Unbalanced Risk To the Downside

The stock market has already factored in the annulment of tariffs, the resumption of the Fed’s rate cutting cycle, and the extension of the Trump tax cuts expiring this year. The S&P 500 is back to trading at 22x projected earnings growth of 14% in 2025, which is extremely high given US GDP shrinkage in Q1, along with the margin pressure from tariff issues.
 

The red-hot trade war cooled down temporarily when President Trump took the tariffs on China down to 30% from 145%. But much damage has already been done. Peter Friedmann, executive director of the Agriculture Transportation Coalition (ATC), told CNBC that US agriculture is facing a crisis due to canceled purchases. The US Department of Agriculture reported farms are suffering from massive losses, pricing pressures, declining demand, and layoffs due to the trade wars.
 

But whatever the level of tariffs end up to be, prices are going even higher from their already-unaffordable lever. Inflation has become the salient issue for the US consumer, especially those in the bottom four quintiles. For instance, 11.1% of all credit card holders now make only the minimum down payment on their outstanding balances. This is the largest percentage on record in the 12-year history of this data series. A Lending Tree survey found 25% of buy now, pay later users fund grocery purchases with this type of loan. This is an increase from the 14% figure in 2024. Also, 41% of survey respondents said they made a late payment on a Buy Now Pay Later loan in the past year, up from 34% last year. The Federal Reserve’s preferred inflation measure, the personal consumption expenditure price index, sharply increased by 3.6% in Q1, up from 2.4% in Q4 last year.
 

The economic data shows significant deterioration, even before disruptions caused by recent tariff changes. It is important to note that previous data includes preemptive actions taken by consumers and corporations regarding tariffs. Upcoming reports are expected to indicate a decline in soft data translating into hard data soon. Additionally, GDP in the first quarter decreased quarter-over-quarter at a seasonally adjusted annual rate (SAAR), suggesting we are already halfway towards a technical recession.
 

BOND MARKETS AND INFLATION

Additionally, the trade deficit has widened considerably, increasing pressure on the administration to secure more favorable trade deals. This, in turn, is expected to exert further downward pressure on GDP growth.
 

Regarding the bond market, the US 10-year benchmark rate has experienced considerable volatility and several significant spikes in recent months. That is a very unusual and humongous move in such a short period of time. Why would that volatility occur in the context of a slowing economy, which has always brought out buyers in the past?
 

I wrote a book predicting the eventuality of this bond market debacle in 2013. The book’s prediction of a bond market crash was based on the pathway toward US insolvency and the destructive inflation concomitant with intractable debt. Inflation has already exceeded the Fed’s 2% target for the past 4 years, and tariffs are exacerbating it. And our nation’s debt is now a staggering $37 trillion, equal to 123% of GDP and 720% of Federal revenue. On top of this, Washington is trying to extend Trump’s 2017 Tax Cut and Jobs Act, which is projected to add $4 trillion to the deficit over the next decade.
 

The tariff situation will also mean there will be a smaller trade surplus on the part of our creditor nations to recycle into Treasuries. In addition, China is most likely selling US debt and then selling the US dollar. But instead of exchanging those dollars for Yuan, they are converting them for gold. The direct evidence of this trade can be found in interest rates rising, just as the dollar is plunging and sending gold to record highs. Without China, Japan, and other foreign investment in our bond market, the US will struggle mightily to find enough domestic buyers (excluding the Federal Reserve) to supplant those bids.
 

It isn’t much of a mystery why gold, which is real money, is replacing the USD as the world’s reserve currency. Also, Hedge funds have been heavily engaged in reckless investment strategies that involved being long Treasuries with 100:1 leverage.
 

And we can’t leave out the largest foreign holder of US debt, Japan. Long duration Japanese Government Bonds are spiking at an even faster pace than that of the US. For example, the Japanese 10-year note surged from .22% in October 2022 to its current level of 1.5%. This means the domestic Japanese investor has, for the first time in nearly a decade and a half, a viable alternative to owning US bonds.
 

However, perhaps the most important reason for the chaotic trading of US treasuries is the lack of liquidity. The Reverse Repo facility, where banks’ $2.5 trillion of excess reserves once laid fallow and collected interest at the Fed, has been pouring into the bond market for the past two years. That enormous amount of credit was readily available to purchase Treasuries but has now dwindled to just $88 billion.
 

The credit market chaos is just one example of the dangerous leverage in the financial system. But what else would you expect when nominal interest rates were close to zero, and real interest rates were negative for most of the 15 years between 2008 and 2023? There is no timeframe in US history that comes close to this decade-and-a-half deformation in the cost of money. Of course, we do have the history of those six years between 1974 and 1980, where real rates were negative, and that led to that infamous economic period marred by stagflation.
 

A CREDIT CRISIS NEARS, UNLESS...

Today’s credit crisis will not remain in the Treasury complex alone. Today’s banking system is also chock full of leveraged loans, CLOs, Private credit, Junk bonds, RMBS, CMBS, and FHA loans, which are the new subprime mortgage crisis in waiting, jumped by 1000% since the GFC.
 

Despite ups and downs, the stock market is still in big trouble unless the following three conditions are met:

1. There must be an imminent cessation of the tariff war. Meaning all countries must stay at the current 10% level or below after the 90-day reprieve ends in July.
 

2. The Tax Cut and Jobs Act (TCJA) gets extended, and the debt ceiling is raised by this summer.
 

3. The $4 trillion increase in deficits over the 10-year horizon, as a result of making the TCJA permanent, does not cause a revolt in the bond market.

A retest of the April lows is likely if the above conditions are not.
 

As always, we will own whichever equity, bond, commodity, or currency best fits the second derivative of inflation and growth. Unbiased and active management truly has its advantages.   EG