The Fed is a slave to rates traders
It talks a big game, but the Fed is a reactionary institution. It reacts to stocks.
Dear readers,
I hope everybody had a lovely Thanksgiving in the US and a beautiful autumn weekend everywhere else.
For some reason, humungous market moves always seem to happen when I’m traveling abroad. For example, I was in Mexico during February 2020, watching US Treasury yields collapse to zero across the curve as the pandemic panic was setting in. Sure enough, the arrival of yet another COVID-19 variant happened in the last few days of my trip to India, my first time leaving the country since my wife and I got home from Mexico seemingly minutes before the world shut down.
On Friday, as yields accelerated to the downside, I had flashbacks of February 2020. The speed and intensity at which rates moved during the first days of the pandemic was astounding and an essential reminder that US Treasuries are quite literally the only thing that increase in price during financial panic. Despite that, even this seemingly untouchable market struggled with liquidity, as off-the-run Treasuries failed to find a bid and traded at ungodly discounts to on-the-run Treasuries.
On-the-run bonds are bonds that have just been issued. Off-the-run bonds describe bonds that are not freshly issued. For example, the current on-the-run 5-year US Treasury note was auctioned on November 22nd, settles on November 30th, and matures on November 30, 2026 (the CUSIP [identifier] is 912821GW9). The 5-year US Treasury note that auctioned on October 27th and matures on October 31, 2026 (CUSIP 91282CDG3) is now considered off-the-run. On-the-runs generally have superior liquidity to off-the-run bonds, but this chasm widened drastically during the initial COVID panic. The Fed’s QE program was in part to address this market breakage.
Friday had a similar, albeit milder feel. The risk-off move could unwind itself by the time you read this—early indications from the markets are higher oil, higher equities, and higher yields. I’m no scientist, so I’ll wait for the markets to tell me the true threat of the latest variant, or lack thereof. But it’s still an opportunity to revisit current market dynamics and Federal Reserve policy. We’ll also take a quick look at the bitcoin price chart, and answer the age-old question: is bitcoin a risk-on or a risk-off asset?
QE infinity
The Fed doesn’t have the ability to react to dynamic conditions; it behaves in a binary way. If things are going well, it can tighten policy. If the economy is in trouble, it eases policy. How is the Fed positioned right now, and how quickly can they change?
Easy monetary policy means low rates and QE. Tight monetary policy would be reducing QE and increasing interest rates. I recently wrote a nice explainer [FREE POST] to help you with some of this lingo:
Currently, inflation is running hot in the United States. Headline statistics point to multi-decade high increases in aggregate price levels. The Fed has monetary policy at essentially the easiest it has ever been, but with inflation waking up, this will soon come to an end. Paying subscribers received a global macro update from me at the end of October that describes why the Fed is clearly heading into a policy error in which it tightens policy despite longer-term growth and inflation expectations coming down, due to tighter monetary policy itself (that’s why it’s called policy error):
For the past several years, and even more since the pandemic, the stock market exhibits behavior of implicit bailouts. When stocks decline in a material way, the Fed is always there to save the day. No matter what the current state of monetary policy, a rapid 10-15% decline in equity prices brings the Fed right back into the easing seat. This brings us to the Omicron variant.