Checking in on Year-End Risks

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Now, on with the show...

Q4 is here, and what a first 3/4^th of a year it’s been.

Here’s a non-exhaustive list of what we’ve seen thus far in 2023:

• After the worst year ever for bonds (2022), the route continued with pretty much all durations and most grades continuing their historic fall. TLT, the 20-year+ duration bond ETF, and a recognized proxy for the overall health of the U.S. bond market, was down 33% in 2022, and as of this writing, is down another 15% YTD. Yellen says she can finance two wars, but the bond market right now is telling her "sure, but it's going to cost you...".
• Equity markets have rallied back from their equally dismal 2022, with the NASDAQ leading the way – up ~40% YTD with the Magnificent 7 carrying, quite literally, the entire weight of the recovery.
• Bitcoin has finally, maybe, begun to mature as an asset class as its key volatility metrics are all hovering at multiyear lows amidst wild swings in traditional markets. In 2023 so far, Bitcoin hasn’t seen a gain or loss of 10% or more, in contrast to 2021 and 2022 when it moved outside this range 9 and 11 times, respectively.
• The Fed has raised another 100bps (currently at 5.5%) and to almost everyone’s surprise, they're actually tightening the balance sheet – while it’s still at ~$8 trillion, that’s down ~$1 trillion from its peak. Short-dated bills and MBS have driven most of the decline, with longer-dated bonds increasing a bit.
• U.S. fiscal deficits are running at or near all-time highs, breaking records. The massive weight of the debt, plus these new deficits, combined with higher rates have sent interest expense parabolic – now sitting at $900 billion annualized (for reference, the Department of Defense’s total 2022 budget was $705 billion).
• The horrific events in Israel will have tail events that haven’t even begun to play out yet. Add this to the ongoing Russia/Ukraine conflict and the rising tensions in the South China Sea, and geopolitical risks are, at least in our lifetime, the highest we’ve ever seen.

All that said, there’s still another 2.5 months left, so as we enter the home stretch, and given that Diego’s last Markets Update had a bullish tilt on it, we wanted to highlight some key, short-term risks to keep front and center as you continue to navigate this wild time.

Note: We won’t touch on the geopolitical situation for now as it’s still evolving very quickly, but we’ll be covering this in-depth in the coming weeks.

Risk #1: Liquidity -> Yield Curve Reversion

In last month’s Research report we covered the interplay between the U.S. Treasury’s financings and interest rates, and the simultaneous levers of liquidity being removed and duration risk being added to the market.

A brief overview: