Crypto News: Four reasons we’re at peak Goldilocks, and why that’s not good

Many market participants are raving about US exceptionalism. And that makes a lot of sense. According to the OECD, US growth is driving world economic fortunes higher. Even so, it feels like a peak. Either US growth and inflation have to slow or the monetary regime will turn more hawkish.

When you hit the peak, it's not the end of the world. I mean, Usain Bolt is still wicked fast at age 37; he could beat 99.9% of all humans on the planet in a 100-meter dash. But his fastest world-record time was in 2009. That's a decade and a half ago.

So if I were to suggest that we're at peak "American Exceptionalism," that wouldn't necessarily spell big trouble. The US economy and US-based investments could continue to do well for years to come. But the email I just got from the Atlanta Fed, saying the US was growing at a 4.2% annualized rate, has the whiff of peak Goldilocks about it.

Basically, with bond yields elevated but seemingly trending lower, stock prices mostly rising and the extra yield investors are demanding to take on less-than- triple-A credit shrinking, this is about as good as it gets.

Here, in brief, are four reasons why.

In the world of fixed income, investors have weathered a torrid period during the Fed's rate hikes to settle into a comfortable range of US yields between 4% and 5% across the curve. Basically, we can get at least 4% and as much as 5% with no risk, depending on the maturity of the investment we buy. That's pretty good.

But that's only positive if rates and rate expectations remain in place. The reality is, US growth of 4%, as the Atlanta Fed's numbers hint at, is a level more than twice what the central bank says is sustainable without stoking inflation. In other words, it's the kind of growth that would lead the Fed to scrap its easing bias.

So where from here? Either the economy will start to deteriorate, or the Fed will be forced to reassess its hike-and-hold rate policy. Just last week, Fed Chair Jerome Powell told us the next policy move is "unlikely" to be a rate hike. But 4% growth would throw those talking points out the window. And we would all be faced with more rate hikes, something that increases the potential for a hard landing into recession.

It follows that if we've hit the peak of growth permissible under the current policy regime, then assets priced for that regime are also at peak. Treasuries are the perfect example here.

We have a market where people are willing to accept lower returns for the risk of holding investments for longer periods. And that state of affairs is only compatible with a scenario that sees rates coming down over time. Right now, bonds are priced as if the Fed will begin cutting this year and continue cutting. That gets you to 4.83% for two-year paper and around 4.50% for 10-year notes.

But if the Fed is forced to hold rates high indefinitely, then this inverted yield curve simply wouldn't work, and a retrenchment would be in order. Still the losses would be limited. After all, the fed funds rate is 5.33% and 10-year Treasuries yield around 4.5%. Realistically, the highest US yields could reach is in the neighborhood of 5%. Given the large coupon payments investors are getting now, that amount of loss is tolerable.

Coming back to the 4% growth scenario though, if the current Fed regime turns into a policy of hike-pause -hike because inflation is still too high, then suddenly long-term bonds look very expensive. Not only would you see the yield curve steepen to that 5% level, but a premium for taking interest-rate risk would creep back in, sending long-term yields even higher. And because the Fed would be hiking, you're talking more about 6% 10-year yields than 5%. That's a considerable loss.

So 4.5% in a world of 3% inflation and 4% growth looks like close to a peak price for 10-year Treasuries.

4.2%

The current level of growth in the US economy, according to the Atlanta Fed's GDPNow tracker

Yesterday's Bloomberg Markets Wrap highlighted the fact that 425 members of the S&P 500 have reported earnings. On average, the results have come in 8.9% better than expected. Earnings per share are on track to be up 6% year on year. From that, you would extrapolate a lot of forward momentum. In fact, Bloomberg Intelligence noted that S&P 500 net 12-month forward revision momentum for EPS and revenue has recently surged to its strongest pace since September.

So why is that CEOs at American consumer companies are sounding cautious, and appear to be concerned about consumer fatigue?

Starbucks CEO: "many customers are being more exacting about where and how they choose to spend their money"
Amazon CEO: "customers are shopping but remain cautious, trading down on price when they can, and seeking out deals"
McDonald's CFO: "the macro headwinds have been more significant than I think we even anticipated coming into the year. And we continue to see those macro headwinds as we have started quarter two"

This seems almost like the flip side of what we see with growth and bonds. There, 4% growth makes the policy outlook and bond pricing look unsustainable. But what if it's the 4% growth that is unsustainable because it masks weaknesses under the surface, particularly in lower income households and small businesses more leveraged to the rate hike pain the Fed has administered?

In the case that rate hikes are finally showing their effect, we should expect the economy to slow, and corporate revenue and earnings along with it. That would mean we have hit a peak for the momentum in upward earnings revision.

If we have hit peak growth, credit spreads — predicated on an improving macro backdrop — may also have hit their peak.

My colleague James Crombie noted recently that "at less than 90 bps, that's far below the five-year average of about 120 bps. As a percentage of all-in yield, it's the least since 2007." That says credit is the priciest relative to safe assets since before the Great Financial Crisis. And while spreads can still narrow from here, yields in the most speculative credits speak against that.

As Deutsche Bank's Jim Reid, head of global fundamental credit strategy, spelled it out recently. "For B and CCC rated US/EU HY, maturity walls 2 and 3 years out are continuing to edge up and are at their highest on record even with the strong rebound in issuance in recent months."

Those are the lowest-rated speculative-grade issuers not in default. And a massive slug of their debt is coming due. Reid's team says "over the next 1-2 years, $B & CCC-rated HY debt will see current coupons of 6-7% reset to 9%. In Europe, the jump is higher. €B & CCC-rated issuers will see current coupons of 3-5% reset to 9-10% over the next 2 years."

To the degree we have hit peak growth, then, we should expect spreads to also widen as issuance ramps up and the US economy slows at the same time.

We have two very different scenarios here. In the first one, it's an overheated economy derailing the inflation outlook, monetary policy framework and bond prices. There's no guarantee that will happen. I tend to lean against it. But the reality is that 4% growth and 3% inflation equals rate hikes. And so, the numbers do have to retreat.

In the other scenario, it's a cooling economy that leads to peak EPS growth and wider credit spreads, particularly for high-yield borrowers. While this seems the more likely scenario on its face, the opposite has occurred until recently and there are no cracks readily apparent. For example, the BarCap US Corporate High Yield spread to 10-year Treasuries is still about 335 basis points now versus a cycle low of 217 back in 2021 during the period of greatest pandemic re-opening enthusiasm.

Peak Goldilocks produces an economic outcome that is neither too hot nor too cold. But the situation seems so perfectly calibrated right now, I have to think things will break in one direction eventually.

One last thing. This newsletter edition was inspired by some thinking about the latest MLIV pulse survey, which will take on the topic of safe havens. As I thought about different havens such gold, the US dollar, even large-cap tech stocks, I eventually thought about how unusually good this investing climate is right now. It can't get much better.

And it made me think that now — when it's clear blue skies — is the time to prepare your safe havens and risk hedges. That led me of course to Silicon Valley Bank and its misfortune in investing in the safest of the safe securities, US Treasuries. So please share your thoughts about your favorite ones here. I promise to come back to the issue.

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