Is the U.S. economy currently ’too hot’?

The Sevens Report highlights a significant widening of the 'Notes over Bonds' (NOB) spread, which measures the yield difference between 30-year and 10-year Treasurys, climbing from 19 basis points in January to over 63 basis points this month—its highest since August 2021 when inflation was surging. This surge signals a potential 'run hot' U.S. economy marked by solid growth and elevated inflation, driven by concerns over political pressure on the Federal Reserve for premature rate cuts and persistent tariffs. While a 'run hot' environment could benefit small caps and cyclical sectors, continued widening of the NOB spread could also indicate an upside inflation surprise, potentially leading to dramatically reduced rate-cut expectations and threatening the current equity rally.

Analysis

The bond market is signaling a potential 'run hot' U.S. economy, according to analysis of the 'Notes over Bonds' (NOB) spread. This spread, representing the yield difference between 30-year and 10-year Treasurys, has widened sharply from 19 basis points in January to over 63 basis points, reaching its highest level since August 2021 when inflation was above 5%. This movement suggests rising inflation concerns, driven by two primary factors: potential political pressure on the Federal Reserve to implement premature rate cuts and the persistent inflationary effects of tariffs, which may be used as a pretext for broader price hikes. This dynamic presents two divergent potential outcomes for the market. The primary scenario, considered more likely for the next several months, is a 'run hot' economy with solid growth and elevated inflation, which would favor assets like small caps and cyclical sectors. However, a continued widening of the spread could signal a more severe 'upside inflation surprise,' which would likely lead to a dramatic reduction in rate-cut expectations and threaten the broader equity rally currently buoyed by bets on Fed easing.

Key Decisions for Investors

• Given the bond market's signal of a potential 'run hot' economy, investors might consider a tactical allocation towards assets that typically outperform in such an environment, such as small caps, cyclical sectors, and equal-weight indexes.
• Investors should closely monitor the NOB spread for continued widening, as this would be a key indicator of a potential shift towards a more adverse 'upside inflation surprise' scenario, which could warrant a defensive portfolio adjustment.
• The primary risk to equities is a repricing of Fed rate-cut expectations; therefore, be prepared to reduce exposure to rate-sensitive growth stocks if incoming inflation data validates the warning from the bond market and dampens the outlook for monetary easing.