Hedge Fund CIO: “The Fed Will Never Again Cause A Market Collapse: The Next Crash Catalyst Will Be Trivial, Stupid”

By Eric Peters, CIO of One River Asset Management

“My beloved dogs Koji and Gustav were taken in Hollywood two nights ago,” tweeted Lady Gaga, the nation reverting to normal, images of the capitol insurrection, the horned Shaman, receding into the depths of our collective humiliation.

“I will pay $500,000 for their safe return,” offered Gaga, no questions asked, returning America to a more innocent time of price inflation and armed dog snatchings. Apparently, these things are on the rise after a year of lonely lockdowns.

You see, handing out cash is rather easy, but you can’t print puppies. So their price quite naturally jumped. And for all the focus on the rising price of long-duration assets in a world of perpetually low interest rates, the market for adorably-ugly French bulldogs has been in a low growl. The imbalance rising, a Minsky moment approaching.

So no sooner had Gaga’s heroic dogwalker taken a bullet to the chest in defense of her pugnacious short-duration assets, then US real rates began a dramatic rise. “The economic recovery remains uneven and far from complete, and the path ahead is highly uncertain,” said Fed Chairman Powell in a policy panic. “There is a long way to go,” he added, attempting to calm fears that rates will rise even slightly.

After all, risks to the economy of an abrupt rise in rates has never been higher with a government budget deficit of 15% for the 2nd year running, debt and leverage at historic highs, and global asset prices having largely adjusted to the lowest interest rates in human history.

Back in 1994, Greenspan hiked rates without preparing the market. Bonds crashed.

Then in 2013, Bernanke suggested he would taper QE purchases. Bonds had a tantrum.

But after decades of monetary manipulations, it is no longer Fed chairmen who markets should fear – they will never again knowingly cause a collapse. The next great catalyst, when it comes, will be against the backdrop of an accommodative Fed. It’ll be seemingly trivial, stupid. Obscure. Franz Ferdinand. French bulldogs.

Temples

“Daily bond returns were 32% correlated with equities in Feb,” said Indiana, our industry’s leading archaeologist, explorer. “This is an asset class with a 2% aggregate return expectation,” he said. “Nobody is holding bonds hoping for something special. They want surety of capital with the aim of buying cheap stuff when asset prices decline,” he said. “That bond aggregate was down more than 2% at its worst point in the month. Bonds no longer work. Not the end of the world. But it illustrates the problem – portfolios are commonly geared.”
 
“Credit performance is terrible,” continued Indiana. “LQD is down more than 4% YTD with spreads barely moving.” Credit is funded through capital markets, not banks. “The weakest LatAm links saw a surge in local rates. Brazilian markets imply rate hikes to 9% through the end of 2023, when the Fed is supposedly on hold. That’s a long way from the current 2% rate,” he said. “It is all one trade. Art. Watches. Antique cars. Houses. Bonds. Equities.” Valuations surged in everything. “An orderly unwind means policy must be prepared to let assets become cheap at some point. The rise in bond yields cannot happen in a vacuum.”
 
“The Fed is being tested,” said Indiana. “Dec 2023 OIS futures now price almost two hikes versus zero for the Fed dots.” This happened with 5yr5yr inflation breakeven spreads down 15bps in Feb and 5yr5yr real yields surging 51bps. “Fed economic types will say the yield rise is good news, reflecting a stronger economy.” The new framework types (Brainard biggest champion) argue that hidden unemployment is rife. “14mm Americans are collecting Federal relief programs that didn’t exist pre-pandemic, a massive number.”
 
“When terms like ‘full range of tools’ are used by the Fed in various settings, I pay attention,’ said Indiana. “Went back to Clarida Feb 2019. Brainard Feb 2020. There are three tools – forward guidance (exhausted), negative policy rates (unanimous distaste at FOMC), and yield curve control (studied for more than a year now).” So the ‘full range of tools’ is really just yield curve targeting now. “Foreign ownership of treasuries is the blind spot for YCC. Rough numbers – foreigners own $7trln (official institutions are $4trln), Fed owns $7trln (including agency mortgages). YCC can accelerate foreign rebalancing away from US treasuries, weakening the dollar, boosting real asset purchases, or both.”
 
“Guess what didn’t move in Feb? China,” he emphasized. “China’s bond market was up a bit on the month and the exchange rate was down a bit,” he said, pausing for the obvious conclusion. “The world is hunting for a new safe-haven and the number-crunching is pointing them to Chinese bonds.” The exchange rate may not be the main act of this play. “China is relaxing outflows, moving up the value curve. Their buying of foreign companies paused in the pandemic, and it is heating up again. That’s the story.”