Edition #211
Higher For Longer
Investors,
I’m excited to share my latest analysis and perspectives with you today, in somewhat of a different format compared to the typical edition of Cubic Analytics. I’ll be focusing specifically on the core dynamics moving markets, which we’ve been maintaining a tight pulse on all year. Market fear returned this week, caused entirely by monetary policy dynamics. Markets eventually reach a level of stress that can create a recursive feedback loop and self-perpetuating cycle of fear. I think we’re in that environment now, where market psychology is creating an exponential impact on macroeconomic fears.
In this environment, I believe it’s vital to remain level-headed & use market chaos in our favor. Over the past several months, I’ve stressed the need to elongate an investor’s DCA schedule in order to reduce short-term volatility. I still believe this is prudent. For premium investors who have been reading my bi-weekly series, “Portfolio Strategy: What I’m Buying and Why”, I’m hopeful that these deep dive analysis is highlighting the strength of the individual companies I’ve been buying in client accounts.
If you’d like to know the exact stocks & ETF’s that I’ve patiently been building positions in, I’d encourage you to upgrade your membership status & read the analysis below:
Personally, I’m viewing market pressure as a gift that is allowing me to put myself & accounts that I manage in a position of long-term success. I know this environment is difficult, but I look forward to sunny days ahead.
Monetary Policy & Yield Dynamics:
The market has returned to a position of fear after a brief reprieve during the mid-June to mid-August rally. Plagued by further concerns of Fed tightening, focus has specifically narrowed in on the length of time with which interest rates are expected to remain high, causing financial assets to be repriced lower in a “higher for longer” interest rate environment.
This shouldn’t necessarily be news, as it’s been the key theme all year that markets have been forced to accept. On December 31, 2021, if you knew nothing other than the fact that headline CPI inflation would remain above +8% for five consecutive months and that the Federal Reserve would pursue historically aggressive monetary tightening, you would have sold your assets & converted into cash.
Although I warned about the Fed’s tightening regime as the key market risk for 2022, I certainly didn’t foresee this monetary policy get this aggressive so quickly. In my “Investment Outlook for 2022”, published on the first trading day of the new year, I raised the following concern:
“If the Fed is forced to tighten monetary policy more hastily, caused by relentless inflationary pressures, I believe asset prices could face worse-than-expected returns.”
Even prior to publishing that perspective, I shared concerns about the monetary policy outlook in October 2021:
The thread continues…
“The tone of the Federal Reserve & other central banks regarding inflation has continued to shift dramatically. At the beginning of [2021], they didn’t expect inflation. Then it became a transitory spike. Then that inflation COULD become more sticky. Now it’s persistent.
I don’t necessarily fear stagflation, but it’s clear that those who have been calling for stagflation are feeling vindicated in this moment…
Powell & Fed officials have stated that their monetary policy strategy is effective in stimulating demand, but doesn’t improve supply-chain dynamics. The bottlenecks are expected to persist for the majority of 2022 or beyond. This will impact inflation.
If the Fed sees improvements in the labor market & has already met their inflation requirements to raise rates, what happens if/when inflation is more persistent or sticky? They’ll consider raising more aggressively. If not, the market will do it on its own with higher Treasury yields.
This is not doom & gloom, but a substantiated concern of a more restrictive monetary policy in the face of a potentially slowing economy, global supply-chin bottlenecks, and inflation that has proven to not be transitory.
There’s a lot of pressure on the Fed right now.”
The threats were on the horizon, and they’ve been staring us in the face throughout 2022.
On Wednesday, the Federal Reserve’s FOMC increased the federal funds rate by another +0.75% (75bps), the third consecutive rate hike of this magnitude. After keeping the target federal funds rate at the lower-bound (basically 0.00%) for two years, the effective federal funds rate has now increased from 0.08% to 3.08% on a year-over-year (YoY) basis. This 3.00% nominal increase is reflective of the historic nature of the current rate hike cycle.
In fact, the last time the effective federal funds rate increased by at least 3.00% on a YoY basis was in September 1981! The magnitude of this tightening cycle is larger than it was in 1995, just 5 years before the Dot-com Bubble burst. It’s also larger than when the Fed was raising rates in 2005, just 3 years before the housing crisis & Great Recession. It’s not apparent what will break this time, but the pattern of excessive tightening in the late-stages of the credit cycle is doomed to repeat.
We’re witnessing historic pressure in the bond market, reflecting the extreme lack of demand for future dollars. This is a reflection of three things:
Investors believe that inflation pressures will remain historically elevated and are unwilling to accept the current yield. With inflation eating away at the interest payments received by the owner of the Treasury, demand has fallen and yields are accelerating to attract investors.
Markets continue to accept that the Fed will keep rates higher for longer. As such, investors don’t want to lend money to the U.S. Treasury and lock in today’s yield if it will be higher in the future. In addition, if interest rates continue to rise, the present value of future interest payments from the bond will be worth less. This means that the value of the bond will decline, resulting in a losing investment.
There is high demand for dollars today, whereas bonds represent future dollars. The U.S. Dollar Index, which compares the value of the dollar vs. a basket of six global currencies (the Euro, Yen, British Pound, Canadian Dollar, Swedish Krona and Swiss Franc), is trading at the highest level since May 2002.
Yields are accelerating because of these three dynamics, highlighting the recursive feedback loop between inflation dynamics, the Federal Reserve, and the bond market. 2-year Treasuries are currently offering a yield of 4.212%, the highest interest rate since August 2007. This time last year, the 2-year Treasury yield was 0.28%.
I’m specifically highlighting the 2-year Treasury yield because of its relationship to the Federal Reserve’s policy actions. Since February, I’ve been sharing data highlighting the correlation between the 2-year yield and the effective federal funds rate, which provides a real-time scorecard of “how far behind the curve” the Fed is.
Based on the chart below, it’s clear to see how tightly the bond market is correlated to Fed policy, which also creates somewhat of a “chicken or the egg” dilemma. Regardless of which one came first, one thing’s for certain: this correlation is very useful to help forecast the direction of monetary policy.
Even with their most recent +0.75% rate hike, the spread between the 2-year Treasury yield and the effective federal funds rate is 1.13%. What does this mean? As of today, the bond market is telling the Fed that they can raise rates by another 113bps. It’s important to note that this is a dynamic relationship. For example, the spread between these two variables was 0.53% at the beginning of August 2022. As such, it’s vital to understand that this is merely what the bond market is telling us today and is subject to change in the future. All we know right now is that the bond market is expecting rates to remain higher, for longer.
Impact on Financial Markets & Asset Prices:
At the beginning of the year, many commentators insisted that the Federal Reserve couldn’t raise rates, let alone get them above 3%. Here we are. Had those experts simply been watching this relationship and understood the Fed’s commitment to fight inflation (it’s literally their mandate to maintain price stability), they would have understood that we were going to get here.
Based on persistent inflation dynamics with underlying inflation measures continuing to accelerate higher and the feedback loop between the bond market & the Federal Reserve, I believe the Federal Reserve will continue to embark on a “higher for longer” monetary policy environment. In turn, this will increasingly drain liquidity out of the financial system (particularly as balance sheet runoff patiently becomes more significant) and simultaneously force investors to calculate future cash flows of any asset at a higher discount rate.
Respectively, this will have three aggregate effects:
All else being equal, liquidity & asset prices have a positive relationship.
Liquidity ↓ = Asset Prices ↓
All else being equal, interest rates & asset prices have an inverse relationship.
Interest Rates ↑ = Asset Prices ↓
Because of the time value of money, which we discussed in last week’s Premium research, more pressure will come to financial markets & asset prices the longer rates remain high & liquidity declines.
Markets have been increasingly accepting of the forward-looking path of monetary policy, one that can most appropriately be described as “higher for longer”. In the Fed’s most recent Summary of Economic Projections, they are currently estimating that the “terminal rate” (AKA the peak effective federal funds rate) will occur in 2023 around 4.6%. That’s merely what they are telling us right now. In their June release of the SEP, they had projected the terminal rate to be approximately 3.8%. As such, it’s vital to recognize that this is a moving target that could certainly be revised depending on the Fed’s progress, or lack thereof, in the fight against inflation.
The selloff in financial assets over the past several weeks has been caused by two things:
Inflation that is appearing to be more persistent than the market anticipated. While headline inflation has appeared to decelerate (down from +9.1% in June to +8.3% in August), alternative measures of underlying inflation dynamics continue to accelerate higher. Whether we look at core CPI, median CPI, trimmed-mean CPI, or sticky price inflation, all of these components are accelerating. Key individual components, like food & shelter, are also showing no signs of slowing down. As such yields have risen to attract investors who need to be compensated for high & persistent inflation.
The Federal Reserve has been firm in their communication that they will fight inflation at all costs and that they can’t prematurely take their foot off the gas pedal. The market is becoming convinced that the Fed will operate with resolve, therefore meaning that rates are expected to remain higher for longer, so long as inflation remains above their target. As such, yields have risen congruent to the expected path of monetary policy.
Personally, I believe that the terminal rate has a high likelihood to exceed 5%. Consider the trend in the Fed’s terminal rate projections:
In December 2021, the Fed’s projection for the terminal rate was 2.5%.
In March 2022, the median projection was 3.0%.
In June 2022, the median projection was 3.8%.
Today, the median projection is 4.8%.
The terminal rate continues to be revised higher and higher, based on the Fed’s projections at the time. What’s to stop this trend from continuing when we consider that minimal progress has been made against inflation, despite weaker economic conditions?
As a direct result of these developments, we’ve seen pain across the asset markets. I expect that this pain will continue, as markets continue to adjust and accept persistent inflation, lower economic growth, and a Federal Reserve poised to keep rates higher for longer.
In late-July & early-August, I shared my view that the market was providing “a beautiful opportunity to de-risk”. In mid-August, the stock, bond & crypto markets were becoming complacent & got too far ahead of themselves. I recognized this by watching the CBOE Market Volatility Index $VIX and seeing it trade below 20. Throughout the year, it’s been an effective strategy to:
Sell risk assets for cash when VIX < 20
Use cash to buy risk assets when VIX > 30
While I certainly wasn’t the first person to recognize or share this strategy, I posted about it in real-time on August 10th:
Four trading days later, on August 16th, the S&P 500 peaked and has since fallen -14.2%. Though the S&P 500 nor the Nasdaq-100 have fallen below their YTD lows from mid-June, the Dow Jones Industrial Average closed on Friday at new YTD lows. Considering that the Dow is composed of mature, value, and high-dividend paying stocks, this could be a worrisome omen for the tech-oriented indexes.
Meanwhile, the S&P 500 is retesting the critical 200-week moving average cloud that I’ve been highlighting all year. Premium members will recall my key prediction in March that called for a retest of the 200-week EMA and potential downside of -10% to -13%. That prediction worked perfectly, but the index is now retesting this important support level for the second time:
The VIX has yet to close above 30 during the latest market downtrend, but closed on Friday at 29.92. As such, it’s very possible that the market could experience another broad-based relief rally in the coming weeks, but I’ll need to see certain milestones be achieved in order to feel more confident about it:
VIX needs a daily close above 30. Even “better”, a weekly close above 30 could add extra confirmation.
Once the VIX experiences a daily/weekly close above 30, I’ll want to see it cross back below 30 in order to increase the likelihood of a shift in trend.
This is merely one component that I’ll be using to make short-term trading decisions, and it’s very possible that these milestones take days, weeks, or months to materialize. Nonetheless, I’ll be watching the $VIX closely as one of many positioning tools.
Regarding Bitcoin & the broader crypto market, I think that digital assets will also experience magnified returns in both directions, depending on what happens with yields, the VIX, and broader financial conditions. At the time of writing, Bitcoin is hovering just above $19,000, though I’m concerned at the fact that price has been getting rejected on the 200-week moving average cloud. As we know, former support can act as future resistance and this is a scenario that I’ve been warning about since June 2022.
Structurally, Bitcoin remains above the pivotal resistance range from 2017-2019. I am concerned about the inability to decisively use this level as support where price rallies higher, so I am prepared for a further breakdown within this teal range, and potentially below it. That could give us a downside scenario below $13.8k, which I believe is becoming increasingly likely. I’ll share more research in tomorrow’s premium analysis that will dive deeper into this price target & downside scenarios.
Conclusion:
Market dynamics continue to reflect weakness and a broader downtrend since November 2021. The catalyst was unequivocally the Federal Reserve’s announcement that they would begin tapering their asset purchases, thereby reducing the amount of liquidity & stimulus they were pumping into the financial system. This announcement was the precursor for outright monetary tightening, which has been the core market dynamic of 2022.
At the present moment, I don’t see any signs that this dynamic is coming to an end. With limited light at the end of the tunnel, I think the path to greener pastures is still long & weary. Investor enthusiasm is terrible, with many people throwing up their hands and simply walking away from the markets until things appear to make more sense. I think that a lot of progress, economically and financially, needs to be made in order to reignite excitement & enthusiasm for investing.
As such, I feel the need to reemphasize risk management and acceptance that the market will experience significant rallies to the upside, which will likely fade back to the downside. This has been the key characteristic of the market in 2022, experiencing several double-digit percent gains only to be denied and proceed to make new lows. The market dynamics of this past week confirm that this is the trend.
If you’d like to hear more of my thoughts on macro dynamics and monetary policy, I’d strongly encourage you to read this thread that I published on Twitter prior to the Federal Reserve’s decision to raise rates by another +0.75% earlier this week:
Best,
Caleb Franzen
DISCLAIMER:
My investment thesis, risk appetite, and time frames are strictly my own and are significantly different than that of my readership. As such, the investments & stocks covered in this publication are not to be considered investment advice and should be regarded as information only. I encourage everyone to conduct their own due diligence, understand the risks associated with any information that is reviewed, and to recognize that my investment approach is not necessarily suitable for your specific portfolio & investing needs. Please consult a registered & licensed financial advisor for any topics related to your portfolio, exercise strong risk controls, and understand that I have no responsibility for any gains or losses incurred in your portfolio.
okay, Caleb is from the future.
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