By Eric Peters, CIO of One River Asset Management
“Participants generally noted that, given their individual outlooks for the economy, the labor market, and inflation, it may become warranted to increase the federal funds rate sooner or at a faster pace than participants had earlier anticipated,” said the Fed in their meeting Minutes.
Stocks puked, the S&P 500 index reversing from Monday’s all-time high.
Beneath the surface, those assets most geared to expectations of eternally easy financial conditions were savaged. Technology. Ethereum fell 20%. Stocks that gain when rates rise ripped higher as 2yr yields jumped 13bps on the week, 10yrs surged 25bps.
“Some participants noted that it could be appropriate to begin to reduce the size of the Federal Reserve’s balance sheet relatively soon after beginning to raise the federal funds rate,” added the Minutes, surprising most traders who rushed to recalibrate their highly leveraged bets.
But for all the portfolio reshuffling and stop-loss selling, not a single market participant doubted that the Fed stands ready to bail everyone out in a market crash. Such conviction is well-supported by decades of repeated behavior from our accommodating central bank.
And yet this cycle appears different in many ways that seem sure to make the coming decade differ markedly from all but one or two in the past century.
Ever since the early 1980s, inflation has been moderating. And since China’s 2001 WTO entry, globalization has suppressed real wage growth for labor in developed economies, while depressing goods prices. So much else has happened too. The disinflationary backdrop allowed the Fed to ease aggressively in each crisis, and tighten in a slow, predictable manner.
But in a deglobalizing world that is now shockingly underinvested in energy production, the Fed may face a crisis accompanied by high inflation that could prevent the rapid easing etched into market psychology. And this is one of the greatest known risks we face in the year or two ahead.
“This all started when Powell got renominated,” said the CIO. “The Paul Krugman’s of the world who influence Biden didn’t want hawkish rhetoric,” he said. “But remember, the Fed is a credible institution. Many pundits call its Governors stupid, but the Fed is no such thing. It will move, if need be,” he said. “And there is a bit of anchoring associated with the fact they have been fighting deflation for a decade and consistently underestimated the forces that kept prices low and stable. So sure, they’ll ultimately err on the side of being less hawkish than in previous hiking cycles.”
“Financialization of the economy is so extreme that it doesn’t take many rate hikes to have a meaningful effect on the economic system anymore,” continued the same CIO. “When you financialize your economy, and it is leveraged to your financial system as it is in the US, then you don’t need much tightening to slow the economy.” You certainly don’t need 5% overnight rates. “In this cycle, the Fed can achieve the same outcome as in previous cycles with more modest changes in rates and liquidity. It is on the march and it started a couple months ago, through the expectations channel.”
“Most people don’t understand how important the expectation channel is,” explained the CIO. “When your economy becomes a casino, players in the casino have outsized control over the economic system in that their forward expectations and bets start the tightening process before the actual rate hikes begin.” All the Fed needs to do is announce it is going to adjust liquidity conditions. “The betting market becomes a bigger part of the economic system. We’re not a manufacturing economy anymore, the US is a casino. And the tightening has started even as the Fed is still buying bonds.”
“This year will be messy, volatile, far sloppier than previous years,” said the CIO. “First the market must adjust to the shift in the Fed’s stance, which will punish the most speculative corners of the financial system,” he said. “But that phase is well underway. The least profitable tech stocks excluding the FAANGs have been savaged.” Square is off 50% from all-time highs, its chart looks more like Ethereum’s than Apple’s. “This year, or at least this quarter, will be all about rotation, and beneath the averages there will be further carnage,” he said. “But we’ll find our level, markets always do.”
“Then next year we will enter a political dynamic unlike anything we’ve seen in a 100yrs,” continued the same CIO. “I’m glad there is so much editorializing about the political risks that are rising now. But I’m not sure even that can change the outcome. When you see the dominos line up, there is a certain inevitability to the change that is coming,” he said. “It’s almost like the housing crisis. In 2006 it was obvious that the housing market would crash.” But it took two years. “Now it is obvious that we are headed toward a catastrophic political collision. It’s so obvious but few people want to really admit it.”