Episode 26

The Gigantism of the Federal Reserve

By:

Director of Trading Education at Interactive Brokers

Rareview Capital founder and CIO Neil Azous joins Andrew Wilkinson to discuss how the Fed might fight inflation in an economy in which fiscal and monetary issues have become joined at the hip.

Summary – Traders’ Insight Radio Ep. 26

The following is a summary of a live audio recording and may contain errors in spelling or grammar.  Although IBKR has edited for clarity no material changes have been made.

Andrew Wilkinson

Hello everybody, welcome to today’s Traders’ Insight Radio podcast. My name is Andrew Wilkinson, and I’m delighted to have with me here on the phone – Neil Azous, founder and CIO of Rareview Capital LLC, which is a registered investment advisor. How are you, Neil?

Neil Azous

I’m great, thank you, Andrew. Great to be with you again.

Andrew Wilkinson

It’s been a long time. We used to do a lot of webinars together.

Neil Azous

That’s right, I’m excited to be here.

Andrew Wilkinson

Very good. Well, I couldn’t think of a better candidate to come on and talk about what’s happening in terms of the Fed. We’ve had a tremendous bearish rally—sorry, a bearish run for the stock market this year. Lots of different factors going on in the background. I wanted to get your views on what’s happening with the Fed, the U.S. economy, and particularly on inflation. So, let me start by asking you this: How does Neil Azous see the world right now?

Neil Azous

Sure. So, there’s been a lot of activity in the last two or three years, either as a result of the pandemic or normal forces doing what they do over time. And that would range from anything like larger deficits, demographics, old people versus young people, this new term we keep hearing about deglobalization and supply chains 2.0. But I try to bring it all back to a market perspective, and the big event for us over the last couple of years, when we were at a wartime during the pandemic, was really the marriage of fiscal and monetary policy, or, if you will, the marriage of the U.S. Treasury and the Federal Reserve … and we termed that here called ‘The Fedury’. And what I mean by that, is that in the past, prior to the pandemic, we had a Federal Reserve, and we really had two or three people at the Federal Reserve: The Chairman; the Vice Chairman; and maybe the head of the New York Fed. They sort of exported three policies to the rest of the world, and it was a pretty fluid set of events over time at all the central banks. We had low interest rates, we had forward guidance, and we bought bonds as part of that quantitative easing program.

If you fast forward, and you see how the world has changed now, when you respond in a war-like fashion, you start to mobilize the fiscal side of things in a lot more robust way. So, whether that’s the deficit, or the administration playing a greater role through executive powers, or the Treasury doing things such as in response to the Russia-Ukraine War regarding sanctions and the confiscation of assets, the overall point is in the past, we had three policymakers, Andrew, or two or three at the Fed that were really driving policy, globally. If you fast forward now, we probably got five to 10 people in the administration, an entire Congress of 400 people, you know, et cetera, and so we basically have 500 chefs in the kitchen. So, by default, we now just have an elevated volatility environment because of the introduction of fiscal activity that is now playing such an outsized role.

So, for us, when we think about things, it’s not so much anymore just in isolation with monetary policy impacting capital markets, it also includes things at the policy and the geopolitical level, as well as the U.S. Treasury given how intertwined they’ve become. And overall, the net result of that is just a higher volatility construct and something that we have to navigate through, which just makes all of our jobs a lot more challenging.

Andrew Wilkinson

So, talk to me a little bit now, then, about inflation and its evolution. Where do you see us with that right now?

Neil Azous

Sure. So, just a quick background of how we go about it first, and then I’ll just tell you where we’re at. So, there are certainly hundreds of metrics that market agents look at to analyze inflation. For us, in the spirit of keeping things simple, Andrew, we believe there are four key drivers of inflation, and we group them into two buckets. One of them is transitory, and one of them is sticky, and what we mean by that is, is that the Federal Reserve will seek to look through any inflation that they perceive to be short-term, like high energy prices or supply chain bottlenecks. And conversely, they’re going to be forced to react to any inflation that’s perceived to be long-term, like housing or wages. So, as I just mentioned, there are four drivers: You have this energy crisis that’s going on; supply chains; housing; and wages. And if you were to just go through those four segments, we think that makes up 90% of the pie. And so we focus on those four big items for simplicity purposes, and when you go through all of those, you know, the net result is very simple. And I can go through each of them, but the key point, overall, is that we can point to a structural backdrop now for all four of those inflation drivers to keep inflation well above 2%, or the trajectory between 3% and 5% for the years to come.

And I’ll just give you a couple quick examples of it unless you want to go through things in more detail, but when you think of … like … the energy crisis … everyone knows that crude oil is the largest input to energy. And at this stage, I think every CEO of an energy producer has been highlighting for years the structural underinvestment, or that lack of capex. And therefore, the expectation is, as a result of that – now that’s been going on for six or eight years since the great energy bear market in 2014 to 2016 – is that the crude oil market is just going to remain structurally tight for the next two or three years. We could certainly go up and down by $25 a barrel, but on an absolute basis, it just… as a result of lack of financing … the green energy movement … the capex– the lack of capex … it just means that it’s structural and it’s not transitory.

On the housing side, just think about it this way: Coming into the pandemic, the country was short 5,000,000 homes, meaning we have not been building homes at the pace that we needed to build to keep up with the demographic growth since the 2008-2009 global financial crisis. So, what’s ended up happening is we walk into a pandemic, we’re short 5,000,000 homes, then we stop building because of the pandemic, so we’re short another million homes, you know, I’m using big round numbers. And then, at the same time, it’s been about 12 years since all those millennials who were living on their parents’ couches during the global financial crisis are now trying to buy their first home. And so, there’s just a structural backdrop of a shortage of housing and an abundance of demand, so that should keep things rising or stable, or if the Fed is going to crush the housing market, the downside is a bit more truncated than it has been in the past based on that supply-demand imbalance.

And then, if you think about the other components like supply chains and wages, similar arguments can be made. Like for wages, right … very much like rent, it’s very hard to reverse once you give an employee a raise. And so how we go about that now going forward, are we in a wage spiral? Is that going to hurt margins, etc.?  The point is, is that all of these things are just not transitory. They’re much more sticky than anyone initially thought, and so it’s very possible that in the springtime of this year, we may have seen the absolute peak in inflation. And we may go down several percent by the end of the year or look at people’s trajectories and forecasts and say, ‘They’re on the right path.’ But on an absolute basis to us, it just seems like things have reset incrementally higher for the next several years, which will make it pretty difficult for the Federal Reserve to achieve that 2% price stability mandate that they have.

Andrew Wilkinson

Do you think that the FOMC [Federal Reserve’s Federal Open Market Committee], somewhat, somewhere in the background welcomes the return of inflation given that it can now get back to using interest rates – something we haven’t seen for many years other than to the downside?

Neil Azous

I think that’s a fair question, Andrew, and to me the truth probably lies in the middle. I think if you rewound the tape a year and we saw this inflation, I think they very much welcomed the idea of that, given that they were looking to achieve something above their 2% target. That way they can sort of give themselves scope to raise interest rates incrementally and then bring them back down to recalibrate the economy when necessary. I think what’s happened, though, over the last 12 months is that the inflation has changed dramatically and well beyond something that they would welcome. The inflation dragon has reared its head, and it’s beyond their scope of overall power to deal with things because it’s included a significant imbalance between supply and demand. And so, I think they welcome it, but I don’t think they welcome this much and for this long of a period of time. And if you really wanted to get into the details of that, I think the data that came out last week, which was the University of Michigan sentiment data, which includes a short-term and long-term inflation expectations in that survey, was a data point that broke the glass that would indicate that they are not comfortable with inflation this high and there’s more nuances to that.

Andrew Wilkinson

Well, let’s into the University of Michigan in a moment. So, behind all the headlines, do you think the Fed is worried?

Neil Azous

I do. I truly do. And when I mentioned that, I think they were reasonably confident that they’re going to be able to achieve some version of a balance between the soft and the hard landing, but I think the data last week shifted their sentiment internally to the point where they became — or I would say, alarm bells went off at the Eccles Building.

Andrew Wilkinson

OK, so come back to the University of Michigan consumer confidence. I like the way you framed it in a piece you sent out recently. You talked about ‘cumulative misery.’ So, the backdrop to this is that the University of Michigan consumer sentiment reading was the lowest since 1978 and that eclipsed the Volcker Recession, 9/11, the Great Financial Crisis, and even COVID-19. Put some color on that, Neil, for us.

Neil Azous

Sure. So, for those who are not familiar, once a month there’s this survey that the University of Michigan institutes, and the data that came out was pretty alarming. So, just putting some hard numbers on it … so people have a reference point or a yardstick … the data came in at a number of 50.2, and it fell by a whopping eight points. And it’s a pretty staggering adjustment to fall that much in one month period, especially to the lowest reading on record. You know, I think the metrics started in 1978, so over a 44-year period, that’s a staggering drop. And then when you put it in the same context that you just did –

when you think about 9/11, the pandemic, the Global Financial Crisis – to drop below that has to raise an eyebrow from a pure sentiment standpoint.

And so, you just referenced this term called ‘cumulative misery’ that I use, and here’s how I sort of frame that: If you think about back in 2008 and 2009, there was a period in there when it we were in the abyss but prices had fallen so much in the asset markets that you felt that everything was in the past tense, or that the government could come and rescue you through … if you remember the alphabet soup programs, including the big $800 billion one called TARP. So, mentally things had fallen enough. The housing and market had crashed. The stock market had gone down 50%. The government and came in and saved you. So, there was this past tense sort of sentiment. And then in the pandemic, while there were certainly moments in there where we all tested, you know, our worst thoughts, there was a mindset that in a relatively short period of time that you would get a shot, and there would be a vaccine, and again, everything was almost in the past tense.

If you fast forward to this exercise that we’re all currently working through, it’s a little bit different. It’s the exact opposite. An argument can be easily made that we never fully recovered from the pandemic. So, the starting point as we walked into inflation was that we were coming from a low base of growth, and that the economy, the country, the world had never truly repaired, as vaccinations are still happening at different speeds, and countries were getting sick at different at different periods, etc. And what’s happened now is that we don’t know when the inflation will end, and we’re also being told that a recession is probable, or at least a greater than 50% chance now over the next 12 to 18 months. So, we’re coming from this low base. We don’t know when inflation ends, and we’re being told that this recession is going to be coming. That ‘cumulative misery’ is a present tense, or a future tense, mindset regarding sentiment. It’s the exact opposite of the other two, and that’s what’s really weighing on people’s emotions and behavior at the moment.

Andrew Wilkinson

We saw the Fed raised rates in June by 75 rather than 50 basis points, and it was more than the Fed had telegraphed. We always used to talk about, and we still do talk about, forward guidance. Could you talk a little bit about what the Fed can do from here in terms of forward guidance, and does it need new forward guidance? And is that a good thing or a bad thing?

Neil Azous

Right, so, just as a way of background, the Federal Reserve had telegraphed that they would raise the interest rate by a half a percent in June, and then another half a percent in July, and then they went into their traditional blackout period, where they do not communicate several days or a week or so before their next FOMC meeting. So, they walked into that meeting with the market pricing in a half a percent of an interest rate hike, and that was the message that was sent and, traditionally, that forward guidance is pretty steadfast and credible – meaning, when they guide the market in advance of that blackout period, or that meeting, they have never really wavered against that unless there’s an emergency situation. Well, fast forward the next day after they went into their blackout period, we received the monthly data regarding the Consumer Price Index, or CPI, and the University of Michigan data that we just briefly discussed. And whatever they saw in those two datasets caused them to change up to a 75 basis points, or 3/4 of a percent, hike. And what that has done in some cases has damaged the concept of forward guidance – meaning, if they told us this one time, and they changed their mind based on some data that came in, what stops them from doing that again? And so, there’s this concept out there about credibility and forward guidance.

The way I think about that is … is that it’s always nice, Andrew, for a market agent to comment on the credibility of the Federal Reserve. I’m giving them a free pass for two reasons, and I don’t think they’re going to change, and I don’t think that the real market professionals, who make significant investments, and take significant risk, are really going to believe that their credibility is truly damaged, and here’s why: I think they received a real-time data set after they went into an embargoed situation, and the data set was so alarming that it required an adjustment in their actions. That’s no different than when they received information regarding the pandemic when they cut interest rates in an emergency fashion. They likely reacted in an emergency fashion to raise them to a certain level. And so, I think, number one, they get a free pass for the emergency action or the alarm bells going off regarding that data that came in.

And then secondly, I would just like to remind everybody that as much as people like to potentially disparage the Fed, or argue that they are terrible at forecasting, the reality is the game that we all play investments is very much predicated on what they’re doing regarding the interest rate market. And the best example of that… It was during the pandemic, where they ringfenced the credit market … the municipal bond market … and provided unlimited liquidity, or a firewall, if you will, to support the world, so we all didn’t — you know – the Earth didn’t stop spinning, Andrew. And so, they were pretty successful at that during the pandemic, and so, it’s very hard actually in the real world to say that they’re truly losing credibility when they actually are able to achieve what they’ve achieved.

And so, that’s kind of how I think about it. They do a gigantic job. It’s a very difficult job, and on a rare occasion, there’s a data set that comes out that changes their hand, and I would actually take the opposite approach and applaud them for reacting in real time, to the data that I believe broke the glass that that led to them negating their forward guidance in the very short-term.

Andrew Wilkinson

Very good. It wouldn’t be a complete discussion unless we talked about the yield curve, its shape and what it’s telling us. Where do we go from here with the shape of the yield curve?

Neil Azous

So, just generally speaking, the shape of the yield curve should invert. In certain parts of the market, it’s already inverted. It should invert in a much more deeper way that will signal an ongoing recession. You know, if you do the analysis on that, depending on which yield curve you like to look at or which maturities, a recession is usually forthcoming somewhere between 6 and 12 months after the yield curve inverts. We saw a version of that back in April of 2022 this year. We’re seeing some semblance of that in the last week or so, and it’s likely to continue to do this, or go deeper into inversion, the more the Federal Reserve tightens financial conditions. So, depending on how far they go above what they call the equilibrium neutral rate, or the rate that they feel like is balancing the economy, if the Federal Reserve hikes interest rates beyond that neutral rate, and financial conditions tighten further, it’s likely that the yield curve will invert further, and that will signal to people that recession probabilities should increase because a recession is forthcoming at a faster rate. I think it’s a pretty basic scenario. I don’t think we need to discuss it ad nauseam. It’s very simple, they’re raising a rate with a very blunt instrument at a very high and fast pace, and at some point, that breaks the economy and inverts the yield curve. And that’s what they’re doing.

Andrew Wilkinson

Very good. Neil Azous, Founder and CIO of Rareview Capital Management, thank you very much for your time today. I always appreciate these chats with you, Neil. It’s been a great discussion.

Neil Azous

Thank you, Andrew. Always happy to be here and look forward to talking to you again.

Andrew Wilkinson

All right, don’t forget to check us out at tradersinsight.news for more market color. Thanks, Neil, and thanks to the audience for listening. Bye for now.

Related Links:

Rareview Capital on IBKR Traders’ Insight

Federal Reserve’s FOMC Statement (June 15, 2022)

FOMC Meeting Calendars, Statements, and Minutes (2017-2022)

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