<p>Looking back at the 2015-2021 period when I traded bond markets at a large bank, it was quite boring.</p><p>Rates were mostly stuck around 0% at the front-end, and to make money you had to find small dislocations and monetize them with leverage hoping volatility would remain low forever.</p><p><strong>Today, the story is different: bond markets are truly exciting.<br /></strong>So let’s have a fresh look at them.</p><p>Before we do that though - an important announcement.</p><p>My macro hedge fund Palinuro Capital is going live in January.<br />This is a dream coming true for me.</p><p>Do you want to be updated about the performance and progress of my hedge fund?</p><p>Fill in the form below and I will include you in the distribution list:</p><p class="button-wrapper"><a class="button primary" href="https://forms.gle/UX3iJLgjRiKVh4U16"><span>Update Me On Alf's Macro Hedge Fund</span></a></p><p><strong>I expect the Fed to cut rates again in December.</strong></p><p>Why?<br />See the chart below:</p><div class="captioned-image-container"><figure><a class="image-link image2 is-viewable-img" href="https://substackcdn.com/image/fetch/f_auto,q_auto:good,fl_progressive:steep/https%3A%2F%2Fsubstack-post-media.s3.amazonaws.com%2Fpublic%2Fimages%2F1b5dc493-dc50-4b85-8e27-b4c1ebb94245_701x660.png" target="_blank"><div class="image2-inset"><source type="image/webp" /><img alt="" class="sizing-normal" height="660" src="https://substackcdn.com/image/fetch/w_1456,c_limit,f_auto,q_auto:good,fl_progressive:steep/https%3A%2F%2Fsubstack-post-media.s3.amazonaws.com%2Fpublic%2Fimages%2F1b5dc493-dc50-4b85-8e27-b4c1ebb94245_701x660.png" width="701" /><div class="image-link-expand"><div class="pencraft pc-display-flex pc-gap-8 pc-reset"><div class="pencraft pc-reset icon-container restack-image"><svg class="lucide lucide-refresh-cw" fill="none" height="20" stroke="currentColor" stroke-linecap="round" stroke-linejoin="round" stroke-width="2" viewBox="0 0 24 24" width="20" xmlns="http://www.w3.org/2000/svg"><path d="M3 12a9 9 0 0 1 9-9 9.75 9.75 0 0 1 6.74 2.74L21 8"></path><path d="M21 3v5h-5"></path><path d="M21 12a9 9 0 0 1-9 9 9.75 9.75 0 0 1-6.74-2.74L3 16"></path><path d="M8 16H3v5"></path></svg></div><div class="pencraft pc-reset icon-container view-image"><svg class="lucide lucide-maximize2" fill="none" height="20" stroke="currentColor" stroke-linecap="round" stroke-linejoin="round" stroke-width="2" viewBox="0 0 24 24" width="20" xmlns="http://www.w3.org/2000/svg"><polyline points="15 3 21 3 21 9"></polyline><polyline points="9 21 3 21 3 15"></polyline><line x1="21" x2="14" y1="3" y2="10"></line><line x1="3" x2="10" y1="21" y2="14"></line></svg></div></div></div></div></a></figure></div><p>Even after the recent Fed cuts, <strong>today’s Fed Funds (orange) are still markedly above the underlying trend of core PCE inflation (blue).<br /></strong>The Fed is a simple animal: their dream is to have a stable labor market with predictable inflation.</p><p>And today, the main risk they see isn’t an inflation pick-up.<br />Instead, <strong>risk management forces them to protect the US economy against a deterioration in the job market.</strong></p><p>Running a real Fed Fund rate (bottom chart, black) at +2% for several quarters on end is an exercise which was last performed in 2007.<br />I don’t think the Fed sees major benefits in running such a tight policy.</p><p>Hence, I believe they will cut rates by 25 bps in December.</p><p><strong>But here is an argument for them to feel confident the US doesn’t need a major cutting cycle in 2025:</strong></p><div class="captioned-image-container"><figure><a class="image-link image2 is-viewable-img" href="https://substackcdn.com/image/fetch/f_auto,q_auto:good,fl_progressive:steep/https%3A%2F%2Fsubstack-post-media.s3.amazonaws.com%2Fpublic%2Fimages%2F53fab964-ae85-42e1-9347-6505b56d0784_1063x644.png" target="_blank"><div class="image2-inset"><source type="image/webp" /><img alt="" class="sizing-large" height="726.9990592662276" src="https://substackcdn.com/image/fetch/w_2400,c_limit,f_auto,q_auto:good,fl_progressive:steep/https%3A%2F%2Fsubstack-post-media.s3.amazonaws.com%2Fpublic%2Fimages%2F53fab964-ae85-42e1-9347-6505b56d0784_1063x644.png" width="1200" /><div class="image-link-expand"><div class="pencraft pc-display-flex pc-gap-8 pc-reset"><div class="pencraft pc-reset icon-container restack-image"><svg class="lucide lucide-refresh-cw" fill="none" height="20" stroke="currentColor" stroke-linecap="round" stroke-linejoin="round" stroke-width="2" viewBox="0 0 24 24" width="20" xmlns="http://www.w3.org/2000/svg"><path d="M3 12a9 9 0 0 1 9-9 9.75 9.75 0 0 1 6.74 2.74L21 8"></path><path d="M21 3v5h-5"></path><path d="M21 12a9 9 0 0 1-9 9 9.75 9.75 0 0 1-6.74-2.74L3 16"></path><path d="M8 16H3v5"></path></svg></div><div class="pencraft pc-reset icon-container view-image"><svg class="lucide lucide-maximize2" fill="none" height="20" stroke="currentColor" stroke-linecap="round" stroke-linejoin="round" stroke-width="2" viewBox="0 0 24 24" width="20" xmlns="http://www.w3.org/2000/svg"><polyline points="15 3 21 3 21 9"></polyline><polyline points="9 21 3 21 3 15"></polyline><line x1="21" x2="14" y1="3" y2="10"></line><line x1="3" x2="10" y1="21" y2="14"></line></svg></div></div></div></div></a></figure></div><p>This chart looks at the US private sector (orange) and government (blue) debt to GDP since the 1990s.<br /><strong>It’s an incredibly important chart to approach US bond markets today.</strong></p><p><strong>The US went through two clear macro phases before today.</strong></p><p><em>In phase 1 (before GFC),</em> the US government refused to lever up: government debt as a % of GDP was at or below 60% and deficits were seen as a bad thing.<br />As the private sector didn’t receive any stimulus from government deficits and it grappled with declining demographics and productivity, it used leverage to achieve higher growth.</p><p><strong>In phase 1, the US private sector was forced to lever up aggressively.<br /></strong>Until in 2008 excessive private debt and loose credit standards led to the <strong>Great Financial Crisis.</strong></p><p><em>This kickstarted phase 2 of the long US macro cycle – the post GFC period.</em></p><p><strong>Between 2009 and 2012 the US government printed money (read: deficits)</strong> to stabilize the US economy.<br />This allowed the <strong>US private sector to de-leverage</strong>: private sector debt as a % of GDP fell below 150%.</p><p>But this fiscal profligacy didn’t last for long: between 2014 and 2019 the US primary deficit as a % of GDP was less than -2% on average – mildly supportive for the private sector, but nothing special.<br />So we sat there in this limbo of acceptable GDP growth, but as neither the US government nor the private sector levered up aggressively we lived through a ‘’meh’’ US growth cycle.</p><p><em>Finally, C-19 hit and the game might have changed for good (phase 3).</em></p><p><strong>Since 2020, US deficits have exploded and this has allowed the US private sector to de-leverage.<br /></strong>US private debt as a % of GDP is now the lowest since 2003 (!).</p><p>So: why does this matter for bond markets?</p><p><strong>Because in a world with less private sector leverage, ceteris paribus interest rates can be a bit higher.</strong></p><p>When there are less mortgages and corporate loans to refinance vis-à-vis higher nominal wages and earnings, the equilibrium interest rates at which the economy can function should be higher.<br />The flipside is obviously that an increasing load of government debt will have to be refinanced at higher rates.<br />In the US case though, that’s more manageable than for other countries due to the reserve currency status.</p><p><strong>This is why the market feels quite strongly about terminal rates being well above 3% this time.</strong></p><p><strong>As per today, markets expect Fed Funds to still be at 3.50% in 3 years from now.</strong></p><div class="captioned-image-container"><figure><a class="image-link image2 is-viewable-img" href="https://substackcdn.com/image/fetch/f_auto,q_auto:good,fl_progressive:steep/https%3A%2F%2Fsubstack-post-media.s3.amazonaws.com%2Fpublic%2Fimages%2F0e025e27-72cb-40af-9165-43c3974732b8_1048x636.png" target="_blank"><div class="image2-inset"><source type="image/webp" /><img alt="" class="sizing-normal" height="636" src="https://substackcdn.com/image/fetch/w_1456,c_limit,f_auto,q_auto:good,fl_progressive:steep/https%3A%2F%2Fsubstack-post-media.s3.amazonaws.com%2Fpublic%2Fimages%2F0e025e27-72cb-40af-9165-43c3974732b8_1048x636.png" width="1048" /><div class="image-link-expand"><div class="pencraft pc-display-flex pc-gap-8 pc-reset"><div class="pencraft pc-reset icon-container restack-image"><svg class="lucide lucide-refresh-cw" fill="none" height="20" stroke="currentColor" stroke-linecap="round" stroke-linejoin="round" stroke-width="2" viewBox="0 0 24 24" width="20" xmlns="http://www.w3.org/2000/svg"><path d="M3 12a9 9 0 0 1 9-9 9.75 9.75 0 0 1 6.74 2.74L21 8"></path><path d="M21 3v5h-5"></path><path d="M21 12a9 9 0 0 1-9 9 9.75 9.75 0 0 1-6.74-2.74L3 16"></path><path d="M8 16H3v5"></path></svg></div><div class="pencraft pc-reset icon-container view-image"><svg class="lucide lucide-maximize2" fill="none" height="20" stroke="currentColor" stroke-linecap="round" stroke-linejoin="round" stroke-width="2" viewBox="0 0 24 24" width="20" xmlns="http://www.w3.org/2000/svg"><polyline points="15 3 21 3 21 9"></polyline><polyline points="9 21 3 21 3 15"></polyline><line x1="21" x2="14" y1="3" y2="10"></line><line x1="3" x2="10" y1="21" y2="14"></line></svg></div></div></div></div></a></figure></div><p>The most important implication for investors is this.</p><p>If the Fed embraces this new narrative, we are looking at few (if any) cuts left in 2025.<br />This is because if neutral rates are considered to be higher, the Fed doesn’t need to cut rates much more to achieve a neutral policy stance.</p><p>With euphoric expectations about earnings growth, nosebleed valuations and a less friendly Fed overly bullish investors might be disappointed in early 2025.</p><p>This was it for today. I hope you enjoyed this macro piece.<br />Please share it with a friend:</p><p class="button-wrapper"><a class="button primary" href="https://themacrocompass.substack.com/p/a-fresh-look-at-bond-markets?utm_source=substack&utm_medium=email&utm_content=share&action=share"><span>Share</span></a></p><p class="button-wrapper"><a class="button primary" href="https://themacrocompass.substack.com/subscribe"><span>Subscribe now</span></a></p><p>And also, don’t forget.</p><p>Do you want to be updated about the performance and progress of my hedge fund?</p><p>Fill in the form below and I will include you in the distribution list:</p><p class="button-wrapper"><a class="button primary button-wrapper" href="https://forms.gle/UX3iJLgjRiKVh4U16"><span>Update Me On Alf's Macro Hedge Fund</span></a></p><p>Have a fantastic day ahead,</p><p>Alf</p>