Short term extrapolations and real problems
Photo by Tim Johnson on Unsplash
It would be quite the understatement to say that the past two weeks have been action-packed in markets. All eyes were on the stock markets, which went from being on the precipice of collapse to staging the most fabulous rebound in recent history to retake its long-term moving average levels, seemingly nullifying much of the bearishness that had appeared to overtake the common narrative.
Put differently, markets are back to where they were before the Russia-Ukraine situation AND before the FOMC’s first rate hike since 2018 AND the recurrence of talk about QT. Looking at the charts, however, it’s as if nothing had happened, even though the reality is very different. Does this all make sense? “BUY THE DIP!”, chanted the crowds, perhaps out of habit rather than out of rational conclusions. Tom Lee is back on CNBC (we like and respect him a lot, but we think he is symbol of BTD to the masses) and everything is great again.
Once again, as with most of the time, everything is about market structure and positioning. The reasons for movements can be made up afterwards as they always are.
A market that was heavily hedged by almost every major player for downside going into a high uncertainty (in fact, with the skew of probability tilted towards the downside aka “hawkish fed”, which was indeed realised) meant that while the negative reality could ensue, the negative reaction in prices had already been “priced in”. Dealers unrolling the hedges against downside they had sold (i.e. buying back stock) after expiry has provided the initial impetus for an unwind, and with the Mar 18th options expiry cleaning out US$3tn (by some estimates, more) of notional, the unwind is significant.
Arguably, this mechanically explains the old trading floor adage that bear market rallies are the most vicious rallies around: not only does the math lend itself to big single day % moves (i.e. a stock that is down -90% can rally +20% and still be down -88%), the reality is that an overarching bearish sentiment (read “bear market” rally) leads to large downside hedges being put on, which when unwound lead to exaggerated moves.
But are we in a bear market? Positioning, charts and price action are helpful tools for working out trading opportunities, assuming the underlying market direction is clear. Post Covid, we were in a clear bull market: the Fed was bidding the market up with accelerated QE, and as a result, so too was everyone else.
That seems to have changed, although the equity markets appear to disagree. So, in this brief note, we’re venturing into a domain which we know we are far from being experts on, but of which we think some understanding could help craft a better picture of what is to come: the world of rates and fixed income.
As always, we are trying to learn more and push our knowledge beyond what we’re used to, and in the process, we’ll naturally make mistakes. If anything in this brainstorm note appears terribly wrong or misunderstood, please feel free to reach out and tell us that we got it wrong.
No mistakes, no learning.
The lay of the land
Let’s start with what we do know:
- inflation is high, driven by both strong demand (for now) and more importantly supply-side issues (from supply chain disruptions to actual elevated costs of commodities), ironically putting developed economy inflation on par or even above that in some “emerging” markets;
- central banks around the world are starting to tighten (with EM central banks like Brazil already WAY deeper into a tightening cycle);
- a war is going on in Ukraine with material impact on grain supplies, not to mention oil and other commodities;
- metal prices are rising, with the most dramatic being Nickel and the ongoing debacle at the LME;
- commodities traders are being hit with margin calls (e.g. Trafigura and Peabody);
- The Fed has not only now nudged rates up by 25bps, they’ve also signalled a willingness to continue to raise rates through the year and into 2023 alongside a reduction in their balance sheet aka Quantitative Tightening.
The view from the standpoint of the equities market can get rather conflicted: on one hand, the argument that bonds are underperforming means that allocations to equities should go up, so there’s buying; on the other, with short term rates rising fast, the opportunity cost of investing in unprofitable companies with long-dated future earnings increases, although with a number of index heavyweights still finding themselves in unprofitable positions (with the others trading at multiples that are far from “cheap”), equities aren’t exactly priced at a bargain.
We’ve always looked at the prices of equities in the market as the product of the fundamentals (earnings, cashflow, dividends etc) and a human-brain sized gap (narratives and beliefs), translated into a multiple: sometimes of earnings, sometimes of sales or cashflow, sometimes of nothing at all.
That narrative gap is what we need to figure out, and in a funny way, it has a lot more to do with how people feel than anything else.
Wealth effects and money
Let’s go back to the last point on our checklist above: quantitative tightening.
Regardless of one’s view of the efficacy of quantitative easing, in addition to all the fiscal accommodation that has happened over the past two years, there is one thing that we can all agree on: EVERYONE owning financial assets has felt richer as a result.
Whether through an increase in home prices (as mortgage rates fell, thanks to the Fed buying up Agency MBS and offering an outlook of lower rates for longer) leading to more homeowner’s equity, to benefits payments being given out and promptly reinvested into a Robinhood account for some YOLO call option action (some of which worked to make those fortunate individuals outsized profits), to a strategy of buying every new crypto launch to land on Twitter and Youtube for a 50x return in 5 days – wealth effects are real, and if it was the intention of the Fed and other central banks to get people up and about and spending, to drive the economy back up, they’ve definitely succeeded.
It then stands to reason that the reverse will also be true: already we are seeing that 30-year average mortgage rates in the US have been climbing fast, despite the Fed only having hiked once. Why? Because forward expectations adjust: rates start going up, refinancing starts becoming less enticing, buying a new property at a higher mortgage rate even less so, fewer bidders in the market, not so much “numba go up” in property anymore. Add to that the removal of buying support of agency MBS from the Fed and mortgage yields, benchmarked to the price of Agency MBS, tend to follow. For the moment, the FOMC’s instructions are merely to not commit new cash to buying Agency MBS, and instead roll over principal payments at auction. Whether this translates into outright selling remains to be seen.
The wealth effect from owning a property whose price no longer only goes up is significant.
But perhaps even more so could be the direct effects of rising rates in other portfolios: consider the average pension portfolio, allocated to the orthodoxy of 60/40 bonds/equities.
Of course, not everyone’s pensions and assets are invested in the same way, but if we do end up with a secular environment of rate hikes in an attempt to control inflation (or even worse, an environment of runaway inflation where debt gets devalued at a much quicker pace), then that 60% debt allocation that was meant to be “safe” becomes a much bigger drag on individuals’ net assets than they’d imagine.
On the other side of the coin, there is a possibility that fiscal stimulus programmes continue to put new money into the hands of individuals, offsetting the wealth effect losses from the immediate financial impact of rate hikes. But these are in turn offset by the elephant in the room: rapidly increasing costs of everything, adding to a headline inflation number that was unimaginable only years ago.
The bottom line here is that we’ve had 2 years of anomalous money flows, capping the end of an equally anomalous period of falling rates and stubbornly low inflation contributed to significant wealth effects. The risk is that we get a reversal of what we’ve seen, with persistent inflation, which is rather difficult to talk one’s way out of, being the trigger for a change in market conditions.
There are many reasons why inflation can get sticky, not least because of commodities, but it’s highly unlikely that the years to come will look like the years past.
Feeling… not so rich
Ultimately, only one overarching principle matters: in order for markets to go up, prices have to go up; and in order for prices to go up, there must be bidders; in order to bid for something, you need money.
The reasons for which someone bids for an asset can be multi-fold, but whatever that reason is (voluntary or otherwise), money is needed. And whether it’s an actual shortage of money or a feeling that the amount of available cash is dwindling (both of which may be true for many), that narrative of “numba go up” and “buy the dip” might be running out of steam.
We are now at the cusp of a set of decisions which our central bankers need to make rather quickly: either they walk the talk of price stability and pay the price of reduced money supply, in which case the expansionary years of QE and the post-COVID response face reversal; or they don’t and only pay lip service to attempting to craft a narrative of tightening without actually doing so.
If one has to go by what the Fed is saying, then this will be an extremely painful period ahead. If the BTD crowd is right and the Fed does what it has done since the financial crisis and talks tough but doesn’t follow through, then it risks a much bigger problem of unbridled runaway inflation and possibly the very collapse of the system that they were created to protect. Despite them completely dithering on making hard decisions while inflation soared last year and exacerbating this mess, we are nevertheless quite pleased that we aren’t the ones called upon to make these calls.
The Fed will do what it decides to do, and we will take our direction from there.
The way we see it, there isn’t really a great outcome either way and the strategies used to generate wealth over the past decade (and longer) are not the same ones that are needed today. Fortunately, there are a few new tools around and lots of really old ones.