Tuesday 25, January 2022

Wrap

It has been clear for quite a while now that we’ve been in an “everything rally.” With a few noteable exceptions, such as fossil fuel energy, gold, silver and some bricks and mortar retail stocks, everything seems expensive. The world is awash in many tens of trillions of dollars of negative-yielding fixed income. Just think about this: people are paying governments to take their money for many years in an exchange that they’ll get a return which is negative in nominal terms. In other words, people willingly invest in assets which yield less than putting cash under a mattress.

It’s insane, but while markets keep making all-time highs, it’s rational. If rates are zero today, but 0.25% in a year’s time, holding a 30-year treasury bond makes sense. As long as you don’t hold it to maturity.

Anyway, although they like to like to pretend otherwise, central banks are not omnipotent, and they cannot hold rates away from the natural rate indefinitely. There is an FOMC meeting today, and they are talking about raising rates. With inflation running at 7%, they absolutely have to do it, otherwise the current real rate of around -7% is going to push employment beyond its natural rate, which will cause the price level to rise.

This would be fine if the US government was not running a deficit of around 5%, and juggling a debt burden of around 100% of GDP. If rates start to go up, the interest cost might spiral out of control. Personally, I am not convinced this will happen: central banks can and do buy bonds for freshly-minted reserves. Funding government spending with money is probably the cheapest way possible, over the course of a business cycle, something that even Milton Friedman acknowledged and even recommended.

Anyway, central banks are getting twitchy, and the members of the FOMC have a huge amount of their personal wealth tied up in the stockmarket, so they will not be capable of being wholly dispassionate about what the consequences of their decision is for the state of the stockmarket.

Anyway, currently the market seems to be betting that the Fed will give inflation the priority. The NDX is down 4%, the dollar is up to 96.5, but eurodollar futures are moving down materially. Bonds are fairly flat, as is credit, although it’s definitely trending down. $HYG is down from $87 to $85 this month. I think that credit will break first: even if inflation is heading higher, the flight (to safety) response of the market will tend to support govt. bonds as funds flow out of (riskier) credit.

Energy has been very strong. I can’t decide if this is a rotation into a long-hated sector or a reaction to the probability that Russia will take control of part or all of Ukraine.

At some point, this bearish market will reverse, but somehow I don’t expect it to do so in the same timescale as we saw in March 2020. The Fed simply doesn’t have the cover to rescue the market now. Unless, …, we see the start of a shooting war. Maybe buy some calls on $BA or $LMT as a hedge?