Make or Brake in the #1 Chart: HYG/TLT

Inflation or Recession?

In “The #1 Chart that I'm Watching”, explained a trade that included selling safe government treasuries (TLT) short, to fund the purchase of risky “junk bonds” (HYG).

This was a great trade during the post Covid inflationary period. The recovery from a crash made high yield (AKA Junk) bonds a great bargain. And inflation made government bonds a great short.

I use the above relative chart of high yield bonds (HYG) to government bonds (TLT) to get a sense of where the market consensus is in regards to inflation vs. recession.

Here is why.

If inflation returns then government bonds would not do well and the chart would continue to rise.

But if recession is in the cards, government bonds would be in demand while high yield bonds would be dumped. The chart would then revisit its lows.

As you can see in the chart, it is in a decision point. After retracing 50% of its 2023 advance, it began recovering in December and retraced 50% of its decline. It now has to “decide” which way to break.

Economic data has been indicating a coming recession for over a year. But loose financial conditions have been pushing markets higher and higher.

Why am I saying that financial conditions are too loose?

First, the proof is in the pudding. Look at the inflation chart below with the blue line for Consumer Price Index (CPI) inflation and the red line for “sticky” inflation.

While CPI inflation is fluctuating, sticky inflation is still running at around 5%.

Second, look at the Monetary Base chart below. This is the quantity of “high powered” money that the Fed controls directly.

I don’t see monetary tightening!

Third, look at the real interest rate in the chart below. The red line is the 1 year real interest rate and the blue line is the Federal Funds Rate (FFR).

The real FFR is negative again and the 1 year dropped from 7.7% in June 2023 to 2.5%.

It is no surprise that the Chicago Fed’s Financial Conditions Index below is showing loose financial conditions:

In Don’t Fight Yellen?! I noted that loose financial conditions are not necessarily good for the banks:

“But what occurred to me was that the apparent “liquidity” in asset markets is at the expense of bank deposits.”

Money has been leaving banks to chase rising financial assets. I bought some regional banks’ put options back then, just in case.

And last week I saw that New York Community Bancorp became a concern due to loan losses and internal control issues.

The Bright Side

Low volatility means that options are cheap. And that is why I find straddles to be the easiest way to play the market right now. A straddle means buying both a call and a put option.

The HYG/TLT chart at the top could still break higher into a continuation of the bubble. But a break down along with a correction (at least) in the stock market is well overdue. With straddles one could be well positioned for both scenarios.

I think that the second half of March will provide more information on where markets are headed.