2023-09-24 What Is Lars Thinking ("WILT")

Submitted by Lars.Toomre on Sun, 09/24/2023 - 08:00
Poster from the 1960 movie "The Magnificent Seven"

The 10-year TSY yield hit 4.50% this past week -- its highest level since 2007. There is considerable talk about this being a good level to extend duration since the real yield is near 2 percent.

Lars Toomre would caution that the American economy is not yet in restrictive territory -- yet!! The 4.50 yield level is only the long-term 100-year average. Markets almost never correct from an excess just back to the average. They almost always go to the point that hurts the most participants the most.

In the present case, there are several constituencies more important than bond investors. Probably, the most important is the Democratic Party which simply cannot have an economic downturn before the 2024 U.S. Federal elections. The will for political power is extremely powerful and can cause people to do incredible things, often considered stupid or beyond all common sense.

The second constituency is the American banking system which is not positioned for a further rise in longer term interest rates, especially in the held to maturity portfolios. The former 30 yr 1.25% due May 2050 was sold near par in May 2020. Last week it sold for 48.18 cents on the dollar. Those are some losses and another 25% or so will occur if the long rate increases another 200 bps. There is insufficient equity capital in the smaller banks to absorb these losses.

The third constituency is what some describe are the upper middle class of the American economy. Some great percentage of people earning around $150,000 per year claim to be living paycheck to paycheck. Can that section of the economy continue to rely upon credit cards to deal with rising food, shelter, transportation, and medical costs? When that spending seemingly cuts off overnight, what do you think will happen?

The fourth important constituency is the holders of the Magnificent Seven big-cap technology stocks. The SP500 ex these seven is only up about 5% on the year. Interest rates rising further above the previously upper end of the ten-year yield range will cause APPL, MSFT, AMZN, GOOG, META, TSLA, and NVDA to have trouble justifying their extended valuations even on a forward-earnings basis.

Think folks... The bond market is about to go through some significant further pain.