It's a Bubble. So Why Is Citi's Dirk Willer Buying?

Willer defines a bubble as an asset trading more than two standard deviations above its long-term real trend and says the market crossed that threshold around the middle of last year. With that indicator on, he says a breakdown in four of the S&P’s seven largest names could provide an earlier exit signal than waiting for the index to fall below its 200-day moving average; excess compute capacity is another potential timing signal, though his analysts do not think overcapacity is near.

Willer argues that a bubble burst could trigger a recession larger than the one after the 2000 bubble, pointing to equity-market capitalization rising from just over 100% of GDP in 2000 to 240%. In that scenario, he expects the Fed to change direction and cut rates sharply, while he says credit could hedge the recession because it would underperform, potentially at limited cost given tight spreads and ample supply.

Willer says the S&P typically pulls back around the first Fed hike but tends to react again near the last hike, when the Fed overtightens; he argues the Fed is not close to that point. He also says equities are more sensitive to volatility in the bond sell-off than to the level of rates itself, and identifies excessive Treasury-market volatility, measured by the MOVE Index, as a point when equities usually start to care.

Willer says the Treasury could shorten the duration of new issuance by shifting from coupons to T-bills, though heavy bill issuance could prompt a Fed response if it strains front-end or repo markets; a Treasury General Account drawdown during a debt-ceiling debate could create room for more bills. He says the Treasury still has options to stabilize the long end, but suggests intervention may be easier during a panic than when markets are orderly.