I’m not sure how it happened, but in what feels like the blink of an eye, I am beginning my 14th year of writing on the global macroeconomic outlook here at Jefferies. Over these years, clients from all walks of financial market life have universally come around to the notion that macro risks must be factored into their investment decisions. Even those folks with strategies built on the most micro of foundations now recognize the need to stay focused on macro. The worlds of merger arb, equity long/short, bond RV, distressed debt, structured credit, convertible arb, and good old-fashioned stock-picking, just to name a few, all now require a healthy understanding of the macro risks. The bankers have even dipped their toes into the macro world, with those impeccably dressed ECM and DCM folks regularly seeking guidance on the macro landscape. Macro has certainly come a long way from its pre-2008 niche status within the rate and FX markets.
As such, it has been a real treat for me to share my passion for macro with the ENTIRE Jefferies client base over all these years. Since beginning my graduate studies in macroeconomics 35 years ago, I have never stopped focusing on how macro forces influence developments in financial markets. And from the beginning, I was always drawn to the role of central banks in the process. I suppose that is what drove me to take my first job out of grad school as an economist at the Federal Reserve Board back in the early ’90s. And there’s no doubt that is what brought me back to the Board in 2009 as an advisor during the GFC. Most recently, though, during my tenure at Jefferies, my fixation on the importance of central bank behavior led me to a longstanding (and quite prosperous) love affair with risk parity trades — up until 2022!!! Then it all changed.
Coming out of 2021 with 7-handle CPI inflation, which was accelerating at its highest rate in over three decades, changed the rules of the macro game. The Fed no longer had the luxury to operate as both an economic and a financial market backstop. They had to fight the inflation inferno, which in turn left economic growth and the financial markets MUCH more vulnerable than usual. Decades of disinflation and credibility buildup had brought a strong level of security to the risk asset space. But that vanished by the end of 2021.
The “Fed put,” which had been at the heart of all my varietals of risk-parity trading recommendations throughout these years at Jefferies, needed to be restruck — at a MUCH lower level. And to be sure, in note after note from the end of 2021 onwards, I made sure that our clients understood the seismic shift this brought. Taking the Fed put deeply out of the money sharply increased the downside risk for spoos. That is precisely why I abandoned any form of risk parity-style trade for the first time ever at Jefferies and moved forward with covered call trades in 2022. And thankfully I did — spoos and blues were each down 18% last year. It was a negative 36% risk-parity bloodbath, while those covered-call trades limited the pain to only down 7%. In the end I walked away with only a minor scar last year after so many years of strong risk-parity-driven returns.
Now, just so we are clear today, the Fed put is still not of meaningful value for downside spoo protection in 2023. After all, CPI inflation is still exactly where it was one year ago, at 7%. Further, the Fed will be in no hurry to declare an early victory in its inflation firefight, even if we quickly drop down to 2% or below during 2023. They have two back-to-back 7-handle CPI years on their blemished track record. That will keep them much more concerned about a repeat of those historic mistakes from the ’70s than about some smidge of recessionary overtightening. As Jay said numerous times over the course of 2022, putting the inflation-anchoring genie back in the bottle is a far more difficult task than fixing a modest tightening overshoot. These are crucial words to remember for 2023!!!
With all that in mind, you might think I’m just going to recommend resetting those covered-call trades from 2022 that outperformed spoos by 11%. Or maybe recommend selling some spoo strangles, given that I have been arguing for a range trade between 3600–4200 since we set those pre-June FOMC lows. I do still see nominal growth support for spoos if we trend back down toward the 2022 lows. And I still see spoo resistance from an opportunistically aggressive Fed if we rally back up towards those pre-Jackson Hole highs. Nothing much has changed in that rangy view.
But to be perfectly honest, I am just not that excited about chasing my tail around in a short-vol spoo position. Why do I want to be playing in the riskiest part of the corporate capital structure (aka equities) when the returns are going to be continually suppressed by a Fed that is hell-bent on NOT making the mistakes of the ’70s? I don’t!!! Wouldn’t it make more sense to be in much safer senior parts of the corporate capital structure that are currently offering near-equity-like returns?? Yes, for sure!!! Remember, at the beginning of last year HY bonds/loans barely had 4% yields. Today you can easily create a portfolio of senior BB/B rated bonds and loans with a low double-digit yield. With spoos likely to just torture everyone in a range trade while the Fed continues prioritizing the anchoring of inflation expectations over market backstopping, collecting some lofty coupon carry feels like a much better risk/reward trade.
The Fed has taken real yields up and drained liquidity to widen spreads. They are now almost begging you to jump into much cheaper/safer credit markets rather than choose the riskiest investments in equities. So follow the Fed and let those fat coupons be your guiding light in 2023. When the Fed wants everyone taking aggressive equity risk once again, they will dump liquidity into the system and make all those bond coupons unpleasantly low. That will be a rerun of QE and thus a time to pivot into equities. That movie, however, is NOT coming to theatre near you any time soon. The Fed has to get inflation back to target and hold it there for a considerable time before the QE bazookas can once again be used in times of economic stress. There are no portfolio balance effects on the horizon to drive us to equities. In fact, right now, the Fed is looking to engineer a portfolio “rebalance” effect, away from equities. They need to slow economic activity and take inflation lower. So just follow the Fed away from equities into the senior secured credit world.
With all that said, it’s time to give your friendly neighborhood Jefferies high-yield bond salesperson a ring. That can be in corporate credit, structured credit, muni credit, or even a bit of EM credit. If you don’t like BB/B high-yield, you can also lever up a bit in higher-rated securities to get those big coupons. Either trade should work nicely as we work through this difficult period where the Fed put is on vacation.
The only thing left to do with this credit trade for 2023 now is to design a hat. I have been playing around with a few ideas and came up with this image below of a happy trash can carrying a money bag filled with junk-rated bonds. I think the headline above it should read something like “Got Junk?”
I’m not sure that will make it through as the final hat design, but that’s where my head is at the moment. And truth be told, I’m quite excited for a move away from those broken-hearted QT hats of last year. Even if a lot of hearts were broken in 2022 — and that hat signaled an absolutely correct message — it’s just never much fun spreading gloom. I’m always happier delivering an optimistic message, even if I need to find it inside a trash can. Good luck trading.
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