Crypto News: Rising 'term premiums' are a bad sign for this bull market

I have been fairly consistent during this particular Federal Reserve interest-rate cycle: "No Landing" is a bad outcome because lends itself to a hard boom and bust cycle. That bust could be closer than we think. Even as everyone is cheering the resilience of the US economy and expecting another blockbuster year of stock gains, alarm bells are going off with a measure called the term premium that suggest a wicked reversal of fortune is coming.

Let's talk about what all this means for your portfolio. Hint: it's still a "wait until you see the whites of the recession's eyes" action plan. But my confidence that a dramatic asset re-allocation is coming has increased. As a consequence, I'm more bearish on equities than bullish. I'll outline the points that have led me to this conclusion.

Fed tightening is really about creating financial distress
But higher rates can't do that if investors fall in love with 'duration'
A love for duration is most easily expressed by the Treasury Term Premium
That term premium was really low for 15 years. But it's rising. That's bad for stocks
When the turn comes, initially safe-haven assets will benefit. Afterwards though, the outlook is less clear. But, after bear markets, market leadership always changes

Monetary tightening is about financial distress, nothing more

Let's start with the overlooked point that higher interest rates are great for savers and lenders. To put it simply, for higher fed funds rates to have a restrictive effect, the financial distress, the rising cost of debt for borrowers and the resulting curtailing of investment, has to override that extra income to savers and lenders. Essentially the Fed has to create financial distress.

I think this is perhaps the most important — and most overlooked — fact about this particular rate cycle because a lot of people think higher interest rates are always restrictive. But that's not true at first. The private sector is a net receiver of interest due to government deficits. So, initially higher interest rates stimulate the economy through the interest income channel. Think of higher rates as a gift, a handout, to rich people who disproportionately benefit as savers and lenders.

It's only when those rates are high enough to put business and household debtors into dire straits that the restrictiveness comes into play. And in today's context, so many companies and households have locked in favorable debt repayment terms that, in aggregate, the benefits of higher savings rates and higher bond returns continue to outweigh any financial distress.

Look at the mid-noughties and the housing bubble, for example.

The Fed started hiking rates in mid-2004. But that didn't mean instant financial distress. House prices kept rising for another two years, until mid-2006, just as the Fed paused. As the distress mounted in 2007, the Fed started cutting. It was too late because the financial distress overwhelmed everything else.

'Term premiums' matter more than we think

So what happened? As a bull market progresses, people don't just get enamored with the market darlings of the day, they take on all manner of risks by essentially 'extending duration.' Extending duration is just a fancy way of saying being comfortable with not getting paid back until much later in the future. It's like lending a friend 100 dollars and getting it paid back, say, three years from now instead of in three months. A love affair with duration means buying riskier stocks with high growth potential whose potential profits are all backloaded into the distant future. Think Tesla, whose stock price represents 180 times its last twelve months' of profit. Loving duration also means putting money into the stocks and bonds of companies with less assurance of getting paid back, like the ones that went bust in the Internet Bubble, for example, or lower-rated junk bonds whose yield have plummeted since August.

The easiest way to visualize what happens with duration is to look at the premium people extract from the US government for investing in longer-maturity Treasury bonds. When that 'term premium' goes down, it's a clear sign that investors have fallen in love with duration and a bull market is underway.

As the economy stuck a soft landing in the late 1990s, term premiums collapsed, lowering bond yields, which helped make risky assets more attractive. A bull market followed.

Then the Fed started to raise interest rates. Suddenly, the love affair with duration started to unravel — immediately in the Treasury bond market, but a year later for all long-duration assets including stocks. When the Fed realized a recession would ensue, it cut rates and the term premium declined again. But a difficult recession meant term premiums rose again, forcing the Fed to cut rates even more aggressively.

Only when 10-year yields bottomed in 2003 did premiums fall again, helping to fuel the housing bubble. Just as in the late 1990s, the 10-year term premium plummeted as the economy prospered. But so great was the euphoria that it kept declining even as the Fed started hiking rates, forcing the Fed to raise rates more than it wanted. In 2005, Fed Chair Alan Greenspan even called his inability to get long-term interest rates to respond to rate hikes a conundrum. But it was all about the animal spirits unleashed as Americans fell in love with long duration assets. Eventually though, the term premium stopped falling. And that's when the bottom fell out of the housing market.

By the numbers

0.54%

-10-year Treasury Term Premium -- The amount of extra yield you get for taking the risk of holding 10-year government bonds

Lessons for today in the term premium

The lesson in all of this for me is that, when people are less willing to risk their money for longer and longer periods during a bull market, watch out.

That brings us to this particular bull market. Here's a chart of the 10-year Treasury term premium since the Great Financial Crisis.

In 2008 and 2009, it really seems like investors had an ugly breakup in their relationship with duration. So averse were investors, the US government was paying out 2% or even 3% more yield for 10-year bonds than what you'd expect just based on future fed policy and inflation alone. But as the economy slowly recovered, that premium plummeted in fits and starts to record lows by the pandemic.

Where are we now? The term premium has exploded higher in the aftermath of a big inflation and Fed hiking cycle. It's now the highest in a decade. And I think it's poised to go even higher still. That's bad news for risky assets because it says the love affair with duration is now unraveling.

If this goes on, expect a bear market

For me, this is the first real sign of danger. Mentally, I keep going back to that newsletter edition I wrote 14 months ago about investors in 2024 partying like 1999. Back then I said that "I come away still with the sense that a no-landing scenario quickly builds into a hard-landing scenario due to overheating." Today, I'd change the statement to something like this: No-landing equals massive duration risk — to the point where the risks become unsustainable except in the best of circumstances.

It's not that the economy overheated per se. The expectations for future profits are just too great. For example, Bloomberg's most recent MLIV Pulse survey showed that "61% of survey respondents believe the S&P 500 will be higher by year-end due to strong US economic and earnings growth." That's simply extraordinary, especially given we're coming off the best two-year S&P 500 return in a generation and given the huge policy risks and extreme market valuations.

So what happens next? I don't think anyone can say with any certainty. And that's why I think it doesn't pay to pre-emptively re-allocate your portfolio. Warren Buffett has to do that because his investments are so large that he'd never be able to extract himself if he waited too long. But ordinary investors can just ride the wave of US exceptionalism and above-trend growth.

In the meantime, I expect upward pressure on long-term interest rates to remain in place as duration risk increases due to inflation, policy uncertainty and a flood of government bond issuance.

If the term premium continues to rise — and I expect it to — then eventually this bearishness on duration will leak into other asset markets and a US equity bear market will ensue.

Bear markets lead to rate cuts of course. And so, Treasuries should rally as stocks decline. The first re-allocation from a bear market and recession then is out of stocks, especially risky ones, and into Treasuries. But eventually that story will be done. And the time to re-allocate back into stocks will come as the economy recovers.

My suspicion — and history bears this out — is that Big Tech will be done as market leaders. The new ones will come from somewhere else. Which sectors and which countries are still unknown. But my mindset as we start to 2025 is less like the fear I had in 2024 — fear of a bubble. It's more acceptance — a realization that a whole generation of investors who never saw the late 1990s are repeating its mistakes — and may soon learn its painful lessons.

Quote of the week

"The fact is that markets behave in ways, sometimes for a very long stretch, that are not linked to value. Sooner or later, though, value counts."

Warren Buffett

Chairman, Berkshire Hathaway

As quoted by Carol Loomis in late 1999

Things on my radar

Treasury Market Gets First 5% Yield in Sign of What Could Come
The term premium driving US yields higher helps global yields rise. UK yields are at the highest since 2008
Last Time Bond Yields Surged Like This, Stock Markets Sank. But that was just a correction
An example of policy uncertainty? A group of Republicans trying to get Trump to increase state and local tax deductions on federal income tax
Another? The Greenland, Canada, Panama talk. It suggests there are now greater unknown unknowns in policy risk