UPDATE: After I wrote this piece, Peter Boockvar from the Lindsey Group tweeted me to tell me that I was a little late to the party with this idea. It turns out, Peter had already spoken about this very topic last month at a Mauldin Conference. I wasn’t there, nor had anyone mentioned the thought to me, but Peter deserves credit for coming up with the idea first. Peter has graciously allowed me to include his PowerPoint Presentation. Click here and save “target as” to access it.
Think back to September of 2010. At the time, most pundits were bearish US equities. There was a ton of doubt about the efficacy of quantitative easing. Many investors were chasing gold, believing the Fed was pushing on a string and another 2008 style collapse was imminent.
Yet one hedge fund manager was brave enough to get on TV, and take the other side. I still remember watching David Tepper make the convincing case that stocks were a screaming buy.
“Either the economy is going to get better by itself in the next three months…What assets are going to do well? Stocks are going to do well, bonds won’t do so well, gold won’t do as well. Or the economy is not going to pick up in the next three months and the Fed is going to come in with QE. Then what’s going to do well? Everything, in the near term though not bonds…So let’s see what I got—I got two different situations: One, the economy gets better by itself, stocks are better, bonds are worse, gold is probably worse. The other situation is the fed comes in with money.”
The Tepper bottom was formed, and if David was not already in the hedge fund hall of fame, this gutsy call immortalized his spot.
The trade was genius because Tepper realized the Fed would ensure a positive outcome for equities regardless of which path the economy took.
Fast forward to today. Instead of the Fed bankrolling you with promises of QE, they are tightening monetary policy, and making plans to wind down their balance sheet. And it has not gone unnoticed. Over the past week, plenty of smart guys have warned that the Fed no longer has your back. Whether it is Epsilon Theory’s Ben Hunt or former PIMCO head Mohamed El-Erian, the idea that liquidity is being withdrawn from the financial system, and therefore switching to an underweight risk position is starting to gain traction.
Although many of these strategists are preaching caution, at least they have the humility to understand that calling tops is a difficult endeavor. On the other hand, I find it amusing how the recent rise has emboldened a new breed of bulls that know for sure that stocks will continue rising. Or equally funny are those who are 100% convinced we are about to crash. I don’t have a clue how they can be so confident of anything in this environment. We have two of the largest Central Banks in the world (ECB & BoJ) desperately shoveling money into the financial system, with the largest (the Federal Reserve), valiantly trying to mop it up with tighter monetary policies. I understand both sides of the argument, but I am not nearly smart enough to know for sure which way we are headed. If someone tells you they know for certain, you should probably ignore them. The truth of the matter is that this is uncharted territory and how the global financial system will react to these different forces is unknown.
But as I sat thinking about the situation, it occurred to me that we might be in the midst of an anti-Tepper moment. The Federal Reserve is concerned about the excessively easy financial conditions. They have already overseen two large bubbles over the past couple of decades, and they don’t want another on their resume. This explains why even in the absence of inflation, they continue to tighten monetary policy. They have adopted a third mandate - financial conditions.
What do I mean about an anti-Tepper moment? When Tepper called the bottom, he did so because he believed stocks would rise because either; the economy would improve, or the Fed would come in with QE. Either way would be positive for stocks.
In the current environment, we have the opposite situation. Either the economy rolls over (which should be bad for stocks), or it bounces, at which point the Federal Reserve continues on its tightening path (which could also be bad for stocks).
The market is surprised at how the Federal Reserve has not wavered in the face of the recent poor inflation releases. Many market participants believe the Fed will take their foot off the brake. Well, to remove any doubt, a couple of days ago, the Fed’s third most influential member, NY President Bill Dudley made it clear that the Fed’s message from the FOMC meeting would not change. From Bloomberg:
Federal Reserve Bank of New York President William Dudley aligned himself with Chair Janet Yellen in declaring his expectation that a tight labor market will eventually trigger a rebound in inflation data that has been unexpectedly weak in recent months.
“We’re pretty close to what we think is full employment,” Dudley said Monday in Plattsburgh, New York. “Inflation is a little bit lower than what we would like, but we think if the labor market continues to tighten, wages will gradually pick up, and with that, we’ll see inflation get back to 2 percent.”
Yields on U.S. Treasuries rose and the dollar advanced after Dudley’s comments.
Fed officials last week raised their benchmark interest rate for the third time in six months and pushed ahead on plans to begin reducing the central bank’s $4.5 trillion balance sheet later this year – a move that may also tighten policy, in the face of growing concerns over stalled inflation. In remarks that Dudley largely echoed, Yellen said at the time she expected the U.S. economy would continue to expand at a moderate pace for “the next few years.”
Dudley, viewed as an influential voice on the rate-setting Federal Open Market Committee, also sounded a positive note on the U.S. economy overall, while saying the central bank wanted to tighten monetary policy “very judiciously” to avoid derailing the expansion that began in mid-2009.
In a Bloomberg survey of economists earlier this month, respondents put a 60 percent probability, based on the median estimate, on the expansion running through at least July 2019 and thereby reaching 121 months, topping the 10 years of gains during the 1990s.
“I’m actually very confident that even though the expansion is relatively long in the tooth, we still have quite a long way to go,” Dudley said Monday. “This is actually a pretty good place to be.”
The Fed’s preferred measure of inflation, after stripping out food and energy components, slowed to 1.5 percent in the 12 months through April, well short of the central bank’s 2 percent target. That has puzzled economists because it comes as unemployment has consistently declined and stood at a 16-year low of 4.3 percent in May.
“If we were not to withdraw accommodation, the risk would be that the economy would crash to a very, very low unemployment rate, and generate inflation,” Dudley said.“Then the risk would be that we would have to slam on the brakes and the next stop would be a recession.”
The Federal Reserve is not concerned about their inability to meet their inflation mandate over the short run. Instead, they are focused on the possibility of the Phillips Curve causing a spike in inflation they can’t control, but even more importantly, they are petrified about easy financial conditions causing another bubble.
As long as employment does not collapse, then regardless of short run inflation readings, the Federal Reserve will continue to tighten 25 basis points every other meeting. I realize this is not a consensus call. In fact, the market has already abandoned this trajectory.
Not only that, but the Federal Reserve will implement their plan to gradually wind down their balance sheet at the first available opportunity. They have prepared the market, and there is no sense waiting.
Yet the bond market does not agree. The market is looking at recent economic performance and pricing out this possibility. And no wonder. Look at the CitiBank economic surprise index which measures the deviation from consensus for economic releases.
The US economy has rolled over hard. And in doing so, the bond market has eased off their expectations of the Federal Reserve tightening
The market had previously been pricing in almost a 60% chance of a December Fed Funds hike, but with the recent economic weakness, that has fallen to less than 30%.
The bond market is calling the Fed’s bluff. They are in essence saying, “we don’t think you will tighten in the face of a slowing economy.”
And here is where I think the market’s miscalculation lies. I agree that in the past the Federal Reserve did in fact blink and failed to tighen. Yet the difference was that during those periods, the economy was rolling over, but financial conditions were worsening at the same time. The stock market was selling off and credit spreads blowing out. That is the exact opposite of today!
The way I see it, going forward either one of these two things will happen. The stock market will realize the economy is weak, and risk assets will sell off. Or, the economy will bounce, and the Fed will shock the market by continuing to tighten.
All the Fed would need to do is follow through on their guidance and the front end of the bond market would get destroyed. They wouldn’t even need to get more hawkish. Simply not blinking will cause a tremendous amount of pain.
Don’t mistake my forecast on a belief the Federal Reserve is suddenly becoming responsible. I fully expect them to ease once financial conditions back up. There is simply too much debt, and there would be too much pain associated with a more traditional level of interest rates. Yet over the short run, the Fed will keep raising until they cause the tightening of financial conditions.
I respect the fact that the Federal Reserve does not control the private creation of money. There is a chance the Fed might not be able control a melt up, and that they will find themselves behind the curve. After all, that scenario is what I have been predicting for some time now. That is why I am buying at-the-money puts instead of just shorting outright. I am taking advantage of the fact that vol is so cheap. But where I differ from some of my more bearish brethren, is that I am going to short out of the money puts against my long put position. If we get a decline of 10%, I will no longer be bearish. At that point, the Fed will once again be taking their foot off the brake, and eventually even pushing down on the accelerator. So I will forsake the payoff from a big crash, and play for the smaller correction only.
On the other side of the ledger, I am buying bond puts. Although everyone is bearish on the economy, I look at the chart of the Citibank Economic Surprise Index that is being passed around and wonder, who doesn’t realize the economy has underperformed? If I had to guess, I would err on forecasting that this index surprises to the upside in the coming months, not the other way round. The flattening of the yield curve makes this part of the trade tricky, and I am still deciding the best way to play it. But I think you should be short fixed income, not long. And once again, the dirt cheap vol makes buying options a much better play than outright shorts.
Seven years ago when Tepper made his bold call, the Fed was trying their best to get stocks higher. At that point, no one believed, and it took guts to ride along in the Fed’s wagon. Today, the Fed is trying to keep financial conditions from becoming too easy, and once again no one believes.
As Marty Zweig famously said, “don’t fight the Fed.” Sometimes it’s that simple.
Thanks for reading,