Undoubtedly, the biggest talk in town last week has to be the rapid rise in the US 10 year yield. We saw markets pricing in interest rates (10 year) at 1.5% and of course that had it’s relative effect on Gold, which went sharply lower, the US Dollar, which reversed 1 week worth of losses across the board and sharply so, S&P500 saw some declines. This is obviously all logical, however, there is one core misunderstanding as to the reason yields are going up. Most people seem to think that yields are raising because the market is pricing in a quicker recovery and faster tapering, in reality, rates are raising because of QE. We saw this in the Great Financial Crisis with each new round of QE raising rates fairly sharply. The reasons are of course fairly straight forward, the one, which is considerably more realistic this time around is inflation expectations, the second is of course that the flood of cheap money will undoubtedly speed of at least some sort of a recovery.
We make one important point above. We say this time around inflation expectations going higher are more realistic? Why? Because of the fiscal stimulus. You see QE is extremely misunderstood by the general population. What QE really is not money printing, it is creating reserves at the Federal Reserve. That means that unless the banks start handing out loans massively those reserves that sit in the Federal Reserves actually never enter the monetary supply, thus, never really making it to the end consumer and thus can’t cause real inflation. Instead that money just creates asset price inflation. This point, is unfortunately, not even well understood among many professionals who continued to expect extreme inflation and instead outside of asset prices we only really saw deflation, which, can be even worse. However, this is exactly why, the fact, that we are seeing a combination of fiscal and monetary stimulus this time around makes the situation vastly different.
We are already seeing some of the unintended effects of the fiscal stimulus. Just look at what happened in the so called meme stocks like GME. The issue it appears is that when you combine asset price inflation with handing out helicopter money to people who end up depositing it into brokerages to try to make a fortune, well you get a financial market that is most definitely broken, void of any real price discovery and instead fueled by large margin positions and wild west type of speculation. It is ironic that people in Congress know so little about markets that they can’t realise the market was virtually a step away from catastrophic failure. If only all of those retail traders with huge call options required delivery on GME stock the system would have virtually blown up. It is also ironic that Congress is failing to see how the regulations with regards to margin requirements to clearing houses literally caused market manipulation. It wasn’t Robinhood that stopped the GME rally it was the Clearinghouses. The biggest irony of it all is that was all possible because of regulation, and those same people in Congress who are clearing showing they have no understanding of markets are crying more of.
Pardon the short detour, but we believe it is an important one. The reason we had to mention the GME situation as an example above is that Yields are definitely raising quicker than when QE 1/2/3/4 was announced. It took 9 months after the first round of QE in the US in 2008 for rates to raise by a 100%. It has taken 9 months for from 2020 for rates to raise 300%. (See the charts below)
What people often forget as well about markets is that rate of change is often more important than actual magnitude of change and this is surely a lot more aggressive. It also shows an attempt by the market to self correct. Of course we will see a lot more inflation due to fiscal stimulus this time around, but we also have to recognise that while COVID was terrible for a lot of businesses, a lot of businesses namely in tech & services thrived. What the bond market is attempting to do is to tell the Fed “hold up”, we are on the brink of a failing system a result of your policy and we need to reintroduce price discovery into the game. We believe the raising rates will very much continue for as long as we see QE going forward. The question is, will the Fed take the hint in times this time around and allow for free market prices to work, or the next time stocks are begging for a bailout, will they continue on the same path and surely imminently result in something catastrophic.
As for the actual effects on different instruments, we expect raising rates to have mild effects on the US Dollar and stocks but ultimately it is unlikely, especially in stocks, to see actual bear market (mind you 20-25% corrections are reasonable) without the Fed shifting its policy to a hawkish one. What we do hope for is for a better read of the music by the people in our Central Banks but we doubt it. We suspect rates will continue to raise and the Fed will likely remain dovish which ultimately will generate the slow down of the economy, because in their fear of allowing stocks to go lower and cause a panic, they will just make the bubble worse and sharply increase the level of bad investments and bad capital allocation, which in turn will eventually lead to rates going lower (as the Fed won’t raise when they need to) which in turn will result into more QE.
The point we are trying to make is simple, rates are raising because of QE & fiscal stimulus combined, which is in turn speeding up the recovery, however, if that means actual tapering – quicker raising of rates, that is the the unknown question.
We recommend people to pay attention to yields and how the Fed reacts to that, because there will be the real clue of what is to come. However, if we are to be naively optimistic, assuming things continue on this path and the Fed allows for price discovery to work and tapers when the markets tells them too, we could be on a road to a healthy market in a couple of years time.