October 4th 2023 has already been a crazy day in the global capital markets. As Brass Rat Capital ("BRC") wrote in the 2023-09-04 WILT post, this FinTech skunkworks sensed the American economy and capital markets were about to go through some volatile and relatively negative times.
Exactly a month later, it turns out BRC was not nearly pessimistic enough!! Volatility has returned with a vengeance, and there is considerable negativity about any progress being made on America's looming Federal deficit in the next eighteen months.
The 2023 United Auto Workers ("UAW") strike indeed started on September 14 against all three of the Big 3 auto manufacturers and has since expanded to additional plants. The UAW demand for a thirty-percent plus pay raise has been repeatedly trumpeted across social and news media. These prominent and well publicized demands are now permeating the consciousness of other American workers, especially since President Biden became the first ever to join a picket line supporting striking workers.
Today, under the threat of a labor strike, approximately 75,000 Kaiser Permanente healthcare workers are demanding a 27.5% pay raise over their next four-year contract. If such pay increase demands are met by the respective employers, the prospects of inflation returning to the Fed's two percent annual inflation rate goal are being pushed off to a much further date. The "Higher for Longer" Fed declaration is becoming very much a reality! People already are questioning the need to get the Federal Reserve's inflation rate target back down to two percent annually given the economic pain likely to be incurred.
Yesterday, Tuesday 2023-10-03, was a historic day on the Federal legislative front. After reaching a last-minute compromise on September 30th that kicked the "can" (the 2024 Federal budget disagreement) off until November 17th, a small number of Republican Representatives (in combination with all of the Democrat Representatives present) executed a rebellion that overthrew the House Speaker, Republican Rep. Kevin McCarthy. Whether the various complaints and disagreements were legitimate,
BRC is nearly certain that the American legislative process is now completely broken at least through the 2024 elections, if not longer. Such a situation suggests that current spending levels (plus or minus by a few percentage points) will continue for at least another year and the 2024 Federal deficit will be north of $1.7 trillion. These enormous budget deficits were projected earlier this year by the Congressional Budget Office ("CBO") to last as far as the eye can see. Who knows how large they might become with the fiscal controls nearly inoperable?
Finally, the wheels are coming off the proverbial enormous bus that is the global fixed-income markets. The US ten-year TSY has gone from 4.108% at August month-end to 4.899% this morning during the Far East trading hours. While there is limited domestic need to sell longer-term Treasuries due to the negative convexity of current coupon mortgages, there appears to be a worldwide buyer strike ongoing with few wanting to "catch a falling knife" by suffering further price losses as yields continue to quickly increase. One should note that most of the Treasury moves have occurred during other than daylight hours in New York City. To some of the "grey beards" who have more than 25 years of experience, such price action suggests some major holders of US Treasuries are liquidating.
BRC's Managing Partner, Lars Toomre, is a former mortgage trader, head of mortgage derivative trading at Lehman Brothers, and a leader of mortgage trading businesses. As a result, Lars is extremely experienced with the hedging of the risk associated with the negative convexity of American fixed-rate mortgages.
It is very difficult to execute such hedging in such a volatile yield environment that the capital markets have experienced. Hint: Hedging in size (bigger than several hundred million) in illiquid markets is virtually impossible. Thus, fixed-income price losses (whether realized or not [due to held-to-maturity accounting]) are going to be all around the capital markets and their participants. At some point, likely soon based upon past episodes of extreme change, the focus of investors will shift from yield to the price of portfolio holdings. Such an event will be very troubling as losses of X percent are widely broadcast.