Something could ‘break’ before the Fed capitulates
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If you’re into finance and macroeconomics, you’ve probably seen this chart:
Fed hike cycles end in crisis – every time. The chart also shows that, since the 1980s, the Fed has been unable to reach a federal funds rate (FFR) at or above the peak of the previous tightening cycle.
It’s no mystery why this happens: lower rates for longer allow more debt to accumulate and create an ever-increasing reliance on cheap rolling costs.
Although the graph above is not a very large data set, it appears that seizures occur when the FFR reaches 50% to 80% of the immediately preceding FFR peak. Given that today’s effective FFR has grown from nearly 0 to 66% of the 2018 peak in the space of four months (for reference, it took over 3 years for the previous cycle to cover the same relative terrain), the likelihood of “something breaking” seems high.
Before gobbling up VIX futures, it is important to check the thesis.
Many point to the huge sums parked by the Fed’s Reverse Repo (RRP) facility, with excess cash generating overnight yield from the Fed, as one of the reasons why “things can be different.” this time “. Translation: there is too much cash for a liquidity crisis.
First, the majority (88%) participants in the RRP are money market mutual funds. That’s a LOT of money that would otherwise be chasing treasuries, commercial paper, or loaned out in the repo market. This means that an interbank lending crisis is unlikely.
That’s not to say we won’t see “something snap” in the private sector – in the form of margin calls, mass layoffs or bankruptcies – due to rapidly rising costs of capital. Ironically, the elevated RRP balance may give FOMC members false confidence that further tightening is possible.
Let’s take a broader look at the money supply:
The interesting thing to note here is the large increase in money supply (both nominal and percentage) during the post-GFC era compared to the post-Dot Com era. By comparing the “success” of each hiking cycle that concluded these two eras (see below), it appears that money supply and economic robustness are inversely correlated. This is especially odd given that post-GFC was supposed to be when regulators cleaned up the financial system with tighter guarantees and lending criteria.
Thus, the suggestion that excessive liquidity will save us from a crisis is not supported by the data (and in fact, the reverse may be true).
I know recession trading that will force a Fed pivot is becoming popular now, but I would be cautious. The pace of this tightening cycle dwarfs that of the last three bubble bursts shown above, and our economy is more dependent than ever on cheap debt. Short-term debt (Something can snap before the Fed even has time to pivot.
Or maybe the Fed is cautiously suspending hikes. Markets would undoubtedly smell the blood and rally around the Fed’s capitulation. But we forget that our economy has been fed at 0% rates for about a decade – we can’t sustain 2%! Therefore, I would NOT try to trade for such a rally and prepare for lower lows.
For those looking to invest in this environment, remember the Wall Street adage, “Don’t fight the Fed.” If you are currently in the markets, that is exactly what you are doing. Consider sitting in a majority cash position. Every new inflation headline will hurt, but don’t add to the pain with nominal losses. And don’t be tempted by a Feeding break – wait for the real capitular fed pivot. As was the case in the last two crashes, interest rates will likely fall straight to zero and quickly! Yes, it would be nice to predict exactly when this might happen, but if you’re investing for the long term, just wait and buy back when Fed policy is more supportive of asset valuations.
Which assets to buy after such a pivot, in a world where Fed policy is accommodative while inflation remains high, is another discussion altogether. In short, inflation hedges are a safe bet while blistering returns from unprofitable growth names could become history.