Due Diligence: I Think That the Market is Wrong and the Federal Reserve is Not Going to Cut Interest Rates. via /r/wallstreetbets
Due Diligence: I Think That the Market is Wrong and the Federal Reserve is Not Going to Cut Interest Rates.
Summary: The market currently believes that there are heavy recessionary pressures hitting right now and that these will come to a boiling point in Q4 2022, forcing the Federal Reserve to cut interest rates. I do not believe that this is going to happen.
Body: The way I see it, the market has been trained like a Pavlovian dog to expect that when ever there are problems with the economy, the Federal Reserve comes in and bails everyone out with their Fed put: QE, rate cuts, the whole shebang. This time, Pavlov's dog is hearing the deafening bell and really wanting some food, but it will not get it. See the figure 1 below. The market believes economic pressures are expected to become too much to handle around the end of Q4 2022, inflation will have fallen, and then we can cut rates and go back to the liquidity extravaganza we have all loved to buy calls upon.
The problem, however, is that this does not align with what the Federal Reserve officials themselves think. The first and most glaring case that I think the market is ignoring is from Governors Neel Kashkari and Christopher Waller. When even Kashkari has turned hawkish, you know there is a problem.
Take a listen to this video. This is from May 10, 2022, not long ago. Of all the parts, most shockingly, it only has 658 views the time I have posted this. With only 658 people that have listened to everything that has been said, I think the market is missing out on some extremely important information.
https://www.youtube.com/watch?v=GQgMe-Ec-C8
The most important part, even though I believe the entire thing is important, starts at 16:55. The two are discussing economic history and how they think it is influencing the present.
Waller: "To get inflation down… in a soft landing… people say you can't do it, you've got to cause a recession and tank the economy, because they're thinking back to Paul Volcker in … 1980… He jacked up interest rates to 20%, tanked the economy… and now the entire world thinks that's what you have to do to bring down inflation."
He then goes on to say, "I'm going to say that's not the case."
And I definitely start to agree with him here – you do not need 20% interest rates. The Volcker Moment was the destination of a 10+ year mistake-ridden journey from Arthur F. Burns before Volcker.
From Waller Again – 17:28: "Volcker had to deal with a world in which inflation was out of control from almost a decade. The Fed had zero credibility in its promises to do anything about inflation, because every time they did…" and this is the best part of all "unemployment would tick up, but they would immediately abandon the inflation (fight) (rate hikes) and went after the unemployment." "That's not the case (now), we barely had inflation for about a year of any significant magnitude, and there is no backing off."
18:40: "…We know the damage that happens if you don't do it. That's the lesson we learned from the 80's. We know what happens from the Fed not taking their job seriously on inflation."
Neel Kashkari: "Well said." Audience laughter….
So, Waller said that they learned their lessons from the 1970's & 1980's. What wrong action led them to this lesson? The Lesson was acting like Arthur F. Burns. What did Arthur Burns do repeatedly that was so bad that eventually led to the Volcker Moment? Well, take a look at 1970/01/01 and 1974/09/01 on the figure 2.) graph below. Each time inflation started to go down, the discount rate – Fed used discount rate in the 1970's, not Fed Funds like today – followed inflation lower to the point where the discount rate never got substantially above the inflation rate until the 1980's, where the discount remained substantially above the inflation rate for some time.
1980 was the key, the economy entered a recession, inflation started to fall – house prices, energy, food, materials – but the discount rate did not fall to being modestly above the CPI y/y rate, the discount rate stayed substantially above the inflation rate for some time – notably in 1983, which put the death nail in the inflation increase with 6.50% real rates. Other wise, there likely would have been another inflation leg higher into 1985.
In figure 3.), this is the CPI y/y vs. the Fed Funds rate.
In figure 4.), this is the real 5 year U.S. rates, using UMich consumer inflation expectations over the next 5 years minus the current 5-year U.S. Treasury rate. I used UMich consumer inflation expectations and not investors inflation expectations from breakevens because I believe the consumer expectations are more accurate – less disconnected – and more relevant and responsive to actual price changes.
Combining figures 3 & 4, we see that the Federal Reserve forward guidance is working, kind of. The 5 year real rates are still negative, and based from what we saw from the 1980's where you need not just positive real rates, but substantially positive real interest rates — 1980's had 6.50% real rates to finally vanquish inflation — vs. the negative 0.10% of today is extremely stimulative.
The most important point here is that at the recessionary bottom in 1972, the real rates were +2% and this was not enough to stop inflation over the next decade, the real rates need to be higher.
Disregard for a minute that we have been in a recession since January and inflation has still increased 7% annualized since the start of our current recession, invalidating the bull parroting that "a recession will cure inflation!" It clearly has not. However, a severe recession might.
And this is where my thesis comes in. The inflation rate is expected to fall when we enter the deeper throws of the recession. If inflation falls to 3% over the next year – extremely optimistic I think – the real rates will still only be +.50% if the Fed gets to a 3.50% Fed Funds, and this is with the fed not cutting rates that everybody thinks they will! The 1980's showed me that we need much higher real rates than 2%, maybe near 6%, once inflation's momentum has increased substantially like it has now and like it did in the 1980's, +.50% just did not cut it back then and will not cut it now. To get substantially positive real rates, we either have to have sustained deflation of about -2% (3.50% fed funds – -2% deflation == +5.50% real rates) or interest rates about 6% with 2% inflation (6% fed funds – 2% inflation == 4% real rates.)
In other words, the Fed Put is dead. Nothing that I think will happen can allow the Federal Reserve to cut interest rates without repeating the mistakes of 1970's and starting a next cycle higher in the inflation rate — which Waller unequivocally stated they will not allow to happen, because of how devastating it will be.
Therefore, the only way I see out of this is that when inflation troughs lower, the federal funds rate stays elevated — no cuts in the Federal Funds rates, and deflation. When the Federal funds rate is not cut going into this inflation trough, the economy is going to severely contract, leading to deflation, like in 2008 when the housing bubble burst. When there is deflation with an un-cut Fed Funds rate at 3.50%, and sustained deflation of about -1.50%, then we will have substantially positive real rates of 5%. This allows the least worst outcome in my mind. The Fed does not have to raise interest rates substantially positive so that the Federal Government does not have to pay substantially higher interest on their debt, and they stamp out the inflation problem. If the Federal Funds rate is cut going into this inflation trough, then we are facing the inflationary momentum of the next legs up like what happened in the 1970's since real rates will now be lower than the substantially positive levels that are necessary.
More evidence that makes me think central bankers see the zugzwang we are in and are going with the not cutting rates and deflation move is from the Financial Times. (no paywall, surprisingly)
https://www.ft.com/content/b937e023-c86c-4b07-b40d-a3266d84f149
And finally, from J. Powell's numerous speeches, but from the Guardian here – https://www.theguardian.com/commentisfree/2022/jun/18/the-federal-reserve-says-its-remedies-for-inflation-will-cause-pain-but-to-whom
"Powell recently made it clear that the Federal Reserve's remedies to combat runaway inflation, "will cause some pain." Will here is a future tense, meaning it has not happened yet.
This echos Waller from earlier — "unemployment would tick up, but they would immediately abandon the inflation (fight) (rate hikes) and went after the unemployment." They are expecting unemployment to tick up — that is the real pain — and they are saying it has to happen and we have to go through with it, meaning we can not try to ease it, with rate cuts.
If this thesis starts to play out this could get bad as this is what home prices vs. income looks like right now in figure 5. As Michael Burry once said, if it's not income that increasing home prices, its leverage.
Positions:
Long Strong Corporate Bonds & U.S. Treasuries: I have not bought any of these, and will not, but I think they will be a good store of value/ slight wealth appreciation to ride out the damage since deflation is good for creditors. I think you can make some money with these with low risk, but I want to make a lot more money since I have some to risk now.
Shorting commodities: High real rates and recessions have always been bad for commodities, deflation is worse. I picked shorting natural gas here.
Shorting Companies that Rely on Low Interest Rates: For this one I have picked going short on Amazon. I think that the consumer is very weak right now, and if we get the deflation they will get weaker. In addition it is by its nature a luxury good, people increase spending at it in good times and switch to inferior goods in bad times, going to Dollar General, Walmart and the like. Amazon is also a classic growth stock with a 51 PE at the time of writing this, not good for what I think will happen. These are pretty short dated, but I'm especially bearish into this earnings season and after will roll them out.
Risk Factors:
As stated previously, the market clearly does not agree with this idea, they think that rate cuts are on the way and the Federal Funds rate will not stay elevated, at a minimum. Even the biggest bears in the market do not agree with this idea – exemplified by Michael J. "Big Short, Bigger Realist" Burry below. If I disagree with this autistic genius, then I am probably 99% chance going to be wrong, but I am holding on to that 1% tightly.
Submitted July 04, 2022 at 03:57AM by due-imaginarium
via reddit
