The Inflation Persuasion

Malt Liquidity 75

You know, I’m something of a macro tourist myself

Lately, it seems like all anyone wants to talk about is the Fed, with FOMC meetings being hyped online as the markets equivalent of WWE Smackdown. Rate hikes and future prognostications are constantly push-notification’d to our phones, yet discourse around me seems to range between flummoxed to conspiratorial. And yet, it shouldn’t be that complicated. The Fed is one of the most telegraphed institutions on the planet — the equivalent of scripted wrestling where the results are mostly known ahead of time. Furthermore, the market’s expectations are also quite telegraphed, as displayed through this neat little tool from CME (who provides FFR futures) that calculates implied probabilities of future rates movement. So what follows is a short primer on the Fed, how I interpret its forward outlook, and how I plan to position around it.

The Fed has 2 main mandates: full employment and price stability. The underlying policy they take to fulfill these mandates is called inflation targeting — the subject of much of Ben Bernanke's research, the essential goal is that the central bank wants to maintain inflation at around 2% as it’s the optimal level to facilitate velocity of money while not destroying savings. Too little inflation and you get hoarding — too much and you get chaos as everything gets bid up in a frenzy to outpace inflation. (A reminder that “[i]nflation is a bit of a self fulfilling prophecy, and the only ‘inflation hedge’ is to outpace the rate of inflation through rate of return.”)

Right now, obviously, inflation is much higher than this target. To control inflation, there’s two primary tools — raising and lowering interest rates, and quantitative easing/tightening. Raising interest rates incentivizes saving and reducing spending, while lowering rates incentivizes investment and capital allocation to seek returns. Since we’re in a high-inflation high-spend regime, interest rates will be raised. QE/QT is about the purchase and sale of (primarily) treasury securities between the Fed and major banks to increase/reduce the outstanding monetary supply to facilitate/slow down lending and backstop bond market liquidity. Currently, we’re doing light QT to stem the flow of money and control the supply.

High inflation essentially just means that too much money is chasing too few goods. There are two main competing theories on this. One is that issues with the supply side is causing inflation — rather than focusing on demand reduction, the theory goes that inelastic supply and supply shocks are causing a shortage of goods, which is leading to their bidding up. Some examples of supply shocks are supply chain issues or geopolitical activities affecting the transaction and production of a commodity such as crude oil. This is the theory propagated by Lael Brainard, the Fed’s number 2.

The other theory revolves around labor market distortions, where, due to issues in the labor market, wage growth outpaces the proper level to maintain the inflation target. This could be due to multiple reasons, including low labor market participation, which causes current employees to be bid up by employers due to their negotiating power increasing. While this may seem at odds with headlines about tech layoffs and hiring freezes, it’s important to remember that tech isn’t the economy, but rather a subsection that has had its cost of borrowing uniquely subsidized for nearly a decade, which allowed them to over-hire and ignore profitability, and that jobs numbers are an imperfect, yet useful, indicator of the labor market. Notably, this is Jerome Powell’s view on inflation.

The problem is that it’s unknowable what is causing the inflation in real time. The Fed has indicators that they look at to assess the economy, but this approach naturally falters because most indicators are lagging and the economy is too complex to get a great read from CPI numbers or jobs numbers. Powell himself notes that there are supply-side factors present, but puts a heavier weight on the labor market theory:

Mr. Powell has noted several times that he considers headline inflation a poor guide to underlying inflation because it is heavily driven by energy, durable goods and shelter. Their prices are being driven by forces such as supply- chain disruptions having little to do with aggregate supply and demand. 

Rather, he is focusing on service prices, excluding shelter, which tend to be stickier and slower moving. And because these services tend to be labor-intensive, that puts the job market center stage in his thinking. 

Regardless of cause, while inflation is substantially above the target, rates will continue to rise. However, as reflected by the somewhat slowing pace of hikes, it’s clear that the Fed has assessed inflation as having peaked. We won’t know for a while what the cause of inflation is, though, and it seems that going forward, Powell is going to weight real-time data more heavily than lagging indicators. If inflation is a supply side issue, there’s a high chance of a “soft landing” once these constraints are eased, and rates will gradually decrease after inflation has returned in-line. If it’s a labor market issue, there’s likely going to be a recession, and rates will decrease rapidly after inflation has returned in-line. I doubt we will have a good idea of inflation’s causes until the end of 2023.

I personally doubt the Fed strays far from what their dot plots imply — rates should peak between 5-5.5%, with rates starting to fall in 2024. I also think that the market has somewhat overpriced the probability of a recession, and is somewhat oversold. I see two major trade ideas going forward, both revolving around debt yields. We talked recently about how COIN bonds have dropped pretty dramatically in price over the past year or so, and while I’m not so hot on their forward prospects, I think that category of decently-yielding debt that has sold off makes for a prime purchase opportunity. We have also talked about the differences between equity and debt:

[W]hen boiled down to its simplest elements, the system is essentially made up of three pillars: equity, currency, and debt. Equity provides liquidity to hope… The most important pillar, and what underpins it all, is debt, which provides liquidity to trust.

Fundamentally debt and equity function as opposites. Debt is a claim on stuff that already exists. Equity is a claim on stuff that is expected to exist. Debt is a claim on the underlying business built off of the cash I supplied you, while equity is a claim on the forward earnings the business you built is expected to earn. As such, in the case of liquidations, debt holders are paid off before equity holders (ignoring complexities such as mezz debt, orphaning CDS, preferred equity, or convertibles.) Therefore, when assessing a high-yield debt trade vs buying the dip on their stock, you want to take into account the original yield on the debt, overall market regime, and the prospects of the business recovering. If I’m offered 50 cents on the dollar for a 8%+ return due in 2026, is this better than hoping the stock recovers? The bond is backstopped, and debt payments take priority over returning earnings to shareholders, especially in growth companies. Stock recovery could depend heavily on overall market inflows and interest rate movement, while bonds pay out constantly over time. In my view, the “dip” is likelier to recover on bonds than stock for the time being. However, this trade need not be unhedged — in case the company does falter to the point of default and chapter bankruptcy, an underlying short position through puts in the stock might be prudent.

The other trade I’ve thought about requires a lot less construction. All it requires is clear communication on where the Fed will stop hiking rates and all-inning treasury debt at near the peak, and going to a beach and locking in a 6.5%+ return for the near- to mid- term future. Keeping it simple is usually the most efficient strategy — in equities, all roads lead to short vol and long delta one. In higher rates environments, it’s pretty much as simple as taking what’s given to you.