

3.  Tuesday, April 15 at 8:30 a.m. April’s Empire State Manufacturing Index is out, after falling to negative 20 last month, the lowest since May 2023, with new orders and shipments falling as input prices rose more than it had during the last two years. We are focused on the Prices subcomponent. Inventories also hit their highest level in two years. Thursday at 8:30 a.m. is the release of another April regional survey, the Philadelphia Fed Manufacturing Index. New orders and shipments also experienced sharp declines in March. Price paid (input prices) rose by the highest amount since mid-2022. We will look at the future new orders index, which dropped sharply in March.

FOMC Voters Speaking:  Light week for voting members. Wednesday April 16 at 7:00 p.m. Kansas City Federal Reserve President Jeffrey Schmid speaks with non-voter and Dallas Fed President Lorie Logan on the economy. Earlier that day, non-voter but hawkish Cleveland Fed President Beth Hammack speaks at noon. Both Hammack and Schmid join Governor Michelle Bowman as the most hawkish FOMC voters. Last week Schmid talked tough, discussing the need to possibly raise rates even if the economy slows to cap inflation expectations and maintain Fed credibility.

BoC interest rate decision is scheduled for 9:45 a.m. Wednesday April 16. Expectations are for no change in rates, but we will look at their Monetary Policy Report, and at 10:30 a.m. Governor Tiff Macklem answers questions from the press. 

Earnings Note: Tuesday, April 15 Citibank, Bank of America, Morgan Stanley. Wednesday April 16 Las Vegas Sands earnings guidance could be of interest about expectations for foreign tourism. Thursday April 17 Taiwan Semiconductor, Netflix, and homebuilder D.R. Horton.