AFMC - Fight The Fed

2023-10-23 10:00:00 ET

Summary

• There is nothing wrong with fighting the Fed.
• The aggressive rate hike caused massive losses in the system, while the US Treasury putting even more pressure on the debt market.
• The Fed is still fighting persistent inflation, it would be a crucial mistake to declare an early victory.
• The best bet against the Fed I see here is long-term Treasury ETFs.

There is nothing wrong with fighting the Fed

'Don't fight the Fed' is one of the oldest investment mantras out there coined in by Martin Zweig back in the '70s. It generally suggests one shouldn't challenge the central bank's rhetoric and actions. But many did and succeeded, didn't they? For example, in 2021, Jerome Powell said :

It'll turn out to be a one-time sort of bulge in prices, but it won't change inflation going forward.

And well, it was anything but a 'one-time bulge'. Those who bet on inevitable massive rate hikes back in 2021, decided to fight the Fed and won. I believe the problem is not in the 'Fed-fighters' but in the 'Fed-ignorers'. Not taking monetary policy into account while making short-to-mid investments might result in painful losses.

Higher for longer? I don't think so

The Federal Reserve projections model suggests a 5.1% rate, a stable job market and 2.5% PCE inflation. So the regulator expects a 'higher for longer' scenario with a decent soft landing.

I have already expressed my doubts about the Fed being able to hold these rates for a long time in "Why 'Higher For Longer' Is A Myth" . First of all, rates hikes (such aggressive ones, especially) always lead to losses in the system. What really matters here is the depth of these losses, as well as the ability of the system to absorb them. Banks' unrealized losses were at $550 billion in Q2 and are set to rise thanks to bonds sell-off. Fine, right? Banks can just hold these to maturity and never even see actual negative returns. Well, that might be true if there won't be any bank runs like those in March. And yeah, that's a big IF. On the other hand, the effect from rates rising should be hedged, shouldn't it? It should be, but it's not. A study by Erica Jiang, et al. found that 94% of aggregate assets are not hedged by interest rate swaps. Moreover, over 75% "report no material use of interest rate swaps". So all in all, the majority of banks would be very sensitive to any shaking in the industry.

Secondly, the bond market shaking is getting worrisome. The far end of the curve got absolutely hammered last month as the US Treasury flooded the market with new supply. During the 2023 fiscal year (ended September 30), the supply of government debt increased by $2.7 trillion. Yellen's borrowing is primarily in short-term bills, but without the Fed's support, the "length" simply collapses with any attempt to absorb new debt. And it doesn't get any better since the budget deficit is still very deep. There are almost no buyers left in the long-term bond market (the Fed is reducing its balance sheet, Treasury ramps up borrowing, foreign central banks continue to sell US debt), which does not look good and could create the ground for a repeat of the UK Gilts scenario during the Liz Truss times.

However, despite some contrary beliefs , the Fed is still fighting persistent inflation. Consumers with vanishing savings and rising expensive debt, continue to ignore the Fed and refuse to cut spending as expected inflation rate stopped decreasing while spending expectations are still high. This is also visible in rising real retail sales. The only monetary solution for this is to get rates to a restrictive level and hold them for long enough. The rates are at a needed level now in my opinion (+0.25-0.5 bp possibly) and there is no room even for calling for policy easing as the Fed's transmission process is far from being over. So the regulator just hopes everything will work out at these rates but I don't think it will.

Fight the Fed with long-term Treasuries

As bonds fall, Fed officials become more dovish than they were in September saying such a rise in yields was equivalent to a Fed rate hike. This may be a reason to take a pause in November and not raise the rate. The market seems to agree since it really no longer makes sense to raise rates (perhaps in December if inflation signals continue), it’s time to take a wait-and-see approach and just look at the macro data. But in any way, you shouldn't be worried about further hikes and lack of dovish signals since the faster rates rise in this environment, the faster they'll fall since the system just can't work for very long in these conditions. And yeah, we know how fast the Fed would react to the financial meltdown from the 2019 repo crisis and just how fast they can change their shoes. That being said, I would use the further potential drawbacks to increase the exposure but I don't think we are far from the bottom.

The best bet I see here is long-term Treasuries ETFs. Talking specifics, iShares 20+ Year Treasury Bond ETF ( TLT ) offers the opportunity to bet on the far end of the curve yield falling down. The effective duration rate is 16.51 years which is just what we need if rates drop is expected. There are other options such as Vanguard's VGLT with lower expenses but the duration there is lower (16.5 years vs 15.1 years) as well as the total AUM. Better yet, there is ZROZ with zero coupons and a much higher effective duration of 26.14 years for a more aggressive approach. Overall, there are enough options here.

Final thoughts

When it comes to going against the Fed, I see 3 main reasons why it might all just work out perfectly:

• It worked out well before
• Things are much clearer now than a year ago
• Fed has simply been winning too much but I believe they will lose it all at the end

Problems in the system accumulate with every day of high rates and something will still break sooner or later, as always. And that's why I am 'fighting the Fed' - there is too much for the Fed to do.

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