The Devil Is In The Details — Part 2
The Fed is attempting to “normalize” its balance sheets, meaning they are going to stop buying new bonds and reinvesting maturing bond coupon payments back into the overall bond market.
They are going to try and return the market to its natural state, one which does not run on endless bond purchasing to prop up asset values.
The trick is, the natural health of the market is unknown (read: too poor), so the Fed must closely monitor the market’s health like a dying patient and carry out the transition as slowly and smoothly as possible to prevent any panic.
This is a delicate dance, to say the least. Recall that the entire market has been mispriced due to the bond market being manipulated, a notion once thought inconceivable.
FIGURE 1 — Lowest Interest Rates Ever
Can the Fed restore interest rates? The 200 trillion dollar question everyone is asking.
This is another one of the reasons the Fed’s meetings are so closely watched in the financial markets. Most are saying that the Fed will not be able to raise rates without causing a recession. They go on to say that a stock market crash is inevitable.
“Get into gold! Get into cryptocurrency! Get out of equities now!”
As I will say repeatedly, I try my best to come into any situation objectively. I call this a comprehensive approach. In other words, I try not to take sides, and when it does come time to take a side I will likely prefer the uncrowded side. This is not a matter of being a contrarian, but rather having leverage to larger gains when the crowded side of the trade turns out to be wrong and rushes back into the uncrowded, correct trade.
The fact that nearly everyone is preaching a stock market crash, the end of the USD, and the end of the US economic empire, I must reflect on the possibility of the complete opposite happening.
What if the Fed can raise interest rates (by no longer buying bonds) without crashing the broader bond, currency/FX, and equity markets?
What if instead of a stock market crash, the bond market collapses due to a sovereign debt issue, and thus, the immense liquidity outflow from bond markets finds a new home in equities sending the stock market propelling even higher?
Bond markets are so large ($200 Trillion), they envelop 3x the amount of wealth as those of the equity markets ($70 Trillion) and 1500x the amount of wealth stored in cryptocurrencies ($140 Billion).
Re-read that last part.
It pays to follow developments in the bond market, because everything else that occurs in the currency market, stock market, real estate market, crypto market, and any other active marketplace is a direct effect of bond market price movements.
While everyone in the financial world seems to obsess over interest rates, what they are truly interested in is the bond market, whether they know this or not.
When the Fed discusses hikes or cuts in interest rates, what they are really describing is how they will move forward with their bond market manipulation.
FIGURE 2 — There’s Now Over $200 Trillion in Public Bond Markets
FIGURE 3 — Equities Now Contain Roughly $70 Trillion
If the Fed is not able to restore normalcy to the market what will happen?
The bond market may break before we experience a stock market correction. If this occurs, then it seems within reason to say that the capital outflow from bonds will likely flow into equities, real estate, and perhaps a portion of it will land in cryptocurrencies.
There is $200 Trillion at play here, so any sort of capital outflows from this market will be substantial. Meaning, the thesis that the stock market will collapse due to QE may turn out to be incorrect if the bond market collapses first.
Just ask yourself the following:
Would you be inclined to give your money to say, an Argentine 100-year bond with an 8% yield? Or, would you rather buy into Exxon Mobil with a 4% dividend?
In other words, which has a better chance of paying you out when you want your money back? A government that’s bankrupted 5x in the last 100 years, or a global leader in the world’s energy business with a growing dividend?
I would have to take the bet that the world will continue to use oil over the prospect of any government with a manipulating central bank honoring its word of paying me out on my bond over the course of 100 years!
It sure seems that nearly everyone would agree here, and this is why I see it as a high probability that money fleeing bond markets will search for a new home in equity markets, regardless of valuation fundamentals such as P/E, FCF, Debt-Equity ratios and any other metrics being historically high.
What to do then?
Clearly, I am not going to recommend anyone gain exposure to bonds, whether they be public or private. Central banks are manipulating public bond markets, and private corporate bonds are offering pitifully low yields for companies that are more indebted than any other time in history.
Instead, I would have to suggest thinking about investing in “cheap” undervalued assets that are being overlooked.
When I say overlooked, you will likely have to greatly expand your timeframe and your geographical comfort zone. You may also have to rethink your thoughts on the phrase: “Don’t attempt to catch a falling knife”.
While QE is often portrayed as the tipping point for the fiat system and the single largest reason as to why cryptocurrencies and precious metals will win out the day, I must say that while I do agree with this narrative on a long term time preference, it is not a fully comprehensive one.
The other side of the same narrative suggests it is within the realm of possibility that bond markets collapse before equities do, and thus the capital outflow from bonds will force itself into the equity market, resulting in an artificially-extended bull market in stocks and alternative asset classes.
The widely-held notion of a stock market collapse may happen, too. But if this occurs where will people put their money?
After an initial flight to safety and solvency, this money would most likely search for a new home in T bills, real estate, blue-chips, precious metals, and cryptocurrencies. This is the scenario that we are usually presented with when it comes to QE.
There is a pecking order, a hierarchy of how things will collapse.
The likelihood of bonds collapsing, then stocks collapsing, with property values collapsing, and fiats collapsing all simultaneously seems a bit far-fetched to me.
This is the scenario that some doomsayers lay out as the way that precious metals and cryptocurrencies will shoot to the moon. While this is possible, it does not seem as sure a thing as something disrupting the bond market creating liquidity flight across all assets.
Told you I was not a Chicken Little type!
What seems most likely is a gradual unwinding of the bond market manipulation via the Fed’s interest rate hikes, thereby returning volatility to the equity markets because the free money QE-era is over, overvalued real estate markets experiencing severe corrections like 07/08 in the US along with a tightening credit cycle, and cryptocurrencies/precious metals continuing to gain traction throughout the whole process due to their connection with the global zeitgeist of FUD (yet, not rocketing to the moon as some suggest).
We are dealing with a global system that determines the lives of over 7 billion beings, so suffice it to say that I think things will take longer than most are currently anticipating.
That is not to say that you should not organize your portfolio accordingly today. You absolutely should, but don’t go betting the farm!
As I like to say, oftentimes the way to receive an asymmetric payout is to be holding a position that goes from uncrowded to “it’s getting a bit stuffy in here.”
I hope you’ve enjoyed this 2-part post and have gained a new perspective on the concept of quantitative easing (QE). Moving forward, I will be structuring my thoughts on the world of crypto-assets as it seems to be the soupe du jour.
“The test of a first-rate intelligence is the ability to hold two opposed ideas in mind at the same time and still retain the ability to function” — F. Scott Fitzgerald
DISCLAIMER : This content is for informational, educational and research purposes only. This post is not to be taken as personalized investment advice.