Dear readers,
This morning, I wrote a guest post for The Pomp Letter titled “Markets Take The Stairs Up And The Elevator Down” to cover the craziness across asset classes this week. Tonight, I will publish a Fed postmortem exclusively for paying subscribers to break down market moves, bitcoin nearing its 2017 highs, and my (still) unwavering belief that long-term rates are reaching unsustainable levels and heading lower any second. Here’s the text from this morning’s letter.
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Global macro update
“Markets take the stairs up and the elevator down.” I’ve always loved this old trader adage because of how true it is, and nothing proved it like what happened this week to Treasuries, and to a lesser extent, equities and bitcoin. Today’s post is an overview of the recent chaos across asset classes and a preview of this afternoon’s Federal Reserve interest rate hike.
On Friday, official inflation data remained at a 40-year high, not necessarily a surprise to economic observers. What did surprise was the lack of any slowdown in core and headline inflation, which sent markets into a flurry of repricing. Why did some traders expect for a marginal slowdown in inflation? Interest rates have skyrocketed across the economy over the past several months, and financial conditions have broadly tightened in a significant way. But the counter effects of trillions in monetary stimulus, trillions in fiscal stimulus, supply chain disruptions, and commodity price increases have been impossible to overcome with only a few rate hikes. In fact, it can be argued that inflation is stickier than ever as our post-pandemic world is going through generational adjustments and the rejiggering of how goods move around the world, not to mention a disruptive zero-COVID policy in China.
All of this inflation, and the statistical strength of the trend, gave markets a shake Sunday evening. The Fed, which announces another rate hike this afternoon, was expected to raise rates by 50 basis points at its June and July meetings, and short-term interest rate markets reflected the same. But as markets opened in Asia and Europe on Sunday evening, a rapid adjustment ensued in Treasury yields, spilling over to risk markets. By Monday afternoon, the Fed leaked (via the Wall Street Journal) that it would be hiking rates by 75 basis points instead of 50, and the market understood that backdoor communication as a sign that July’s meeting would also see a hike of 75.
A net increase of 50 basis points in Fed hikes over the coming six weeks was enough to send risk markets into freefall. Stocks entered a formal bear market, and bitcoin fell all the way back down to $20,000, nearing its 2017 highs and lowest level since December 2020. But the real move was in Treasury yields.
The entire Treasury yield curve ratcheted higher by 50 to 75 basis points as prices went into a brief freefall (bond prices and yields move inversely), confirming the good ol’ elevator thesis. Two-year Treasury yields, which respond directly to monetary policy expectations, reached levels last seen in 2007, and 10-year Treasury yields, which trade off general growth and inflation expectations across the world economy, broke out to 2011 levels and surpassed a previously major barrier of resistance at 3.25%. The entire yield curve sits around 3.5% as of this writing. The main takeaway from all this chaos in the Treasury market and rapid adjustment in Fed hike expectations is the tightening of financial conditions.
How can the Fed slow down inflation? By slamming the breaks on the economy via tightening policy and thereby financial conditions. And the tightening trends are certainly gaining steam. First, we have mortgage rates now topping 6% which is sure to slow down the housing sector as affordability plummets due to higher borrowing costs. Elsewhere in the economy, higher Treasury yields feed directly into higher corporate borrowing costs—making credit more expensive and causing companies to slow or stop expansionary plans and hiring. To make matters worse, credit spreads, or the borrowing premium above Treasury yields that companies pay their lenders, are widening. Higher rates are already impacting economic activity, and recessionary fears have increased as the Fed seems committed to its plan of attack on inflation. And its plan of attack appears more and more like causing a recession. A mild one, or so it hopes.
Tightening financial conditions are also present in the level of the dollar versus other currencies—the dollar index is now at 20-year highs, making trillions of dollars borrowed abroad more burdensome to pay back when revenues are locally denominated. Add to that oil prices and other commodity prices at multi-year highs, and countries around the world are beginning to feel choked. Whether or not the Fed is to blame for commodity prices is besides the point—a strong dollar, expensive energy, and the reversal of hot-money trends spell disaster for emerging markets and their asset prices.
We see the decline in equities as a result from this myriad of financial tightening, and bitcoin’s correlation to the stock market has made its price collateral damage. Bitcoin has its own fundamentals, but it has been unable to escape this wave of weakness in risk markets due to global macroeconomic conditions.
Looking forward, the main question to ask is how fast the Fed’s tightening of monetary policy will bring down inflation, as every risk asset is caught in the crossfire along the way. Expect volatility to remain with us until more clarity is achieved on the path of inflation. I do believe inflation will cool down as the economy faces recessionary pressures. For now, however, it remains stubbornly high, which in turn will make the Fed stubborn on the magnitude and pace of tightening its policy rate.
Until next time,
Nik
This post was sponsored by Voltage, provider of enterprise-grade Bitcoin infrastructure.
