Business Cycle Manufacturing .gov
(Any views expressed in the below are the personal views of the author and should not form the basis for making investment decisions, nor be construed as a recommendation or advice to engage in investment transactions.)
Financial market cycles are manufactured by Central Banks. A handful of people get to decide the state of the economies and their financial markets.
How are market cycles designed by the Fed? We’ll have a look at the one from 2008 to 2022, as it is freshly coming to and end. A historic 14 year long bull market. In 2008 we had the Great Financial Crisis, fueled by the collapse of shitty Mortgaged Backed Securities, derivative products built on top of them, and spread across the globe by banks, creating a tasty contagion shake. The inevitable downfall of this system coupled with the interplanetary systemic risk accelerated the collapse of entire industries. It was like a snow ball falling off a black slope.
To recover from the GFC, the Fed reverted its destructive tightening policy and came up with a rescue package. A $1.75T balance sheet extension plan combined with interest rates going from 5.26% to sub 1% within 15 months. QE1 was born. Billions of dollars were injected in the economy to refuel empty tanks of liquidity, and lowered interest rates re-boosted spending and brought back consumer confidence. Meanwhile the US government was bailing out who was left to bail out. Companies that collapsed before the rescue package were unlucky. The plan was a success.
Fast forward to 2017, unemployment and inflation are healthy, and the S&P500 fully recovered within 5 years. So by 2017 the Fed thought they could press the break pedal. But they were quickly constrained to abandon the idea.
In 2017 and after 3 rounds of QE, the Fed thought that things were going well. Financial markets could go over a little bump. Unemployment fell to a 17 year low at 4.8%, and inflation was steady within the healthy 2% level. The S&P was up 20% over the year and making new all time highs every month. But although inflation was low, it displayed some signs of over stimulation, as it rose by almost over 1% YoY from 2016. The Fed was successfully achieving its mandate of low inflation and low unemployment, all while the stock market was prosperous. It was time to think of a reverting plan.
So they came up with a Quantitative Tightening (QT) monetary policy. The first monetary contraction plan since the 2008 rescue. In June 2017 the FOMC announced a balance sheet normalization program, coupled with a series of rate hikes to take the Federal Funds Rate from 1.04% to a plateau of 2.20% reached end of 2018 and eventually achieving up to 2.42% by July 2019. The FFR plan was going well and it was the rational thing to do. In a perfect world, the Fed would love to have rates as high as possible while the economy is booming, so that they have full ammo of easing policies available to re-boost in case things go South. At 1% FFR they have very little room. Especially combined with on-going QE.
The QT plan quickly had to be halted. By December 2018, the S&P had dropped 20% from the September high, causing panic and bankers to beg for the Fed to stop. “Why’d you do that? Everything was going so well!” screamed the bankers. So the Fed executed itself, and Janet “I don’t see a financial crisis occurring in our lifetime again” Yellen re-opened the flood gates. Knowing of course, that she was just postponing the inevitable to a later date. So the bull market resumed, and it could have carried on for a very long time. There was only one thing that could stop the party: a black swan event. An unthinkable event that the Fed could not possibly have taken into consideration. And that’s 2020 Covid pandemic. The beginning of the end.
What happened during the first half of 2020 is a brutal and fast revelation that accommodative Central Bank policies were hiding a weakened financial system, which was only surviving thanks to the artificial injection of cash. Just like in 2008, the interdependence of economies revealed the extent of systemic risk it created for the world. Things went down fast and we all know what happened in March 2020.
This time the business cycle was not coming to an end because of natural market forces. It was due to an unprecedented pandemic which motivated the Fed and governments to save the card castle in an irrational way. So the inevitable bull cycle end got postponed again. The March 2020 crash just left a big ‘BTFD’ type of trough on stock indexes charts. The Fed thought “we’ll deal with the consequences of our actions later”, and prioritized saving the markets at all costs. Today, Fed Chairman Jerome Powell admits that it was the right thing to do back then, but that consequences would have to be faced later. And this is where we are now. In retrospect, although debatable on the over exaggeration of the QE plan, the Fed did an amazing job at saving the markets. They deployed liquidity like never before, bringing their balance sheet to $9T, an increase of $4T over 2 years, printing 40% of the total amount of US Dollar in circulation in just 12 months. It was a true display of the Fed’s power.
The plan’s effect could only work so long. Fundamentals were broken and the market always ends up correcting inefficiencies, especially if they are artificially designed. The Fed launched the Secondary Market Corporate Credit Facility, through which it purchased $14B worth of ETFs and corporate bonds directly on the open market. High yield corporate junk bonds were almost trading at par with US Treasuries. Risk was removed from the system. In addition to the Fed’s direct support of financial markets, companies could now borrow at 0% interest rates and refinance their previous loans. Cash was worthless and investors rushed to debt and assets.
Valuations were disconnected from the reality of the economy. Wall Street was thriving, but Main Street was still struggling. The stock market was not growing because of a sudden increase in productivity and innovation. It was thriving because all risk was removed. Accommodative rates boosted company valuations, and the immense availability of liquidity added fuel to the fire. Valuations deviated from the actual GDP and went on their own route, reaching record high levels. Certain company’s market capitalization englobed their entire industry’s market cap. Investors justified it with fantasist explanations. The few mega cap companies were taking over entire stock indexes.
Retail investors and fund managers went completely risk-on, knowing that valuations would go to the roof as updated valuation models now reflected QE and 0% interest rates, while risk-averse investors were on the fence and being laughed at. “I do not believe that he understands the fundamentals that are creating explosive growth and investment opportunities in the innovation space” said Cathie Wood about Michael Burry; while retail was euphoric as they were outperforming Buffet. So meme stocks were the great play of the cycle, creating fortunes and taking back some too. Cryptocurrencies got the liquidity boost they’ve been waiting for while stocks reached ridiculously high valuation multiples. It was speculative assets heaven. The unprofitable tech companies, the SPACs, the doggy coins, the JPEGs… all had their fun in this cycle.
Financial markets are energy drink addicts. They constantly need their liquidity and low rates injections from the Fed. They cannot sustain too long without the intervention of Central Banks.
Covid related QE could only last so long. However, the continuous uncertainty looming over the economy because of new strains of the virus forced the Fed to maintain accommodative policies, just in case we had to go through more lockdowns. But the pandemic eventually eased, and the Fed got behind the curve. Way behind the curve.
The Fed has to bring back interest rates as high as possible after a bull cycle so that they can lower it again when the economy gets exhausted. But each time the new terminal rate is lower than the previous cycle’s. So this system will work until it won’t, and we are approaching the deadline. As the peak of terminal rates get lower every cycle, the Fed is left with less ammunition for the next recession. It’s an endless game of trying to find the right balance to postpone the inevitable, and pass on the apocalyptic decisions to the next Fed board members and government elects. A complete reset would be needed to get back to healthy terms. And this cannot be achieved without a prolonged period of economic pain with the social unrests that come with it.
The ‘reset’ and new financial system will offer new dynamics. Satoshi foresaw that the current mechanisms would eventually come to an end, which ultimately motivated its work on the Bitcoin experiment. After the Bretton Woods and the Nixon shock, the world will undoubtedly be brought together with a newly designed structure, under which Bitcoin does stand a chance and has a role to play.
In retrospect, was the surge and speculative adoption of crypto too soon? Satoshi foresaw that the Fed will eventually get to a point where it will run out of solutions. See the Federal Funds Effective Rate’s chart above, the Fed can only lower rates to 0 (unless they somehow decide to run negative rates) before hiking them as high as possible to then be able to decrease again. What Satoshi essentially foresaw, is that this unsustainable system will eventually end, as rates could not go high enough to make future QEs work. So the Fed will eventually get in a position where it is stuck and cannot hike as much as it should in order to respect its low inflation mandate. This will totally destroy fiat currencies value.
Bitcoin was originally designed to be a savior of the fiat currencies’ downfall, and an alternative to Gold. It’s a Call option on the future in the event the fiat system fails and inflation cannot be tamed. But the 2020 to 2021 run was fueled by speculative aspects, not by fundamentals. And Bitcoin was played as a high positive Beta holding along more traditional assets. So the correlation was high. The inflation narrative for that period does not work. If and when then the inflation narrative takes form and fully makes sense is when we’ll be able to justify ridiculously high price targets for Bitcoin. But it’s not time to shine yet. Bitcoin and crypto will have their glory in due time.
When, is the question. We now have a somewhat better idea of what the Fed will do in the coming months following the latest FOMC meeting’s announcements. On May 4 they announced a 50bps rate hike, bringing the current FFR to 1%, keeping in mind that we started the year at 0.25%. This was combined with their Quantitative Tightening plan, which will kick start on June 1st. This will take form in a $47.5B in balance sheet reduction for 3 months comprising of US Treasuries and MBS. In September they will double that to $95B per month with no termination plan yet, although consensus currently agrees on a total balance sheet shrinkage of $3T. So by end of the year that’s over half a trillion dollar in QT. This compares to almost double the QT from 2017–2019 which was $50B per month. On top of the QT plan they announced the possibility of two 50bps hikes in June and July, bringing the FFR to 2%. This displays a clear conviction of the Fed to tighten monetary conditions and fight inflation.
Investors are playing a dangerous poker game with the Fed, thinking it is bluffing and won’t cause too much pain. Our best chance at predicting where the Fed will take rates up to is by looking at the eurodollar futures curve. Eurodollars are deposits held in USD outside of the US. They are highly liquid and closely tide to the Federal Reserve’s interest rates decisions. As of time of writing (May 20) the curve tells us that the FFR will potentially reach over 3.5% by mid 2023. So with the current rate at 1%, the Fed is behind the curve and needs to accelerate its hawkish policy. All while implementing the largest pull of liquidity it ever did.
But will a 3ish% terminal rate be enough to successfully fight a growing inflation issue, as it records levels not seen in 40 years? With inflation currently at circa 8%, a 3% terminal rate would bring the real rate to 5%, still way off the Fed’s target 2% inflation. So there clearly is going to be an issue post full implementation of Fed’s hawkish policies. Inflation will not be totally dealt with going out of this, and governments will have to face the direct consequences. While the Fed will eventually have to bring another QE to the table… this, is when the inflation hedge narratives will make sense.
Until then, cash is king.
