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So far, my 2023 investing looks just like 2022: lots of waiting. I’m not waiting for a recession to pass or for GDP to improve. I’m not waiting for a certain employment report or for corporate earnings to change. I’m not waiting for the Consumer Price Index (CPI) to moderate or for the Purchasers Managers’ Index to rebound. I’m waiting for just one thing before I increase my risk exposures. I’m waiting for the Federal Reserve (Fed) to stop raising interests. I’m waiting for a Fed Pivot.
Google searches for “Fed pivot” increased this year. Source: Google Trends
To be sure, many are waiting for the Fed to reverse its policy course. Some have even publicly pleaded for a ceasefire. However, our reasons differ. Mine relate to my market framework rather than—as I see it— weakly-supported, economic dogma.
The Fed seems to be worried more about its legacy than the economy: it is ignoring deflationary and dangerous signals. Relying on lagging inflation indicators like the CPI, Fed Governor Waller is calling for another hike of 0.75% in July.— Cathie Wood (@CathieDWood) June 19, 2022
If the Fed raises rates again next week, the recession will be greatly amplified— Elon Musk (@elonmusk) December 9, 2022
A Fed pivot: What it is and why it happens
A Fed pivot is a point at which the Fed changes its monetary policy stance. It can mark a switch from “loose” policies to “tight” ones, or vice versa. This most visibly manifests in the federal funds rate (FFR) for which the Fed targets as a matter of monetary policy. Hence, the Fed pivots when it shifts from raising the FFR to cutting it, or from cutting to hiking.
There are several theories underpinning a Fed pivot. The most popular relates to the monetary transmission mechanism of policy. In this Keynesian framework, that is shared by most other mainstream schools of thought, the Fed controls (or at least influences) U.S. economic performance by changing the FFR. High interest rates weaken demand and, as a result, economic output. Low interest rates, on the other hand, stimulate growth. Thus, many believe that the Fed raises the FFR until “something breaks” in the economy, which prods the central bank to cut them until growth resumes; however, only up to a point. Then, the Fed must restart its hiking in order to prevent catastrophic “overheating”; and around and around we go.
Changes in the federal funds rate trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output, and prices of goods and services.The Federal Reserve
This theory rests on the belief that monetary policy is a blunt tool that works with a lag. In other words, changes to interest rates have imprecise impacts that require time to manifest. Milton Friedman mostly famously posited this view for an American Economic Association session in 1972. In it, he examined the lags between changes in money supply metrics (M1 and M2) and industrial production and the CPI. Friedman found inconsistent relationships between his various measures of money and economic performance, ranging from a lead of 1 month to a lag of 31 months.
Despite finding many inconsistencies between changes in the money supply and economic outcomes Milton Friedman still professed a relationship. Source: Milton Friedman, Have Monetary Policies Failed?
Friedman was surprisingly unfazed by these inconsistencies. Sound theories have tight relationships between cause and effect. Instead of scrapping his framework, though, Friedman summarily asserts that monetary policy had simply been misapplied (“My final conclusion from this reexamination of postwar experience is that monetary policy did not fail in the past three years in the relevant scientific sense. The drugs produced the effect to be expected, though the wrong drug was administered and the patient expected it to be far more potent than it was capable of being.”). This gave birth to the popular belief that monetary policy has predictable, but lagged effects.
In late 1971 Friedman reexamined postwar evidence and found an 11- to 31-month lag from monetary growth to inflation, leading to his later summary of the evidence that there was a two-year lag from money growth to inflation and “output responds more quickly than prices…” The two-year rule of thumb from monetary policy actions to inflation, which entered Friedman’s framework in 1971, has since become standard.Edward Nelson, Milton Friedman and U.S. Monetary History: 1961-2006
Quite honestly, I’m disturbed by the economic orthodoxy’s comfort with such imprecise findings. If monetary policy is so blunt then why do we stress over tiny, 0.25% changes in the FFR? Why do policymakers thoroughly debate such small adjustments? Why do markets react so violently to miniscule policy shifts? Shouldn’t there be large room for errors and plenty of time for investors to react to such a blunt and lagging policy? Something’s off.
The history of the FFR’s rise to prominence as a policy tool raises another flag. The Fed was originally designed to improve commercial bank liquidity and the FFR was one of its means. That only changed 64 years later when Congress desperately sought a policy fix for the stagflation of the 1970s. Keynesianism offered the FFR as a convenient solution. The FFR wasn’t devised as macroeconomic tool from first principles. It was elevated to one after the fact. Thus, FFR’s professed impacts appear like rationalizations.
The orthodoxy guiding policy in the post-WWII era was Keynesian stabilization policy, motivated in large part by the painful memory of the unprecedented high unemployment in the United States and around the world during the 1930s. The focal point of these policies was the management of aggregate spending (demand) by way of the spending and taxation policies of the fiscal authority and the monetary policies of the central bank. The idea that monetary policy can and should be used to manage aggregate spending and stabilize economic activity is still a generally accepted tenet that guides the policies of the Federal Reserve and other central banks today.Michael Bryan, The Great Inflation
Thus, I see scant evidence for such faith in monetary policy. While their theorized effects may hold true at certain times and for certain parts of the economy, they don’t seem to deliver the precise and macroeconomic effects assumed. Worse, asserting blunt and lagged relationships removes monetary policy from objective scrutiny thereby protecting its vaulted status within mainstream economics (and those people and institutions reliant upon it).
Less important, not unimportant
I’ve invested in credit markets for nearly two decades. Thus, I have a practitioner’s understanding for how interest rates impact corporations, borrowers, and investment markets. I don’t deny their importance; interest rates absolutely matter. However, in my experience, the FFR’s impact is not as clean-cut as many macro-focused economists, policymakers, and investors believe.
Markets are multivariate, nonlinear, and nonstationary; they have many inputs that vary in importance with, and over time. In some periods the FFR can be a large factor and other times none at all. Thus, monetary policy’s market impacts are hardly predictable. Unpredictable, though, differs from claims of blunt and lagging impacts. The latter presumes a level of certainty which simply does not exist.
A large body of research tells us it can take 18 months to two years or more for tighter monetary policy to materially affect inflation. … To be sure, there is considerable uncertainty about how these policy lags will play out. … Still, monetary policy unquestionably works with a lag. [Emphasis is mine.]Raphael Bostic, President and Chief Executive Officer, Federal Reserve Bank of Atlanta (source)
Economists are highly convicted in monetary policy’s lags despite not understanding them.
The chart below shows the relationship between the FFR (blue), corporate bond yields (using Moody’s Baa ratings category as a proxy, shown in red), and the spread between the two (i.e. the difference, shown in green). Remember, the FFR is a market rate. The Fed only influences it via arbitrage (it buys and sells a small list of regulatorily-fungible securities, like short-dated U.S. Treasury notes). Only commercial banks can access the FFR. Corporations and individuals borrow at a multitude of other interest rates that vary with their creditworthiness, length of the loan, collateral, and claim priority.
Note how much the spread for borrowers varies over time. It looks unrelated to the FFR; otherwise, the green line would be near-horizontal. The spread ranges from a low of 0.50% to a high of 8.82%. While some relationship exists (both the red and blues have declined over time), it’s hardly linear. There are times at which borrowers pay high rates of interest despite a low FFR, and vice versa.
Thus, I don’t strongly accept the monetary transmission myths so commonly believed by market participants. Corporations and individuals drive economic output. The Fed’s impact on their borrowing rates seems less important than other factors. The FFR is just one of many inputs.
Why my Fed focus then?
Yet, I remain focused on the FFR’s trajectory for my own investing; but not for their professed economic impacts. I mentally model investment markets as carry trades (as discussed more here, here, and here, for example). Thus, I believe that borrowing costs impact market transactions. However, I’m less focused on the absolute level of interest rates as I am on their volatilities—or the amount by which they fluctuate.
The financial system is simply a series of interconnected financial service companies including banks, insurance companies, investment companies, pension funds, finance providers, and individuals. Many buy assets with leverage. Banks borrow from depositors and lenders, insurance companies borrow from policyholders (whom they repay under certain conditions like property damage or death), pensions promise retirement payments in return for present contributions (which may be employer-funded), individuals use margin debt. Thus, the financial system is a leveraged system whereby many investors rely upon borrowed funds. It’s a carry trade.
There are two parts to a carry trade: the funding side (i.e the cost of borrowing) and the return side (the investment return). Carry trades can be incredibly profitable when both are stable (due to the leverage). However, variations in either side of the trade—the investment return or the funding cost—can be catastrophic (also due to the leverage). Carry trade investors care only about the spread—or difference between these two rates—not their absolute levels. For example, an investor should equally prefer to borrow at 3% and invest at 6% and to borrow at 9% and invest at 12%, all else equal (which is never the case in practice, of course).
Thus, realized interest rate volatilities concerns me. The chart below shows that the realized volatility for corporate borrowing spreads is currently high (the blue line in the bottom panel). While not always the case (for example, the COVID lockdowns increased volatility in 2020 and the Great Financial Crisis in 2008), today’s higher-volatility environment seems to coincide with the Fed’s hiking cycle (the orange line in the top panel). I think rising borrowing costs might be forcing some carry trade investors to unwind (i.e. sell). This has a procyclical effect where forced selling further depresses asset yields, leading to more unwinds.
While not always the case, today’s high corporate spread volatility (blue) seems to coincide with the Fed’s hiking cycle (orange). Source: TradingView
To be sure, I’m working with a small sample size. The Fed has only hiked a handful of times in history. However, they do associate to periods of higher volatility. Thus, I’ve scaled my conviction to the limited available data, which is more than can be said for policymakers.
Godot seems to come
While my framework might dictate that I wait out the Fed, I still need to evaluate its practicality. For example, I was skittish of markets early into the Fed’s Quantitative Easing policy. While well-grounded in theory, my decisions hurt my investing. Eventually, I course corrected. I developed a better investing framework with more practical utility.
The effective FFR seems to fall after peaking rather than plateau.
Today, waiting seems more promising. As shown above, hiking cycles always end. Furthermore, the Fed seems to immediately shift from hiking to cutting. Only once was the FFR stable for any prolonged period of time (mid-1990s). Thus, history seems to also favor a Fed pivot. Futures markets are also pricing in FFR cuts for later this year adding to my conviction (below).
Futures markets are pricing in FFR cuts for later this year. Source: Federal Reserve Bank of Atlanta
Importantly, my carry trade perspective shortens the required confirmation period between a Fed pivot and my expected market reaction. I should quickly know if I’m wrong. Friedman’s “two-year rule” implies that I’d have to wait nearly 24 months before confirming or refuting my investment thesis with economic data. Ascribing early gains to “forward looking” markets would not be honest. Hence, my carry trade framework seems like a more integrated, dynamic, practical, and honest investing approach for a Fed pivot.
Pivoting to a better Fed pivot view
Many market participants seem to be waiting for the Fed to pivot its policy stance. While most seemed focused on the Fed’s economic impacts, mine is more market-focused.
Monetary policy is believed to have blunt and lagged impacts. However, there’s scant evidence for these assertions. Rather than explain the relationship between the FFR and market performance, such accepted claims have insulated monetary policy from objective scrutiny. Instead, the FFR’s impact are generally and summarily accepted.
In my experience, the FFR’s impacts are less certain than popularly believed. Markets have many and changing inputs. At times the FFR can matter, but sometimes not at all. Other factors appear more important at most times.
Yet, I remain focused on the Fed’s hiking path. This is due to my framework that models markets as carry trades. Volatility in borrowing costs can cause forced-selling and potentially depress asset values in a self-reinforcing loop. That said, the limited sample size of Fed hiking cycles reduces my thesis conviction.
Luckily, history’s on my side for waiting. The Fed almost always cuts policy rates after raising them which is reflected in futures markets. Thus, compared to the popular monetary transmission framework, I can more honestly assess and limit the wait time required when waiting for the Fed to pivot.
A friendly reminder: This article conveys my personal opinions and should not be construed as investment advice or recommendations to purchase or sell any investment, product or service, nor should the content be relied upon for making investment decisions. Commentaries are for informational purposes only.
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