The Fed, Recession & Future Outlook

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An overview of The Fed’s failures, reactions, future outlook and trade ideas.

Introduction

Over the last two years, we have seen the (over)use of the weapons of the central bank, including quantitative easing and bond purchases. Liquidity was available on scales that have never been seen before: money simply had nowhere to go. The Fed had taken the bad news of coronavirus and lockdowns, and provided the economy with what was essentially a 1–2 year long financial party — literally free money. Valuations skyrocketed and investors dumped cash into cool sounding stocks, literal ponzis, monkey pictures, trading cards and anything that even suggested a return greater than 1% was achievable. The subsequent crash was inevitable, the only real question was when? It seems that has now been answered.

M1 Money Supply, Source: Fred

Recent History

Basic macroeconomics and modern monetary theory would tell you that the simple cost of QE is inflation — increased money supply would mean there are more dollars chasing the same amount of goods, so consumers can offer higher prices, therefore producers of goods/services would start asking higher prices. It could also be said that inflation is not even a big deal, because it would erode the cost of debt for the government, meaning that all the borrowing done in the initial response by The Fed could essentially come for free. However, reality does not play by the same rules as macroeconomic theory. There are no assumptions that always hold true and there is no rational behaviour. Reality is complex, where there are millions of factors influencing large systems (economies) and participants with varying influence and impacts. What actually happened was inflation on scales beyond expectations of The Fed, who initially insisted that it was ‘transitory’ and would pass as suggested by theory.

What Went Wrong?

The Fed’s actions, though alone were not necessarily the cause of a (near) recession, they made the economy fragile. When an economy is on the brink of high inflation, all it takes is a sudden lack of wind energy generation, bad harvest or supply-chain issue to turn mild inflation into scorching hot inflation. On top of this, there are bad actors in the world, such as Vladimir Putin, who are seeking weaknesses in the opposition to achieve their own incentives. He has seen the precarious situation the USA has put themselves in, and capitalised on it by squeezing oil supplies, which will effectively work as a siege on the USA restricting their ability for retaliation in Ukraine.

US Annual Inflation Rates, Source: US Inflation Calculator

The Present

As a result, we now have a situation in which The Fed has tried to play catch-up by quickly raising rates, which currently sits at 1%, up 0.5% year-on-year, and quantitative tapering.The reasoning behind this is to obviously curb inflation rates, which reached 8.5% year-on-year in March 2022. However, the effect of The Fed is not necessarily due to their actions and policies, rather it is the *expectation* of their actions and policies — and the current sentiment seems to be distrust in The Fed’s timing. This isn’t unwarranted: they lowered rates and continued quantitative easing too much and for too long. We are feeling the impacts now, and there’s not really any reason to believe the tapering and hiking will be any different.

US 10-Yr Treasury Yield, Source: Fred

Outlook & Trade Ideas

Recession could very well be imminent — and I believe it is. There is no party without the hangover, there is no borrowing without repayment and there is no Fed action without reaction. There have already been sharp sell-offs in speculative equities, particularly technology and others, where future long-term returns propped up prices. Over the last 6+ months, a trade idea would have been to short the US treasuries — this could still be a viable trade even today, however it would be important to remember that the next 2–3 rate hikes are likely priced in already, so the trade would be dependent on your conviction on whether The Fed will hike/taper beyond that point. Taking a more long-term perspective, this may be a buying opportunity for the future earner equities, as now it is clear which companies were products of an inflationary speculative bubble and which are likely to stay for the next 10+ years. Otherwise, it’s important to remember that the credit cycle has been essentially the same for the last 15 years — low rates and low inflation, whilst now it seems we have flipped the switch to higher inflation and, soon, higher rates.