Say Hello to 2024 and Say Farewell to “T-Bill and Chill”
It’s time to welcome 2024. There’ll be plenty to love about the year ahead. Things like watching the kids around us grow into better adults than we are. There are also reasons to think 2024 might be a bruising one. We enter this new year with much unfinished business, geopolitically and domestically. On the geopolitical front, we now have two hot wars with direct implications for the modern international order, in addition to the pain and destruction that all wars level on people no matter how they rank on the geopolitical Richter scale. Domestically, we get to crack the book back open on who the world’s leading democracy wants to be for the next few years. If recent events are any indication, we have work to do to prove to others and to ourselves that we are up to the dual task of self-governance and of global leadership. In the meantime, casual observation suggests that 110% of Americans are dreading the upcoming presidential election. OK, fine, obviously 110% is not a real statistic, but actual recent polls that don’t “give” warm and fuzzy either (as Gen Alpha humans say).
On the year that’s behind us, I will spare you the play by play, but it was quite the year to keep up with (see here for John Authers’ recap of what we thought would be but wasn’t). Ultimately, 2023 can be summed up like this:
We had a banking crisis that took down household names (in some circles) but did not snowball, despite the fact that it “had potential.”
Inflation came way down significantly (though prices are still way up relative to the “before times”).
The US economy avoided a widely-predicted recession. In fact, the economy has remained very healthy despite being hit upside the head by the Fed.
The stock market delivered solid returns on the back of seven companies (which is not a large number relative to the 500 or so companies that make up the S&P 500), but who’s to look a gift horse in the mouth?
The bond market delivered pain to investors for months (This reference to long bonds as a “wealth incineration machine” by Jim Bianco here in early November will go down in history as the turning point) right until it staged an historic rally in a matter of roughly two months. Ultimately, the 10-year US Treasury yield managed a near perfect round trip, ending 2023 where it had ended 2022.
The graph below puts it all within the context of recent history (As an aside, just take a look at 2008 for reference. It may come in handy later: no inflation, interest rates way down, and the stock market… well, you know what happened to the stock market in 2008).
Let’s pause on the bond market for a second, because that’s the whole story in one place. Since peaking in late October, interest rates have declined significantly and very quickly. In the graph below, the red dots are yield declines over November alone. All longer-dated rates (5 years and longer) came down about half a point (0.5%) in a single month. Compared to all the other months going back to 2000 (the black dots all nicely lined up), this was a very large move down. The same happened again in December, making for two historic yields declines back to back. As a result, the dislocation that was present at the long end of the curve then is largely gone, making for very nice gains for those who’ve held long bonds through the rally.
All in all, the long end of the US yield curve is where it was a year ago, after coming down significantly from where it stood just three months ago (the orange line in the graph below).
Why so much falling, you ask? The answer: The Fed. Between November and December, the Fed concluded that the war on inflation had been won. We’ve been spared the “Mission Accomplished” banner, but not much else. And if the Fed doesn’t need to raise rates to fight inflation anymore, then the next move must — whenever it happens — be down. Since financial markets are a discounting machine for the future, if the future is a bunch of rate cuts, then bonds don’t have to wait until those cuts happen to reflect the anticipated moves. Yields go down today, and bond prices go up today as well. This is a feature of markets, not a bug in the code. The only potential fly in the ointment is whether the market is guessing the right number of rate cuts and the right timeline for them.
If you were looking for a mortgage or you were borrowing to finance business activity recently, high rates have been very unpleasant. But if you were an investor, high rates meant you could earn a very handsome return without having to worry too much about nasty things like risk and volatility. You could kind of kick back and relax. In fact, investors adopted – and this is a real expression, not something I made up – the mantra “T-Bill and Chill.” It makes sense. Why not chill a little? Life’s a lot, take the stress down a notch when you can.
Here is the thing about 2024. If the Fed is indeed on the verge of taking rates down, the era of “T-Bill and Chill” may be over. What happens when “T-Bill and Chill” is retired? There are two natural candidates for the next era:
“Other Thing and Chill.” Maybe something else comes along that’s as chill as 5% T-Bills. Everyone is happy and investors stay as relaxed as they’ve been.
“Hey, what happened to Chill?” Maybe when the Jimmy Buffett style vacation is over, stress surges back, and markets are dealt a bad case of the Mondays.
Before we handicap the odds between those two, I want to repeat something important from above. The US economy has been very resilient, and things have been very good out there: Jobs, economic growth, even productivity has been a bright spot (Apparently everyone finally learned how to do the job they were hired for in a hurry after COVID recently). In fact, there is a strong case for the possibility of a good economy going forward.
So it’s not overly tenable to make the case for bad things in the future just because we have good things now (That’s called superstition, which is not a preferred mode of analysis). Let’s get a little more analytical than that.
What has it looked like out there when the Fed has cut rates in the past? A good barometer for the financial weather is volatility, particularly the kind that’s used to price options. When sun shines on markets, volatility tends to be low. When there is a storm in markets, volatility is high. Let’s look at data going back to the early 1990s with the VIX (the index for implied volatility on the S&P 500) becomes available. In red (left scale) is the Fed Funds rate, and in blue (right scale) is volatility. With the exception of the early 1990s (the last “soft landing,” and the only such soft landing in the last 60 years), every time it cuts, the Fed tends to cut a lot over a short period of time — because it sniffs out that the economy is slowing down hard — and that’s followed in short order with a jump in volatility. Some spikes are smaller like 1998 or the early 2000s and some spikes are historically large, like 2008 and 2020.
It is very possible that we get a soft landing, like the one from the early 1990s. The odds might even be decent, better than just the historical average given what we know about the economy so far. But if that’s the case, rates won’t go down all that much, maybe a couple of points at the most. That would be fine, in fact, that would be great. Assume rates stay elevated for a while. That’s the “higher for longer” scenario that is the Fed’s baseline.
On the other hand, if we start seeing the economy cool past the point of “just softness,” rates could come down hard. And if that’s the case, we should not be surprised if stocks did poorly and if volatility jumped from where it is today (mid-teens in the right axis) to a number like 40 or higher. That’s the land of stress on portfolios and sleepless nights, but it’s also a scenario where opportunities make themselves a little more obvious in markets.
Not Math Over the Holidays! Boo, Dr. Treussard!
OK, now that we’ve talked about volatility and option prices, we have no choice but to go the last mile… This one is going to be a little “math-y” but it’ll help us understand what markets are telling about things like the price of risk and what Wall Street salespeople are telling us may be good for us, which doesn’t align quite right. Don’t you hate when that happens?
So, implied volatility is the lever that controls to the price of options (which are like insurance contracts on stock prices). When people are freaking out about stocks going down a lot, they raise their estimate of volatility and that makes options to insure against market declines more expensive. If that made your brain hurt, just think about the obvious in your life. If you were in the business of providing insurance against something bad happening, like a medical bill, would you charge more or less if you expected the worst case as a $5,000 medical bill or a $50,000 bill? Right. You would charge more if the worst case had the potential for bigger magnitude.
Now that we know this about how options are prices, we can better understand the strategies some asset managers have been using to attract investors to products promising to “enhance yield.” When considering these investment strategies, you should weigh your preference for immediate income against the possibility of future gains. But either way, these strategies typically involve selling equity options and usually come in one of two forms:
The first involves stock funds that sell a portion of the portfolio's potential for growth by selling call options—essentially trading away the chance for higher profits (A very famous bank in New York is attracting a lot of assets in an ETF that does just that).
The second type offers what seem like fixed returns unless the market takes a significant downturn, at which point portfolio returns are negatively impacted. This is achieved by selling put options, effectively providing market insurance to others (A very famous bank in New York is offering this to a lot of its private-bank clients).
As you can see from the graph just above, implied volatility (VIX) has been low lately. This means that you are selling these options to others for low prices. So, the next time you encounter one of these strategies, ask yourself: Is it really worthwhile to sell your portfolio’s growth potential or sell market insurance to others on the cheap? How does that strategy align with the adage to “buy low and sell high?”
With that, we wish you a very happy new year and we can’t wait to find out what happens in 2024 (at least as long as it’s about our kids amazing us daily).