The Breakdown - The Fed Is Scared of Stock Market Animal Spirits

Episode Date: January 6, 2023

  In today's episode, NLW looks at the macro landscape that will set the tone for the markets in 2023. According to the minutes of the December Federal Open Markets Committee Meeting, released on Wednesday, the Federal Reserve is concerned about investor enthusiasm regarding a theoretical future pivot undermining monetary policy tightening. Enjoying this content?   SUBSCRIBE to the Podcast Apple:  https://podcasts.apple.com/podcast/id1438693620?at=1000lSDb Spotify: https://open.spotify.com/show/538vuul1PuorUDwgkC8JWF?si=ddSvD-HST2e_E7wgxcjtfQ Google: https://podcasts.google.com/feed/aHR0cHM6Ly9ubHdjcnlwdG8ubGlic3luLmNvbS9yc3M=   Join the discussion: https://discord.gg/VrKRrfKCz8   Follow on Twitter: NLW: https://twitter.com/nlw Breakdown: https://twitter.com/BreakdownNLW   - “The Breakdown” is written, produced by and features Nathaniel Whittemore aka NLW, with today’s editing by Michele Musso and research by Scott Hill. Jared Schwartz is our executive producer and our theme music is “Countdown” by Neon Beach. Image credit: Drew Angerer/Saff/Getty Images, modified by CoinDesk. Join the discussion at discord.gg/VrKRrfKCz8.  

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is produced and distributed by CoinDest. What's going on, guys? It is Thursday, January 5th, and today we are catching up on the macro scene. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dive deeper into the conversation, come join us on the Breakers Discord. a link in the show notes, we're going to bit.ly slash breakdown pod.

All right, friends, well, for the last couple days, as you know, we have been catching up on crypto from over the break, but today we are going into the macro realm. Because remember, before there was the wrecking ball of Luna and then 3AC and then Sam, and now maybe Barry, there was the macro environment and the Fed just tanking all risk assets. In fact, this week we had something of an anniversary. Yesterday we got the Fed meeting minutes from December, and the meeting minutes are kind of a chance for the Federal Reserve to give extra nuggets of information to drive markets in the direction they want.

It's not an accident that they're released weeks after the actual FOMC meeting. They're used as yet another tool of self-fulfilling prophecy. So if the Fed thinks the markets didn't get the message they were trying to send well enough or got it too well, they can recalibrate. This happened in dramatic fashion in January of last. last year in 2022. In December 2021, the Fed confirmed at their FOMC meeting what everyone anticipated that rate hikes were coming in 2022. In fact, that confirmation drove markets higher, as pretty much everyone in the market thought that the Fed had waited too long to hike rates at

that point. What markets didn't anticipate was that in addition to rate hikes, the Federal Reserve actually anticipated starting to reduce the size of the balance sheet in 2022 as well. In other words, a shift from quantitative easing to quantitative tightening. This was surprising because after the Fed's last period of QE, it took years to actually start to move to balance sheet normalization and eventually reduction. So to do it in just months after rate hikes began would be a dramatic shift. Here's how macro analyst and trader Alex Kruger put it back then. This is excerpted from a thread that he published on January 9th, 2022, almost exactly a year ago.

There has been a very fundamental shift at the Federal Reserve, The Fed has flipped decidedly hawkish. Their main worry is not employment. It is inflation. And to fight inflation, the Fed has to increase interest rates. It all started with Powell's inflation no longer transitory comment of November 30th and culminated with the FOMC minutes released on Wednesday, where Fed officials discussed faster balance sheet normalization. The latter is worrisome enough to trigger a bare market. Raising rates or tapering quantitative easing should not be bearish enough to change the upwards trend across assets. But this goes beyond that. In less than six months, the Fed went from expecting no rate hikes for

2022, party goes on, to expecting three rate hikes accelerated taper and discussing accelerated balance sheet normalization. Balance sheet normalization was not on anyone's radar for a long time. Not only is this now a possibility in the near term, but the Fed is talking about doing so faster than in 2018. That's why crypto assets dropped 15 to 30 percent in two days last week. Accelerated normalization would be dreadfully bearish. What does balance sheet normalization mean? It means reversing the asset purchases conducted under QE. This is also known as quantitative tightening. How does that matter for crypto? Simple. Crypto assets are at the furthest end of the risk curve. Just as they benefited from extraordinarily lax monetary policy, they suffer from unexpectedly tight monetary policy, as money shifts away into safer asset classes.

Furthermore, Bitcoin is now a macro asset that trades as a proxy for liquidity conditions. As liquidity diminishes, macro players now in the fray sell Bitcoin, and all of crypto follows. Let's put this in shitcoin terms. What happens when DeFi projects increased yields via increased supply? Prices go down. And what happens when projects burn supply? Prices go up. The Fed here is your shit coin master in chief, and the U.S. dollar is the king shitcoin.

As the Fed goes from increasing supply, the size of its balance sheet, to burning supply, the U.S. dollar starts going up, and everything else goes down vis-a-vis the dollar. Now, Alex almost perfectly nailed what happened last year after those minutes were released. Of course, he didn't know about all the institutional failure and fraud that would contribute to crypto's downfall over the last 12 months, but he laid out the macro background pretty precisely. So that was last December's FOMC meeting minutes, but the question becomes, what did we get this time? Effectively, these meeting minutes painted a picture of a central bank with a communication problem. The rapid rate increases of the last year have given investors hope that inflation would

quickly slow. But Fed officials are concerned that they will be unable to defeat inflation unless they can keep financial conditions tight through a combination of increasing borrowing costs and lowering stock prices. Market rallies that ease financial conditions threaten to hinder the Federal Reserve's attempt to cool the labor market and tamped down wage growth. The Minutes said, quote, an unwarranted easing in financial conditions, especially if driven by a misperception by the public of how the Fed will react to economic developments, would complicate the committee's effort to restore price stability. Chief U.S. economists at research firm SGAH macro advisors said, quote,

it was a very direct statement. The Fed is saying it is committed to a particular outcome, which is higher unemployment and a weaker labor market. The key issue for investors is whether the Fed will really stick with that plan if inflation is moderating. Now, despite some signs that inflation had peaked last summer, Fed officials indicated that they would continue raising interest rates in case inflation proved to be more persistent this year. While inflation moderated in October and November, the Fed minutes, quote, stressed that it would take substantially more evidence of progress. to be confident that inflation was on a sustained downward path.

They also viewed the risk of persistent inflationary pressures as, quote, a key factor shaping the outlook for policy. Fed economic projections updated in December show a terminal rate for Fed funds above 5%, maintaining this restricted policy well into next year. It also showed inflation only moderating to 3.5% in the coming year still above the target. The Minutes said that no FOMC participants anticipated that rate cuts would be appropriate this year. market indicators are currently pricing a 70% chance that the Fed delivers a 25 basis point hike when it meets again at the start of February, with a 30% chance of a larger 50 basis point hike.

Prior to the release of the minutes, markets had been pricing in at least one rate cut by the end of the year. Really the issue here is the tension that has been on display for the entirety of 2022 and now coming into 2023. It's the Fed saying we are not going to pivot, stop talking about pivoting, we need to hold rates at these restrictive levels for longer, to ensure that inflation is done because if we don't, inflation could come creeping back. Markets, meanwhile, say we don't believe you. And that we don't believe you is driven by a combination of factors, including, one, signals that suggest recession and growth slowdowns are coming or even here, and two, a general lack of faith in the Fed's conviction.

Remember, just how many times last year markets started rallying, only for the Fed to throw cold water on the rally, only for some new indicator to suggest that the Fed was right, only for markets to slink off for a while, only to have the whole cycle repeated again. What the Fed is talking about in these minutes is exactly that, that one of the biggest challenges to them enacting the policy they want is the stock market getting out ahead of itself and in general markets rallying. Now, what about comments from the peanut gallery, aka FinTwit?

Deep Value investor says, hiking into recession, Volker style. Reading the minutes gives you a real sense of how bullheaded the Fed is. When they have a goal, there is very little consideration of risks, consequences. or alternative views. Macro-Alph writes Fed Minutes summary. Don't fuck around with us by pushing arc, shit coins, and Nasdaq to the moon, or we will have to hike to 8%. I think he's dead on, by the way, about this one.

I think that is exactly what they're trying to say. Bob Elliott, the CIO of unlimited funds, says everyone will squint at the minutes, but it won't tell much. The data the Fed sees is what matters and how they respond to it, even though it's backward-looking. Quarter-four growth is strong, U.E. at secular lows, inflation-moderating, but wages growing too fast. Recipe for tighter policy. Still, these minutes weren't the only communique we got from a Fed-related entity this week. Minneapolis Fed President Neil Kashkari also

fully fleshed out his views on appropriate rates policy for the year in an essay published on his medium account on Wednesday. On inflation, he wrote, quote, while I believe it is too soon to definitively declare that inflation has peaked, we are seeing increasing evidence that it may have. In my view, however, it will be appropriate to continue to raise rates at least at the next few meetings until we are confident inflation has peaked." End quote. Keshkari advocated for a further 1% rate increase throughout this year, writing, I have us pausing at 5.4%, but wherever the endpoint is, we won't immediately know if it is high

enough to bring inflation back down to 2% in a reasonable period of time. Any sign of slow progress that keeps inflation elevated for longer will warrant, in my view, taking the policy rate potentially much higher. Now, despite not having an FOMC vote last year, Keshkari emerged as one of the biggest hawks among Fed presidents, which was a switch from an extremely doveish stance earlier in the pandemic. He will be one of the five Fed presidents voting on Fed policy decisions this year, making his elevated rate forecasts all the more important. Kashkari also acknowledged that he and his colleagues missed the signs that inflation was

coming in 2021 and explained that Fed models were calibrated to detect inflationary pressures coming from tight labor markets and elevated inflation expectations, but were not well suited to forecast inflation coming from surging demand, exceeding supply, as we saw during the pandemic. He compared last year's inflation to Uber surge pricing, writing, this is a challenge for economists inside and outside the Fed. Can we develop frameworks and tools to analyze and potentially forecast inflation outside of labor market and expectations channels, specifically surge pricing inflation, but potentially others as well? If we can deepen our analytical capabilities surrounding other sources and channels of inflation, then we might be able to incorporate whatever lessons we

learned into our policy framework going forward. Now, of course, many thought this was pretty rich, given just how many commentators, from the very beginning of Fed QE in 2020 after COVID hit, were predicting exactly what happened, if not always for the exact reasons. Nick Timuros from the Wall Street Journal wrote, Keshkari's essay offers a framework for thinking about why the Fed and other forecasters whiffed so badly on inflation. He says economists need to come up with better ways to diagnose inflation caused by, quote, surge price dynamic or factors besides labor and expectations.

Economics blogger CCW mode wrote, doesn't get much clearer than this, to be honest. Kashkari wants 5.4% terminal rate, and Nick is spelling it out that the Fed isn't happy about the current job opening numbers, higher for longer. Economic analyst of the Boston View says, I've seen enough.

The Fed should not hike rates at the February meeting. They can keep the hawkish language, but the hikes in the pipeline have landed. And just to add, Kashkari confirmed some really dumb-ass thinking today that I had suspected, which is the idea that the Fed needs to keep hiking even if inflation has peaked as a way to, quote, send a message. Is this the Sopranos now? How about using language to send a message? So, of course, the question is how did markets react to all of this?

U.S. stocks ended Wednesday's sessions with minor gains as traders weighed hawkish-fed minutes against a multitude of data showing a slowing economy. The S&P 500 snap a two-day losing streak, perhaps justifying Fed concerns that financial conditions were seeing a, quote, unwarranted loosening, although the morning rally did come to an abrupt halt as the Fed minutes were digested by the market. Joe Gilbert, a portfolio manager at Integrity Ascent Management said, The Fed wanted to send a message to the market that they would not be easing or cutting rates any time in 2023. However, we must remember that the Fed also did not forecast raising rates by 400 basis points 12 months ago. So their forecasting ability of their own actions is sometimes quizzical.

Beyond the immediate news, it's pretty clear where the market's mind is at. To take, for example, a slate of big banks, they are forecasting a U.S. recession is quickly approaching. More than two-thirds of economists surveyed from 23 of the large financial institutions that do business directly with the Federal Reserve are predicting a recession this year, with two other institutions anticipating recession to begin in 2024. These firms, known as primary dealers, cover a range of trading firms and investment banks including Barclays, Bank of America, TD Securities, and UBS Group.

they point to a number of red flags, including American consumers rapidly spending down pandemic savings, a declining housing market, and banks tightening lending standards. As just one example, BNP Parabas could not have been more clear in publishing their 2023 outlook entitled Steering Into Recession, which said, quote, We expect a downturn in global GDP growth in 2023, led by recessions in both the U.S. and the Eurozone. Most economists pointed to the Federal Reserve as the reason behind the slowdown, as their rapid rate hike policy of the last year continues to constrict economic growth to address out-of-control inflation.

On average, economists surveyed by the Wall Street Journal anticipated unemployment to rise above 5% this year from its current 3.7%. Only five firms predicted that the U.S. will avoid recession over the next two years. Those five are Credit Suisse, Goldman Sachs, Goldman Sachs, H.S. B.C., J.P. Morgan and Morgan Stanley. Jeremy Swartz, a senior U.S. economist at Credit Suisse, wrote in his annual economic outlook note that, quote, several historically reliable lead indicators are sending recession signals, but in our view, these measures are unable to correctly gauge recession risk in the current environment. Now, still worth noting these non-recessionary forecasts are far from optimistic.

They're predicting stalled out growth at only 0.5% on average. Goldman Sachs had the most positive outlook anticipating 1% growth for U.S. domestic production. Now, beyond these predictions, are there actually any interesting economic data points rather than just suppositions. Well, one comes from U.S. manufacturing activity, which contracted for the second straight month in December. In so doing, it finished up its worst annual reduction since 2008. Measures of prices paid for materials fell for the ninth straight month, which is the longest stretch of decline since 1975. 13 industries reported contractions with wood products, fabricated metals, chemical and paper seeing the largest declines in production volume. Only primary

metals in petroleum industry saw expansion. The data then seems indicative of a shifting demand away from goods and into services alongside an easing of supply chain constraints. David Rosenberg from Rosenberg Research said ISM just settled the recession debate, of the 18 industries down to just two reporting any growth and up to 13 in contraction. We last saw a gap like this in April 2020. Joey Palatano writes, almost all the major USISM manufacturing subcomponents come inconsistent with a slowdown, and yet employment is still positive. Ideal scenario for the Fed is an overall slowdown with positive employment. growth, but that's a tightrope act.

Speaking of labor, the job openings and labor turnover survey, Jolt's data for November, has shown sustained resilience, remaining at historically high levels despite rising interest rates and recession concerns. Remember, throughout 2022, strong demand for workers was used to validate Fed policy decisions. Chairman Powell has indicated that the high ratio of job openings to unemployed workers is one of his key gauges of labor market tightness and therefore inflationary pressures driven by wages. Rubila Farouk, the chief U.S. economist at high-frequency economics, said, quote, for Fed officials, these data support the view that rates need to move higher and will need to stay high for

some time to soften labor market conditions and lower prices back to target. Reinforcing that this morning, we got even more data showing a sustained hot jobs market. Jobless claims fell in the final weeks of 2022. And in the environment where markets are rooting for a recession so they can get back to easier Fed policy, markets fell on the news. So that Frendos is the outlook from here. That's the macro background. We're starting off 2023 in much the same condition that we ended last year.

And I anticipate that we're going to keep having this fight between the Fed and the markets. So here we go again. Until tomorrow, guys, be safe and take care of each other. Peace.