Intern Macro Update (Feb '22)

Welcome fellow interns. We’re putting out this note about the macro backdrop as it seems to be the biggest contributing factor to price action at the moment. We have not seen much (if any) dispersion in the markets, as most tokens are simply tracking Bitcoin, and Bitcoin is just following equities.

As they say, “don’t fight the Fed,” so we’re seeking to figure out what the Fed can and can’t do.

Generally speaking, the Fed operates on a dual mandate of (1) maintaining low unemployment, and (2) targeting an inflation rate which averages 2%. With a significant portion of Covid-related job losses being regained over the past 18 months, the Fed (and correspondingly, the market) has turned its attention to the persisting ~7% inflation rate. The simple analysis/conclusion would be that the Fed needs to raise the fed funds rate to match the inflation rate (as it has been done historically).

Nevertheless, as we explore below, we believe that:

(a) the Fed would not be able to raise rates anywhere near that level even if it desired; and

(b) the current CPI inflation numbers being printed do not accurately measure monetary-policy related inflation and therefore the Fed won’t even be required (or desire) to raise significantly to combat it.

Taper Tantrum Round 3

https://twitter.com/jyashouafar/status/1485672815961460737
https://twitter.com/jyashouafar/status/1485672815961460737

The Fed has been talking about rate hikes and tapering the Fed balance sheet for several months and has been squarely focused on March 2022 for its first (likely 25bp) rate hike. Leading into the Fed meeting and press conference, many began to speculate that the Fed would hike early (in the January meeting) and/or greater (50 bps).

In fact, the market began to price a greater than 50% chance that the Fed will produce 5 hikes to 1.25%-1.5% in 2022. It’s important to note that this potential hike schedule is fairly significant in isolation but is essentially a non-serious response to a currently-tracking 7% inflation rate. So while the Fed is blustering and speaking hawkish publicly, they’re still essentially telling the market that they don’t take inflation seriously.

Nevertheless, the market which has been addicted to the drug of easy-money policies over the past decade, threw a ‘taper tantrum’ in response to these increasingly expected and priced-in rate hikes and faster balance sheet taper. The S&P 500 and Nasdaq drew down 12.5% and 17%, respectively, peak-to-trough in January.

This year-open sell-off was accompanied by historic levels of bearish positioning by equities investors. Record volumes of puts were bought against indexes and ETFs and bearish sentiment was in the 98th percentile over the past 3.5 decades.

It’s clear from positioning that the market is attempting to price in aggressive interest rates for the foreseeable future and a tapering of the balance sheet — leading to a bearish outcome for equities. As we’ll discuss in the following section, we don’t think the Fed is in a position to effectuate either the plan they’re threatening nor the exaggerated version the market is hedging against.

The Fed is Between a Rock and a Hard Place

As mentioned, the Fed has a dual mandate of (a) maintaining low unemployment and (b) targeting inflation averaging 2% per year. Heading into the Covid crisis, the Fed had enjoyed a decade of sub-2% inflation with minimal inflationary worries even after the introduction of QE1. In 2020, they were suddenly faced with an economic and political shock — the massive unemployment caused by Covid shutdowns. The decision to provide significant liquidity into the market was an easy one because it aided in pushing directionally in the benefit of both mandates.

Nevertheless, the Fed is met with several non-stated directives as well, which recently included (a) de-leveraging the public and private markets (a bit more on this below) and (b) maintaining the Dollar’s global reserve currency status. Unrelated, but worth mentioning, is that recently the Fed is discussing racial justice issues and ESG (environmental, social and governance) issues as driving forces behind its policy and decision making processes as well.

While Covid provided the backdrop for the Fed’s extreme actions, they were in a position that required them to maintain low interest rates simply to prevent the federal government’s budget from exploding. The federal government’s debt to GDP ratio reached 128% in the past year. Any scenario where debt-to-GDP is over 100% becomes increasingly precarious for an economy which is growing at a rate lower than the interest rate on its public debt (this is particularly true for a nation who runs perpetual deficits at the federal level).

Debt to GDP Ratio

The federal government’s total debt level stands just above $30T today. In 2021, the federal government spent $562.4 billion on interest payments on federal debt compared to $4.05 trillion it received in total revenue (and ran an approximately $2T deficit in aggregate, adding over 7% to the total debt). The average interest rate on the federal government’s outstanding debt is currently approximately 1.5%. With inflation currently tracking at greater than 7% per annum, any significant raise of interest rates would lead to interest payments alone ballooning and requiring a large portion of the federal government’s revenues.

This scenario would either lead to a downward spiral of increased taxes and austerity measures - effectively crushing the economy and guaranteeing significant unemployment - or the Fed’s continued subsidization of interest rates in an effort to financialize significant portions of the debt on it’s balance sheet while allowing the economy to run hot in nominal terms with a view to deleveraging the federal government’s “balance sheet.” The net effect of the latter course of action is significant devaluing of the Dollar (which as mentioned, also runs counter to another of the Fed’s unstated mandates). This is precisely why the Fed is engaged in a complex tango with the domestic market as well as central banks of foreign jurisdictions - where monetary easing (and debasement) of foreign currencies gives the Fed additional leeway to continue their deleveraging process domestically.

After 2020, which saw a significant devaluing of the USD versus a basket of foreign currencies, 2021 saw it recover most of its losses. We believe that, from a forex perspective, the Fed has achieved the leeway it requires before continuing its easing process (although this is only one factor amongst many - and specifically inflation, which must be “controlled,” before it can truly ease once again).

Not all Inflation is Created Equally

Last Thursday, February 10th, saw the release of CPI data which was higher than expected for the 9th out of the last 10 months - driving the bulk of the actual (and political) pressure on the Fed to act against the measured inflation with faster and larger rate hikes and balance sheet tapering.

Nevertheless, when observing the aggregate CPI number, it is important to identify and analyze each of the composite items in the basket as increases in each category are not driven by the same forces.

Interestingly, the entire above-average contingent is comprised of (1) heavy manufacturing (cars, appliances and furniture), (2) travel-related categories, and (3) fuel and energy. We can likely attribute increases in manufacturing related products to Covid-related disruptions to factory production. For example, because fewer new cars are being built and delivered, the cost of used cars is being driven up dramatically. Similarly, travel-related categories are likely seeing an influx of demand due to pent-up (and shorter term) desire to travel after widespread lockdowns. Lastly, fuel and energy are likely being driven up due to a combination of Green policies globally (impacting supply of oil and gas based fuels) and various geo-political factors (e.g. Russia, Venezuela, and Iran). Interestingly, it’s difficult to peg the bulk of these price increases (especially vis a vis the remainder of the basket) on monetary policy.

Direction of CPI data matters a lot. As humans, we have an enormous tendency to extrapolate direction which can be seen from how markets reacted to last week’s print. Today the rate of change in inflation is up, a trajectory it has been on for a while. This leads to assumptions that the trend could continue higher and that high, sticky inflation could be here to stay. The trend has increased market volatility for assets which are central bank sensitive. If inflation data has in fact peaked, and given the all to real human tendency to extrapolate rates of change, we could be looking at a very different inflation debate just a month or two down the line - and it seems that simple math supports the proposition that CPI prints will fall off dramatically in that time frame strictly due to having a higher year-ago base to measure from. This could provide some real relief and potential dovish, upside shocks to assets most sensitive to the macro outlook.

Macro-economists’ opinions around the Fed’s next step are the most polarized they’ve ever been. Outside of the great financial criss of 2008 and the early 2020 response to the Covid pandemic, the current predicament the Fed is in is one of the most interesting in history. We eagerly await the Fed’s decisions in March to observe how it is interpreted by the markets and how it impacts the lives of ordinary people.

Conclusion

The most recent CPI print of 7.5% led to a a significant increase in bets that the Fed will hike by 50bps+ at March’s meeting, with the market initially pricing in a ∼90% probability of 50-75bps hike following the print. Interestingly, the market is beginning to pull off that knee jerk reaction, with odds settling at ∼60% as of publication.

It seems the market is beginning to digest deeper research into the reality behind the the headline CPI number and realizing that it is not as drastic as it appears. Further, the narrative is beginning to spread that the market’s reflexive expectation of ever expedient and increased rate hikes are not possible. As the market begins to become more rational to this fact - especially with clear Fed messaging in and an only 25bp March increase, should it come - we believe that risk assets (including crypto) will begin to perform well.

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