In today’s Finshots, we explain how one of the biggest voices in the investment world has flipped from worrying about inflation to a recession in just 2 months!
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The Story
When a country wants to borrow money to fund its various needs, it issues bonds. It could be short-term bonds for just a year or so. Or it could be long-term bonds that only need to be repaid after 10 years. Maybe even 30 years. It’s up to the country really.
And how do they decide on the rate of interest they need to pay on the bonds, you ask?
In a very crude sense, they try and get it close to the expectations of inflation in the country. See, they have to make it attractive enough for investors to buy the bonds. And everyone wants to beat inflation. So maybe the government might think that over the next 10 years, inflation is likely to hover around 6%. They might then issue a bond priced at ₹100 and tack on a little extra yield. The yield or the interest in this case might be 6.50%.
Now this makes government bonds quite unique and interesting. They actually serve an important function — they’re indicators of inflationary expectations.
And if investors soon start believing that inflation is higher than anticipated, they’ll start to demand higher returns from the bonds. They might look to sell the existing bond and invest in some other asset. Something they believe will offer more bang for their buck. This selling pressure drives the price down.
And here’s something you should know about bond price and yield. They have an inverse relationship. Take the example from before. Say the price drops from ₹100 to ₹99. Now if an investors snaps this bond up and keeps it safe until its maturity, they’ll still get ₹100 back. Plus, they get paid 6.50% every year. So the interest along with that additional benefit of the price rising on maturity leads to them earning an additional yield.
That’s what we mean by the inverse relationship between bond prices and yield.
All good so far?
Great.
Now let’s turn our attention to Bill Ackman — the protagonist of the story. Bill is a big deal in the investment world. He’s an activist investor. That means he buys shares in a company, controls a fair bit of a firm, and then forces companies to make changes he thinks it needs. But also, he’s made quite a ton of money buying and selling bonds. For instance, he bet many companies would default on their borrowings during the pandemic. He bought a sort of insurance against this. And netted $2.6 billion.
So yeah, when he talks (or tweets), people listen.
And in August ’23, Bill Ackman made a big announcement. He believed that the US Federal Reserve (their central bank) was underestimating inflation. He thought inflation would be a bigger problem than anticipated. And that bonds would soon react to this ground reality. People would ask for higher yields. So he said the 30-year US bond would break the 5% level. It was trading at around 4.1% back then.
So, he bet against the bonds. He took a short position of sorts where he’d make money if the yields went higher and prices fell. And lo and behold, just 2 months after his bet, that’s exactly what happened, the 30-year bond yields shot up, And also, for the first time in 16 years, the yield on the 10-year Treasury bond just crossed the 5% mark too.
Seems like everyone was well and truly worried about inflation. And Bill Ackman maybe added fuel to the fire with his tweet.
But then, out of the blue, Bill Ackman tweeted again. This time, he said he was closing his position. Or reversing the trade. He was signalling that he didn’t expect yields to go much higher from here.
But why, you ask? Isn’t inflation still a worry?
Well, for starters, it might simply be a bet on historic trends. See, 5% isn’t a magic number. It’s just that historically, in the past 40-odd years at least, it hasn’t breached that level often. A resistance builds in and it becomes a ceiling. And that leads to investors pencilling this in as a ‘rule of thumb’. They treat it as a magic ceiling even if it isn’t one technically. So they’re inclined to bet on the probability that the yields will fall from this level.
And you know that bond prices and yields have an inverse relationship. If the yield falls, the price rises. So you’d rather buy a government bond and ride the price rise this way. You’d get a nice chunk of money.
But also it looks like Bill Ackman’s priorities have changed. He’s ditched inflation and seems to be suddenly worried about an impending recession. He said, “The economy is slowing faster than what recent data suggests.”
And this is quite confusing, no? Just a while ago, there was inflation on the cards. And now it’s a recession. Make your mind up, Bill!
Or maybe if you think about it, the inflationary environment might just be what leads to a recession. You see, inflation could squeeze the spending power of consumers. But if the US Federal Reserve is worried that inflation might get worse, they’ll keep interest rates high anyway. And that could trigger a situation where people struggle to meet their existing loan payments. For instance, the US is facing one of its highest levels of defaults on car loans. And this could have a domino effect.
And if you look at India, you’ll see a clear sign of an American slowdown playing out too. Remember the shocking news from a couple of weeks ago when Infosys said they probably won’t hire from colleges this year? It’s shocking because these IT companies are a mainstay of campus placements come rain or shine. So when they declare something like this, it could be a pretty big signal.
Now yeah, we know that experts have been predicting this forever. But even a broken clock is right twice a day, right? Is Bill Ackman on to something?
Time will tell.
Until then…
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PS: Bill Ackman’s big short on US bonds supposedly netted him a whopping $200 million. A few tweets was all it took, eh?
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