Inverted yield curve  since mid-2022

 bond investors expect interest rates to decline in the longer term, a reflection of a slowing economy and one that in the
past has signaled a recession

curve began to “dis-invert”/ bear steepen  mid-2023

 bear steepening: Longer-dated yields rising more quickly than shorter-dated ones means the steepening isn’t
happening for the usual pre-recession reason. Instead, investors are concluding that policymakers are in no rush to cut
rates, “higher for longer” given how strong the economy has been. Long-bond yields are pushing up to reflect those
expectations. On top of that, the supply of Treasury bonds has surged as the federal government’s deficit keeps
growing, likely adding to the downward pressure on prices.  strong economy but higher rates will tighten financial
conditions further, further dampen the economy as it ripples through to mortgages, credit cards and business loans,
which may be a welcome development to the Fed. The risk, though, is that it hits the brakes so hard that the economy
stalls completely.
 Typically when the yield curve begins to reverse the inversion it means the economy is getting closer to a downturn, and
short-term yields often drop in anticipation that the Fed is poised to start slashing rates to jump-start growth. Traders
call that a “bull steepening.”
 But this time is different. Rather than the curve changing shape because short-term rates are falling, it’s changing shape
because longer yields are surging on expectations that the US’s economy’s strength means the Fed will hold rates
“higher for longer.” That process is called a “bear steepening.”

10-year Treasury yield breached 5%, a level not seen since 2007 (grueling
selloff in U.S. treasuries, most notably in the longer end of the yield curve)
 COVID: quantitative easing (used cash to buy gov securities) - Fed sharply beefed up its assets portfolio and continued to
gobble up hundreds of billions in government securities throughout 2020
 Currently: quantitative tightening (BS runoff – selling gov securities)
o Wells Fargo economists expect a recession sometime next year to prompt the Fed to cease quantitative
tightening around October 2024. Fed unlikely to continue passive monetary policy tightening via [quantitative
tightening] during a period of negative GDP growth, rising unemployment and material cuts to the federal
funds rate
o balance sheet will play an important role in removing monetary policy accommodation, operating in the
background while the federal funds rates serve as our primary active tool.
SELLOFF
 The Treasury 30-year auctions come as federal deficits ($33 trillion) have exploded this year. Since June, the US has sold
more than $1 trillion in T-bills. Primary dealers had to buy 18.2% of the 30-year Treasury Bond at the latest auction, the
highest level since December 2021 (Banks, which are required to buy any bonds the rest of Wall Street doesn't, typically
don't buy more than 11% of a Treasury Bond auction), signaling poor investor demand.
 The budget deficit is increasing due to several factors, including higher federal government borrowing costs arising from
the Fed’s interest rate increases, quantitative tightening, weaker-than-expected tax receipts +
 Less Demand: Fed’s and central banks’ sudden exit from the market. After multiple rounds of Fed quantitative easing,
the Fed has been in a QT mode, reducing the size of its balance sheet and not replacing bonds that reach maturity with
new purchases + Central banks in brazil, china, Japan, Saudi have already halted US bond purchases and are even
outright selling.
 Worry that the escalating budget deficit will create more supply than demand, requiring higher yields to clear the
market.  the real concern is sustainability of those deficits - that by pursuing a fiscal policy that drives up yields so
much  putting the squeeze on companies and consumers across America when yields go too high, too fast and part of
the economy will break
BALLONING FISCAL DEFICITS
 Governments around the globe will need to boost their sovereign debt issuance to pay for ballooning fiscal deficits,
largely as a result of their COVID-era policies.
 Investors in U.S. Treasuries, for example, will no longer be able to dodge the glut of new issuance in that market that has
followed the debt ceiling standoff earlier in 2023 by moving into the gilt market if the UK is also selling an increasing
volume of new debt to fund its spending.
 The U.S. deficit is likely to end 2023 at about 6% of gross domestic product (GDP), while the UK deficit will probably be
more than 5% of GDP.

US Cuts Quarterly Borrowing Target to $776 Billion, offering Investors some relief on fiscal deficit
 The Treasury Department cut its net borrowing estimate for the October-through-December quarter to $776 billion,
against the $852 billion for the period predicted in late July
 thanks to stronger-than-expected revenues (Deferred tax receipts from California), offering some relief for investors
concerned about the rapidly widening fiscal deficit.
 The federal deficit roughly doubled in the fiscal year through September compared with the year before, effectively
reaching $2.02 trillion, forcing the Treasury to step up its borrowing.
 The bank’s economists predict the Federal Reserve’s so-called quantitative tightening, which is forcing the Treasury to
borrow more from the private-sector investors, will continue through the end of 2024. QT currently involves letting up
to $60 billion a month of Treasuries mature without the Fed replacing those securities.
 The Fed Took the 10-Year to 4%; the Treasury Brought It to 5%: last refunding announcement, on Aug. 2, has “arguably
proved to be the most important macro event of the last three months.” A look at the rise in 10-year yields since then,
which abruptly took off on the day of the Treasury announcement, after having stayed flat for 10 months despite
repeated Fed hikes
 SKEWING SHORT-END: The big item that investors want to know is whether the Treasury will choose to will relieve
some of the pressure on 10-year and other longer-dated Treasuries by shifting more issuance toward short-term bills
due to concerns about the impact of additional supply on long-term yields.
o Morgan Stanley's Dhingra, who expects the Treasury to rely on T-bills to finance its budget needs, said such a
move could push the percentage of T-bills as a share of outstanding U.S. debt to around 22%. That is slightly
higher than the 15% to 20% range adopted by the Treasury. If the Treasury does want to shift toward bills,
there is probably room for them to do so. As this chart from Bank of America shows, the amount of bills left in
the hands of primary dealers (meaning that they couldn’t find institutional buyers for them) has risen, but not
to the kind of scary extent that might have been feared. That would be a divergence from the August refunding
when the Treasury aggressively raised the auction sizes for notes and bonds, which have longer maturities,
after largely relying on the sale of short-term bills to raise its cash holdings and finance its growing deficit amid
the debt ceiling suspension in June.

Fed speakers speculating about high yields doing job for them  markets betting rates will fall
 comments from several Fed speakers this week suggest the central bank may hold interest rates steady when it meets
Nov. 1, with some indicating that further hikes may not be necessary.
 Dallas Fed President Lorie Logan said recent surge in long-term rates may mean less need for additional hikes.
 That commentary helped arrest a five-week jump in 10-year yields and has coincided with a rush into ETFs tracking
Treasuries that has seen nearly $7 billion poured so far this month

Upside surprises of strong economy

 Over the last several weeks, the asymmetry in the market's reaction to incoming data has been noteworthy. Upside
surprises to growth have brought up sharp increases in long end yields, while downside surprises inflation have met
with muted rallies. To us, this means that for market participants, upside surprises to growth fuel doubts whether the
pace of deceleration in inflation is sustainable. In this context, it is no surprise that upside growth surprises have
mattered more to long-end yields than downside inflation surprises.
 We've indeed seen a spate of upside surprises. The 336,000 new jobs in the September employment report were nearly
double the Bloomberg survey of economists. Month over month changes in retail sales at 0.7% were more than double
the consensus expectation of about 0.3%, and triple if you exclude auto sales. We saw similar upside surprises in
industrial production, factory orders, building permits as well.
US Core PCE Prices Jump Most in Four Months as Spending Picks Up (+0.3%)
 One key area of concern for officials is service-sector prices (Cars, prescription drugs and travel), which rose by 0.5%,
the most since January.
 The most important support for household spending is the strength of the labor market, which at the moment remains
healthy. But other factors, like a record surge in household wealth coming into this year and lingering pandemic-era
savings, have played a part as well.
 While wages and salaries rose 0.4%, real disposable income fell for a third straight month. As a result, consumers have
been saving less to support their spending, raising concerns about Americans’ ability to keep spending at such a pace
through year-end.

UAW reaches deal with GM, ending strike against Detroit automakers
General Motors (GM.N) and the United Auto Workers (UAW) struck a tentative deal on Monday, ending the union's
unprecedented six-week campaign of coordinated strikes that won record pay increases for workers at the Detroit Three
automakers.
OUTLOOK FOR 4Q23
 still think that a Santa Claus rally is possible. But between now and Thanksgiving, it’s easier to see downside than
upside for the stock market given the unsettling developments in the Middle East and jitteriness in the bond market

 expect incoming data in the fourth quarter to show decelerating growth, which we expect will lead to a reversal of
the recent yield spikes driven by term premiums moving lower.
 The subtle shift in the tone of Fed speak over the past two weeks suggests a similar interpretation, indicating a waning
appetite for an additional hike this year in the wake of tighter financial conditions while retaining the optionality for
future hikes. They think that the yield curve is doing the job of the Fed.
 This jibes with our view that there will be no further rate hikes this year. While our conviction on fourth quarter growth
slowdown is strong, it will take time to become evident in the incoming data.

headwinds
 rise in Treasury yields has further implications: The spike has contributed significantly to tighter financial conditions.
huge boost in high-quality government bond issuance could also crowd out many other borrowers, or at least force up
funding rates for corporate borrowers and others that need to refinance. long-end yields act as the discount rate for
many other purposes
 third quarter consumer spending benefited from large one off expenditures.
 with the expiration of student loan moratorium, we think will weigh heavily on real personal consumption in the
fourth quarter and by extension, on economic growth. Tighter financial conditions driven by higher long end yields will
only add to this drag.
 pending government shutdown due to government dysfunction
 Israel’s war with Hamas escalates

FED
 Meanwhile, both monetary and fiscal policy are unlikely to provide any relief and could tighten further. More
specifically, while the Federal Reserve has not raised rates any further, it is likely far from cutting. Furthermore, the
tightening the Fed has done over the past 18 months is just now starting to be felt across the economy.
 Even though the Fed has tightened monetary policy at the fastest rate in 40 years, it's confronted with sticky labor and
inflation data that has prevented it from signaling a definitive end to the tightening cycle or when they will begin to ease
policy. At the same time, the fiscal deficit has expanded to levels rarely seen with full employment.
 This is precisely why the Fed has indicated a higher for longer stance. In our view, the strength in the headline labor data
masks the headwinds faced by the average company and household that the Fed can't proactively address.
14 oct old news
While many forecasters now see the US skirting a recession, the economy’s outlook remains uncertain. On one hand,
unemployment is low, hiring is robust and households seem to have more excess savings than previously thought. On the
other, small businesses are growing more pessimistic about the outlook, borrowing costs are high and the resumption of
student-loan payments risks denting consumer spending.

CPI
A hotter US CPI initially pushed short rates higher, but the long end later followed with a sell-off in 30Y bonds last seen in
March 2020 amid the Covid market turmoil. Triggered by a weak auction, that leg higher underscored the markets' ongoing
concerns about the US fiscal outlook and for now is also side-lining geopolitical concerns

US supercore CPI rises by most in year, reinforcing the Federal Reserve’s intent to keep interest rates high and bring down
inflation. The data suggest the central will keep the door open to another interest-rate hike this year, even as central bankers
emphasize patience ahead of their next meeting.

 US supercore CPI (services prices, excluding energy and housing): 0.61% [the biggest in a year]
 US core CPI (excludes food and energy): +0.3% AS EXPECTED
 US headline CPI: +0.4% (boosted by housing and energy costs) HIGHER THAN +0.3%

 The supercore annual inflation rate was rate dipped to 3.91%, down from over 4% in August but well above the 2.23%
average over the half decade through 2019.
 The core annual inflation rate was 4.1%, the slowest pace in two years.
 The annual CPI inflation rate held at 3.7%, notably above where it was in June and July.

 Housing costs made up more than half of the overall increase in prices in September, and some economists expect that
to reverse in time as rent inflation has eased.
 Gasoline prices also contributed to the headline gain, and those have come down in October.
For Federal Reserve policymakers, the stickiness of US inflation argues for the higher-for-longer scenario for interest rates.
Futures prices continued to show a small chance of a further hike, but also somewhat diminished expectations for the scale of
reductions in 2024.

The September CPI report won’t convince most Fed officials that interest rates are sufficiently restrictive... Our baseline is for the
Fed to hold rates steady for the rest of the year, but we see non-negligible risks of another rate hike, something the market is
probably underpricing

Strong labor market

Credit Outlook matches worst reading in a decade

 Small-business optimism dropped to a four-month low in September, reflecting worsening expectations for the economy
and credit conditions. The share of survey respondents saying it was harder to get a loan compared to three months ago
increased to 8% on net — the most since March, when Silicon Valley Bank collapsed.

US households anticipating faster inflation – early Oct

 Consumers’ year-ahead inflation expectations rose sharply in early October, driving a steep deterioration in views of
their finances as well as sentiment. Americans expect prices will climb at a 3.8% rate over the next year, the highest in
five months and up from the 3.2% expected in September, according to the preliminary October reading from the
University of Michigan.
 The shift higher in energy costs at a time of rising rates means energy expenditures will displace other consumer
purchases. The jump in fuel prices arrested an earlier rebound in consumer sentiment that was based on falling
inflation.

Retail spending
 US student loan payments jumped very quickly from near zero to $10 billion over the past two weeks.
 pending government shutdown due to government dysfunction
 widening UAW strike at US automakers
 The combined impact of these events may potentially drag down retail spending by as much as 1% in the near-term.