Original Compilation Translated: Shenchao TechFlow
Guests:
Alfonso Peccatiello, Macro Specialist, Founder of The Macro Compass
Hosts:
Ryan Sean Adams, Co-founder of Bankless;
David Hoffman, Co-founder of Bankless
Podcast Source: Bankless
Original Title: Fed Rate Cut: What Will Happen to Markets?
Broadcast Date: September 18, 2024
Background Information
Jerome Powell and the Federal Reserve are poised to cut interest rates, but the question on everyone’s mind is… what will happen next?
Alfonso Peccatiello, known as “Macro Alf,” is a macroeconomic analyst and investment strategist who joins the panel to help us address this question.
Are these rate cuts timely or too little, too late?
Will the Fed cut rates by 25 basis points or 50 basis points?
Will we experience the economic recession or soft landing the Fed hopes for?
What will happen to crypto assets?
We discussed all of these topics and more with Macro Alf, one of the leading thinkers in the macroeconomic space.
The Lag of Fed Policy
In this episode, David and Alfonso explore the Fed’s monetary policy and its impact on the economy.
Alfonso points out that the Fed appears lagging in the current economic situation, particularly concerning rate cuts. He notes that the Fed’s primary task is to maintain economic stability, even though its formal goals are to control inflation around 2% and maintain a healthy labor market.
Alfonso explains that the Fed’s focus on curbing inflation over the past two years has led to positive real interest rates, which have had varying effects on borrowers and investors. For investors, higher real interest rates make holding cash more attractive, reducing the motivation for riskier investments. For borrowers, the burden has increased as they must repay debts at higher rates, which slows down economic activity.
Risk of Over-tightening
David raises the question of whether the Fed has been too slow to maintain high rates, which could lead to an economic slowdown.
Alfonso believes that the current scenario indicates the Fed might lag again in cutting rates. He warns that if the Fed continues to be inactive, there is a risk of a sharp economic slowdown.
Alfonso further emphasizes that the degree of monetary policy tightening over the past 18 months has exceeded the levels seen in 2006 and 2007, indicating that current policies are highly restrictive. He mentions that historically, the effects of monetary policy tend to have a lag, often taking 12 to 15 months to materialize. Thus, while many currently believe the economy can withstand high rates, the lagging effects of policy may manifest negative impacts in the coming months.
Future Economic Outlook
Towards the end of the podcast, the discussion shifts to future economic trends. Alfonso notes that despite the prevailing optimism in the markets, historical experience suggests that a seemingly stable economic situation often precedes impending issues. He cautions listeners that while current policies may seem effective, the long-term lag effects should not be overlooked, as greater economic challenges may lie ahead.
Why Hasn’t the Economy Collapsed Yet?
In the podcast, Ryan poses a crucial question: why has the economy not collapsed despite the Fed implementing the most restrictive monetary policy in history? Alfonso elucidates the reasons behind this phenomenon.
Alfonso points out that the current economic lag is quite prolonged due to multiple factors. Typically, when interest rates rise, borrowers (such as households and businesses) reduce borrowing, thereby decreasing spending. However, the current situation differs. Since over 90% of U.S. mortgages are fixed-rate for 30 years, many households do not feel the immediate impact of rising rates. Their fixed-rate loans mean that even if new mortgage rates reach 7%, existing homeowners remain unaffected as their loan rates are still lower.
Corporate Response Strategies
The situation for businesses is similar. Many large companies (like Apple and Microsoft) adopted strategies before the pandemic to extend debt maturities and borrow long-term at low rates. This means that even as the Fed raises rates, businesses do not need to immediately bear higher borrowing costs. Therefore, firms continue to maintain ample cash flow in the short term and may not necessarily reduce investments or spending due to higher rates.
Impact of Fiscal Policy
Additionally, Alfonso mentions that fiscal policy in 2023 has also provided support to the economy. The Biden administration has implemented substantial fiscal deficits, injecting extra funds into households and businesses. This fiscal stimulus has, to some extent, offset the tightening effects of monetary policy, allowing the net wealth of businesses and households to increase even with rising rates.
Bad News
In the podcast, Ryan and Alfonso discuss the implications of bad news in the current economic context. Ryan notes that the Fed’s tools do not seem to be functioning as expected, and potential underlying issues in the economy are akin to a tsunami approaching in the distance—no immediate effects are visible, but a crisis is looming.
Alfonso points out that market reactions to bad news have fundamentally changed in recent years. In pre-pandemic times, weak economic data was often interpreted as good news, suggesting potential rate cuts and fiscal stimulus. However, Alfonso believes the situation has shifted, and bad news has genuinely become bad news.
Changes in the Economic Environment
Alfonso explains that in the past economic environment, markets were accustomed to viewing bad news as “good news,” as it typically meant the Fed would take measures to support the economy. He mentions that from 2013 to 2019, the market generally assumed that bad news did not indicate real risk because the Fed was always there to back the market.
However, the current scenario indicates that the economy is edging closer to recession, and the impact of bad news is becoming more pronounced. Alfonso emphasizes that when economic growth is sluggish, the tolerance for unemployment decreases, and any economic data that falls short of expectations could trigger market panic. For instance, the U.S. currently needs to create about 120,000 jobs monthly to keep the unemployment rate stable, whereas the private sector is only generating around 100,000 jobs per month. This gap means that if bad news emerges, the market will react swiftly, leading to stock market declines.
Memories of the Past
Ryan asks when investors last felt that “bad news is bad news.” Alfonso replies that this can be traced back to the 2008 financial crisis, when negative economic data signified the approach of recession, fundamentally changing market sentiment.
Signals from the Bond Market
Alfonso also notes that the current bond market is sending signals. Poor economic data leads to rising bond prices and falling yields, reflecting market expectations for the Fed to adopt further easing measures. However, the stock market often declines in response, indicating concerns about future economic prospects. In this context, bad news is not merely bad news but exacerbates market unease.
Alfonso emphasizes that under the current economic situation, the impact of bad news has changed, and the market can no longer easily disregard it. As economic growth slows, market reactions to bad news will become more sensitive, prompting investors to reassess this new economic environment.
Fed Rate Cut Predictions
In the podcast, David and Alfonso discuss the likelihood of the Fed cutting rates soon. David mentions market expectations for a rate cut, particularly discussions around a 50 basis point reduction.
Alfonso’s Perspective
Alfonso believes that the Fed will likely opt for a 50 basis point cut, citing several reasons:
Missed Opportunity: Alfonso points out that the Fed should have cut rates in July but failed to act in time. Given the deteriorating economic situation, they should not persist in their stubbornness but rather rectify their previous oversight.
Communication Strategy: He argues that the Fed should clearly convey the reasons for the rate cut, explaining that it is to correct prior mistakes and demonstrating their awareness of the economic slowdown while preparing to take further easing measures.
Future Meeting Schedule: The next Fed meeting is in November, and if they only cut rates by 25 basis points this time while the economy worsens further, they will have to wait until November for another cut, which is not prudent risk management.
Market Expectations: Currently, the bond market has already priced in future rate cuts, with market expectations for 250 basis points of cuts over the next year. If the Fed fails to follow through, the stock market may become anxious, as it relies on the bond market’s expectations.
Nature of Rate Cuts
David inquires whether a 50 basis point cut would indicate that the Fed is acting swiftly.
Alfonso states that such a cut can be seen as a correction for their failure to cut in July, reflecting the Fed’s acknowledgment of the economic slowdown.
Global Economic Impact
Alfonso also mentions that the global economic situation is influencing the Fed’s decisions, particularly the impact of China’s economic slowdown on the U.S. He emphasizes that the Fed needs to exercise caution when cutting rates, while also communicating their understanding and measures in response to the economic situation.
Alfonso believes that the Fed should implement a 50 basis point rate cut to address the current economic challenges and reassure the market through clear communication. He emphasizes that the upcoming rate cut is not just a reaction to the economic slowdown but also a precautionary measure against potential future risks.
Elizabeth Warren’s Open Letter
Ryan mentions Senator Elizabeth Warren’s recent open letter to the Fed, urging a 75 basis point cut. Ryan asks Alfonso for his views on this letter and whether it will impact the Fed’s decisions.
Alfonso’s Analysis
Alfonso believes that Warren’s letter is essentially a strategy for political bargaining. Here are his observations:
Political Bargaining: Alfonso suggests that Warren’s call for a 75 basis point cut is an attempt to influence the Fed’s eventual decision for a 50 basis point cut. By presenting a higher demand, she hopes to prompt the Fed to take more aggressive easing measures.
Fed’s Communication Strategy: Alfonso notes that the Fed cannot publicly communicate during the blackout period (the silence before decision meetings), but they still convey messages through the media. He mentions that the Fed has previously communicated its intentions to the market via Wall Street Journal reporter Nick Timiraos.
Market Reaction: Alfonso states that when the blackout period began, the market only expected a 10% chance of a 50 basis point cut, but following Timiraos’s report, that expectation quickly rose to 55%. This indicates that the Fed can still influence market sentiment through the media during the blackout period.
Stability vs. Instability: Alfonso cites economist Hyman Minsky’s viewpoint, stating that “artificial stability can lead to instability.” He believes that the Fed’s attempts to control market fluctuations to avoid recession and panic may in itself cause greater instability.
Alfonso emphasizes that as investors, we need to understand the rules of market operation and manage risks accordingly. He believes the Fed is striving to convey its intention to implement a 50 basis point cut, while Warren’s letter is part of political maneuvering that may not directly affect the Fed’s final decision.
Market Reaction
In the podcast, David and Alfonso discuss market reactions to the potential Fed rate cuts, particularly the impact of Elizabeth Warren’s request for a 75 basis point cut on the market and the Fed’s decisions.
Alfonso’s Analysis
Market Expectations: Alfonso points out that the market has started to price in a 50 basis point rate cut by the Fed in September, with this expectation reaching 60%. He further indicates that the market also anticipates a 25 basis point cut in November, and a higher probability of another 50 basis point cut in December. This suggests that the market broadly believes the Fed will further cut rates in the coming months.
Importance of Economic Reaction: Alfonso emphasizes that rate cutsThe effectiveness depends on the economic response. If the economy can quickly adapt to interest rate cuts, it may yield positive results. However, the positive effects of rate cuts typically take one to two years to manifest, thus the Federal Reserve’s policies need to be forward-looking rather than merely reactive.
Performance of Risk Assets: David pointed out that market participants are particularly focused on risk assets such as cryptocurrencies in the context of the Federal Reserve’s interest rate cuts. Alfonso noted that rate cuts are generally favorable for risk assets, especially when economic conditions are good, as they are perceived as support from the Federal Reserve. However, if the rate cuts are a response to economic weakness, the reaction of risk assets may differ.
Historical Cases: Alfonso referenced Japan in the 1990s, highlighting that despite rapid rate cuts by the Bank of Japan after the economic bubble burst, the market did not recover. This was because the cuts were not proactive measures to support the economy but rather a passive response to economic weakness.
Alfonso believes that the impact of the Federal Reserve’s rate cut policy on the market depends on the nature of the cuts. If rate cuts are viewed as economic support, the market may react positively; if they are seen as remedial measures for economic weakness, market reactions may be subdued. Therefore, investors need to closely monitor the Federal Reserve’s policy direction and the actual performance of the economy to make informed investment decisions.
Preparing for the Future
Understanding the Current Market Environment
Performance of Risk Assets: Alfonso noted that if the economy enters a recession, risk assets (including cryptocurrencies and stocks) may be impacted. As cryptocurrencies are increasingly seen as risk assets, they may be sold off during market downturns to raise cash.
Impact of De-leveraging: In times of economic downturn, investors often face de-leveraging pressures, leading to increased correlation across all asset classes, exhibiting similar price movements. When investors need cash, they are less concerned about which assets to sell, opting instead for those that can be liquidated quickly.
Portfolio Adjustment Strategies
Maintain Diversification and Risk Balance: Alfonso mentioned the “risk parity” strategy, advising investors to focus on the contribution of each asset class to the overall portfolio risk, rather than merely allocating funds based on fixed ratios. For instance, ensuring each asset contributes equally to the portfolio’s risk.
Reference to Historical Data: Historically, investors often underestimate the extent of Federal Reserve rate cuts. During economic recessions, the Federal Reserve tends to implement more aggressive cuts, resulting in strong performance for bonds in such scenarios.
Recommended Asset Classes
Bonds: During recessions, bonds generally maintain returns, especially in the context of Federal Reserve rate cuts. Although bond prices have already risen, they remain a relatively safe investment choice during economic slowdowns.
Gold: Gold typically performs well during economic uncertainty, and with central banks continuously increasing their gold reserves, demand for gold may continue to rise.
Safe-Haven Currencies: In times of economic crisis, investors often turn to safe-haven currencies such as the yen and Swiss franc, which tend to remain stable during market turbulence.
Avoiding Significant Losses
Focus on Risk Management: Alfonso emphasized that investors should prioritize reducing risk in their portfolios rather than seeking hedging tools. Avoiding significant losses is a fundamental principle of investing, as substantial losses can lead to irreparable financial situations.
Reassessing the Portfolio: Considering the potential for economic recession, investors should review their asset allocation to ensure they are not overly concentrated in high-risk assets.
Probability of Economic Recession
In discussing the likelihood of an economic recession, Alfonso shared his perspective on the probability of a recession occurring within the next 12 months. He estimates the probability to be around 50%. Here are several key factors from his analysis:
Impact of Fiscal Policy
Rapid Fiscal Stimulus: Alfonso pointed out that the current political environment allows the government to act quickly to inject funds into the economy during times of weakness. This differs from past instances, such as during the 2008 financial crisis, when fiscal stimulus measures typically required 6 to 12 months to implement. Today, the government’s rapid response can stabilize the economy to some extent.
Leverage Levels in the Private Sector
Lower Leverage Levels: Currently, leverage levels in the private sector are relatively low, meaning that the debt burden on businesses and households is lighter. This situation suggests that the economic impact of a recession may not be as severe as in the past. In 2007, many households and businesses were over-leveraged, exacerbating the financial crisis.
Market Expectations
Market Recession Probability: The market currently estimates the probability of a recession to be between 35% and 40%, lower than Alfonso’s 50% assessment. This indicates that market participants have relatively high confidence in future economic conditions, but may also be underestimating the risks.
While Alfonso believes the probability of a recession is about 50%, he thinks that if it does occur, its magnitude and impact may not be as severe as in the past. This is mainly due to the government’s rapid response capability and the lower leverage levels in the private sector. Investors should consider these factors when assessing future economic conditions to better adjust their investment strategies and risk management.
Currency Devaluation
In discussing currency devaluation, Ryan and Alfonso mentioned changes in the money supply and their effects on the economy and asset prices.
Definition of Currency Devaluation
Currency Devaluation: Currency devaluation generally refers to a decrease in the purchasing power of money, resulting in a reduced ability to buy the same quantity of goods and services in the future. Ryan noted that even if the economy may face a recession, currency devaluation is an almost inevitable phenomenon.
Changes in Money Supply
Fiat Currency System: Alfonso noted that since the U.S. abandoned the gold standard in 1971, monetary policy has fundamentally changed. The issuance of dollars is no longer tied to hard assets like gold, allowing the government to create new dollars without limit.
Impact of Inflation: As the dollar supply increases, the risk of currency devaluation rises. Alfonso explained that when the government creates too many disposable dollars through deficit spending, the supply of goods and services in the market cannot increase quickly, ultimately leading to price increases, or inflation.
Role of Government and Banks
Government Deficit Spending: The government creates new disposable dollars through deficit spending. For example, the government might issue checks to citizens, increasing the money supply in the market. This practice has been ongoing for the past 30 years, contributing to currency devaluation.
Bank Credit Creation: Banks inject credit into the economy through loans (such as mortgages). Alfonso explained that banks assess borrowers’ loan capacity based on their future cash flow potential, thereby creating new money. This credit expansion further drives up asset prices.
Impact on Asset Prices
Real Estate Market: Due to low interest rates and ongoing credit creation, housing prices continue to rise. Even if wages do not increase significantly, improved borrowing capacity enables people to purchase higher-priced properties.
Comparison with Gold: Alfonso also mentioned that when measured against gold, the actual increase in housing prices may not be significant. This indicates that the rise in housing prices is primarily due to the effects of the fiat currency system rather than an intrinsic increase in property value.
Liquidity of Money
Concept of Money Liquidity
Importance of the Denominator: Ryan pointed out that understanding the flow of funds in the economy hinges on the “denominator.” He noted that the terms used by governments and central banks (such as quantitative easing and fiscal deficits) essentially describe the creation or destruction of money. In most cases, these measures increase the money supply.
Normalization of Fiscal Deficits
Shift in Fiscal Deficits: Alfonso noted that fiscal deficits have transformed from being seen as a “defect” in the past to now being viewed as a “feature.” He believes that the government’s annual deficit spending of one trillion dollars has become the norm, and this shift has profound implications for liquidity and the economy.
Impact on Investors: This ongoing fiscal expenditure will support economic growth but may also lead to inflation and market volatility. Investors need to pay attention to how these policies affect bank reserves, inflation, economic growth, and market performance.
Indicators for Investors to Monitor
Government Spending and Deficits: Investors should monitor large government projects and stimulus programs, particularly those involving hundreds of billions in spending, as well as annual budget deficits. This data is publicly available, and investors can review monthly deficit data released by the U.S. Treasury to understand government spending.
Efficiency of Spending: In addition to focusing on the deficit itself, Alfonso emphasized the importance of spending efficiency. How the government utilizes these funds and where the money flows will directly impact economic productivity and long-term growth.
Widening Wealth Gap
Increasing Wealth Gap: Alfonso also mentioned that the implementation of fiscal policies is exacerbating wealth disparities. As younger generations (such as Millennials and Generation Z) become the main electorate, the economic pressures they face may drive different policies seeking wealth redistribution.
Sustainability Issues: He believes that the current economic system is unsustainable and may lead to greater social and economic pressures in the future, prompting policy changes.
Anti-Devaluation Assets
Classification of Anti-Devaluation Assets
Stock Market: Alfonso noted that stocks are an important anti-devaluation asset, as companies are dollar-denominated and capable of generating cash flow. He emphasized that while companies grow over the long term, investors need to pay attention to valuation at the time of purchase to avoid buying stocks at inflated prices. He recommends investors select high-quality companies and invest at reasonable valuations to ensure good returns over the next 10 to 20 years.
Allocation of Risk Assets
Aggressive Assets: In a portfolio, Alfonso recommends allocating some risk assets, such as cryptocurrencies and gold. Although these assets do not generate cash flow, they possess different monetary characteristics which can diversify the portfolio.
Selection of Defensive Assets
Bonds: As a defensive asset, bonds typically protect portfolios during recessions or deflationary periods, though they may underperform in certain situations (such as in 2022).
Commodities: Alfonso also mentioned that commodities, as dollar-denominated assets, can protect portfolios during inflationary periods, making them worthy defensive assets to consider.
Macroeconomic Investment Strategies
Macro Hedge Funds: Alfonso shared his plans for an upcoming macro hedge fund. He believes that the current macroeconomic environment presents significant investment opportunities, and specific strategies can be employed to leverage these economic fluctuations to provide diversified sources of returns for portfolios.
Conclusion
Key Takeaways:
Federal Reserve’s Decisions: Alfonso believes the Federal Reserve may implement a 50 basis point rate cut to address current economic challenges. He advises investors to pay attention to market reactions under different economic conditions, remain flexible, and avoid being dogmatic in their views.
Importance of Asset Allocation: In an uncertain market environment, appropriately allocating anti-devaluation assets (such as gold, stocks, and cryptocurrencies) is crucial for protecting portfolios. Investors should adjust their investment strategies in response to their risk tolerance and market changes.
Continuous Learning and Adaptation: The market changes rapidly, and investors must continuously learn and adapt to new economic conditions. Alfonso’s educational platform, “Macro Compass,” offers a wealth of resources to help investors gain a deeper understanding of macroeconomics.
Finally, thank you to all the listeners. Remember that investing carries risks, and decisions should be made cautiously. The future is full of uncertainties, but we will continue on this journey of exploration. I hope everyone can maintain an open mind and actively face the challenges ahead. Thank you for your support, and see you next time!
