I put the meme above together in Twitter this week, to illustrate something I’ve been contemplating about Federal Reserve policy. I’ve been following Jeff Snider for quite some time now, and he regularly questions the efficacy of central bank policies.
The summary of ideas I’ve gleaned from Jeff Snider’s work at https://alhambrapartners.com/commentaryanalysis/ is as follows. Please note that this is just my take from reading his work as well as other bond market/Macro takes from other sources in the RealVision crowd.
Basic background with QE and the fed funds rate:
- Central banks do not create money. Money is created by commercial banks in the banking system.
- Interest rates at the long end (US Treasuries) reflect the current rate plus growth expectations. Inverted yield curves such as the famous 2 year vs 10 year reflect negative growth expectations, predicting recession.
- Interest rates at the short end (US Treasuries) merely reflect predictions of the federal funds rate in the coming months.
- Quantitative Easing is merely an asset swap where banks exchange top tier interest-bearing collateral such as US Treasuries and Mortgage-Backed Securities for Bank Reserves on the federal reserve ledger. These reserves do not pay interest, and can’t be withdrawn, they can only be transferred to other banks with accounts at the federal reserve and they show up as a cash-like asset on their balance sheet.
- Central banks such as the fed spend a lot of time discussing perception of policy rather than reality. They never predict recessions. Their goal is mainly to convince people that the economy is doing great and they’ve got everything under control in order to bolster “animal spirits,” kind of like glorified stock market cheerleaders.
- QE works by convincing enough investors that they are “printing money” so that they pile into assets such as housing and money spills over into the real economy. This creates a virtuous spiral (aka asset bubble) where money is borrowed and plowed into assets which gain value, allowing more money to be borrowed against them to boost asset prices even more. This sounds a lot like what happened in Japan.
- Lower fed funds rates encourage banks to expand loans to credit-worthy borrowers at lower rates. This includes lower mortgage rates, as mortgage-backed securities are guaranteed by the federal government. Corporate bonds are also bid up both by investment banks and by investors reaching for yield. Deposits to the general public are cut because banks have less use for them, and private loans, credit cards, and small business loans don’t go down much. One of the biggest effects here is that liquid bond portfolios go up in value as these rates drop, so investment funds re-balance this money into the stock market to keep their stock/bond allocation ratios at their target levels.
Tightening policy with rate hikes and QT (fed balance sheet reduction):
- When the federal funds rate increases, it has a number of effects including:
- Reduces the value of liquid bond portfolios, requiring target funds to sell stocks and purchase bonds to re-balance.
- Feeds quickly into higher mortgage rates. These rates moved from a 2.8% average in July 2021 to 4.2% today. This puts pressure on housing prices by limiting what homeowners can pay and making investors wary of price action.
- Makes it more expensive for corporations to roll over their debt. This doesn’t seem to effect much as long as this debt can be rolled over. The danger is that rising yields my spark solvency concerns, shown by widening credit spreads, which can quickly snowball if it prevents this debt from rolling over, leading to defaults and reducing junk bond liquidity.
- When the government reduces the size of it’s balance sheet (QT), it has a number of effects probably best described here: https://fedguy.com/quantitative-tightening-step-by-step/
- Bank reserves are mechanically reduced. Here’s roughly how that works:
- Interest and principal payments on treasuries held by the federal reserve deducted from the treasury general account or the account of the mortgage broker.
- Banks transfer that money to the federal reserve in the form of “bank reserves” which are credited back to the federal reserve, and the quantity of bank reserves on the federal reserve ledger declines.
- Normally, these payments going to the federal reserve would immediately be replaced by new treasuries held by the bank. Short-dated treasuries still need to be rolled over, and the bank still needs tier 1 capital, so the banks end up purchasing these treasuries from the treasury general account.
- If the federal reserve decides to sell assets from their balance sheet to reduce it faster, these are purchased directly by the banks in exchange for their reserves.
- These banks can either build up treasuries on their balance sheets, sell them on the open market, or use repo transactions to lend them out or borrow against them.
- There is a psychological impact here as investors who were piling into assets such as housing due to fears that QE was highly inflationary money-printing start to worry about these assets declining in value.
- Bank reserves are mechanically reduced. Here’s roughly how that works:
In short, my view here is:
- QE/QT is mainly psychological and doesn’t otherwise affect much. Essentially nothing much happens until investors start to worry about declining asset values enough to spark an avalanche of selling.
- Rising interest rates increase the danger in the financial system by making it more expensive to borrow on assets: mortgages, margin debt, repo operations, and other forms of leverage. This is initially absorbed by the system with little direct effect until it finally starts an avalanche effect as assets are sold to reduce leverage, then more are sold because they are going down, then margin calls hit and values drop like crazy.
- Both of the effects above are roughly binary. They do nothing until a threshold is met, then they do a lot. The federal reserve has a history of tightening until something breaks, and that is what they will do again.
Finally I should mention a few things about the CPI:
- When people or the federal reserve talk about “inflation,” they generally mean the latest CPI reading.
- CPI can spike higher due to supply shocks such as oil shortages, demand shocks such as one-time stimulus checks combined with a rush to fix up home offices, or excess money supply.
- Supply and Demand shocks are generally considered “transitory” because a free market will adjust to produce more of what is demanded while people with crimped budgets will spend less elsewhere.
- If free markets are not allowed to adjust because we are not allowed to drill more oil or mine more metals and we can’t produce the fertilizer to grow more food, then the costs of these items grow fast by crimping demand.
- As prices rise, people heat their homes less, businesses shut down because they can’t afford the input costs, poor people get less to eat, and so on until demand is reduced enough.
- This is the dreaded stagflation where the economy is terrible and everyone has to adjust to having less. Essentially this is where we are now.
- Monetary inflation is quite different. Currency becomes plentiful and easier to get leading to rapid demand-driven growth in pretty much everything. Companies want to expand production, they have the power to charge more and they can pay more, it becomes more difficult to save, everyone wants to borrow and no one wants to lend so interest rates are pressured higher especially at the long end. With 30 year treasury yields at 2.4%, this is clearly not the case.
- Hyperinflation is different than all of the above. This is when the government is pumping money into the economy like crazy to pay for everything. Government employees, businesses, etc. are paid ever higher sums as the economy deteriorates and people lose faith in the currency altogether. You see poor people burning physical cash for heating, that sort of thing. This is definitely not the case.
Now its time for some charts. The federal reserve is raising rates and conducting QE to reduce the high CPI after all, so here’s how that typically works:
Here’s my latest portfolio allocation:
- HEDGES (7.4%)
- 7.0% TLT Calls
- 0.4% SPY Puts
- PRECIOUS METALS (40.8%)
- 7.0% AG (Silver), calls
- 2.8% SAND (Gold, Silver & others), calls
- 6.0% EQX (Gold), calls & shares
- 3.7% LGDTF (Gold)
- 4.2% SILV (Silver)
- 4.0% SILVRF (Silver)
- 3.2% MTA (Gold & Silver)
- 2.9% MGMLF (Gold)
- 1.8% RSNVF (Silver)
- 2.2% SSVFF (Silver)
- 2.2% HAMRF (Gold)
- 0.7% DSVSF (Silver)
- URANIUM (22.7%)
- 10.8% CCJ, mainly shares & some calls
- 3.4% UUUU
- 3.6% UEC
- 1.8% BQSSF
- 1.7% DNN
- 1.4% ENCUF
- US CANNABIS (14.6%)
- 1.7% AYRWF
- 1.9% CCHWF
- 1.9% CRLBF
- 2.0% CURLF
- 1.8% GTBIF
- 1.7% TCNNF
- 1.9% TRSSF
- 1.8% VRNOF
- BATTERY METALS (1.9%)
- 1.3% NOVRF
- 0.6% PGEZF
- CRYPTO (1.1%)
- 1.1% XRP
- OTHER (0.5%)
- 0.4% OGZPY
- 0.1% ATCO calls
- CASH (11.1%)
It’s been a big week, though my portfolio value ended up flat. I had been planning to build up a lot more cash this week, which I often do by selling covered calls.
I was happy to find that all of my covered calls had landed in the money, reducing my precious metals exposure by 3% and my Uranium exposure by 9%. Meanwhile, I added a bit to TLT calls (which lost value) and made my first jump into Battery Metals.
I had originally planned on waiting a year or so before putting much into battery metals as I was worried about an enormous reduction in demand from China as their property sector de-leverages as well as a potential recession here. What changed my mind was the catalyst of the fallout from the Russian invasion of Ukraine. Commodity production is already highly concentrated from severe underinvestment in the west combined with increasing demand to for ESG projects like wind, solar, and electric vehicles. Just like the Sprott physical Uranium fund became the catalyst to drive the chronic undersupply forward in that market, the enormous disruptions from Russia and Ukraine are catalysts for a number of other commodities already in chronic undersupply, including Nickel. I saw some of these battery metals names, with production in North & South America, still trading at severely beaten down prices compared to a year or two ago and I decided I’d better get a starting stake now.
As for my hedges, I think I’m going to stick with TLT calls for the most part. The way I see it, TLT will slowly decline until recession hits (not when its announced; they are always announced and dated by NBER a year or so later) and then it will spike higher. TLT calls tend to be cheaper for the move and you lose less money waiting for them to expire worthless. Puts will exhibit a similar spike effect but the timing isn’t as reliable and you burn more money waiting for them to expire worthless. However, I do think shorter-dated SPY puts can be valuable in playing technical or sentiment-driven market moves. This last week, I purchased a 1-week put prior to the fed meeting in case of a 50bp hike, then sold it the next morning when that didn’t happen for a $120 loss, then purchased a 2-week put end of day Friday assuming that the bounce was temporarily done. I plan to sell it before expiry and it is more of an attempt to follow the market than a hedge, but it still functions as a hedge when it’s on and it costs less to run it that way.
I do think a recession this year is pretty much a given, seeing as how consumers will have to crimp spending due to hefty increases in gas, food and rent so I don’t see how consumer demand is supposed to make up for the enormous reduction in fiscal spending as stimulus checks and unemployment boosters are a thing of the past. This is reflected in the extremely low yields of long bonds, despite the high CPI readings, and the inversions building on the curve. The 20Y-30Y, 7YR-10YR & 5YR-10YR have inverted, but the famous indicator is the 2YR-10YR which hasn’t inverted yet. Once it does, I think I should pile into a lot more TLT calls. Until then, I want to be patient and slowly accumulate long-dated TLT calls because it could easily head lower.
That’s all for now, good luck and happy trading!
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