Federal Reserve Impact on Markets

PRIMER: The Unwinding of Leveraged Bond Trades That’s Shaking Markets. Last week, heavily leveraged bond trades were unwound in a spectacular fashion. And while the worst might be behind for now, I don’t see a structural fix to this bond market imbalance. There are two very popular, heavily leveraged trades in bond markets: swap spreads and basis trades. Both involve going long the cash Treasury bond, and going short something against it: the basis trades uses the Treasury future as short leg, and the swap spread uses interest rate swaps. In both cases, the trades involve a large use of leverage because the purchase of the cash Treasury bond is financed using the repo market: for a $100M trade in basis or swap spreads, due to repo market funding hedge funds must only use a tiny portion (~2-5%) of the needed capital to enter the transaction. Let’s focus on the swap spread trade for a second. As long as repo markets remain orderly, investors can use it to fund purchases of 30-year US Treasuries, pay a fixed 30-year interest rate swap against it and earn a whopping 90 (!) bps per year in ‘’swap spreads’’ - see chart below. But why on earth would investors be able to earn such a premium on US government bonds? It’s because of regulation and the growing supply/demand imbalance problem in US Treasury markets. Bank regulation has crippled the ability of market makers to warehouse risks, which means their ability to absorb large issuance of Treasuries on their balance sheet has diminished. On top of it, Treasury departments of US banks are penalized for owning large amount of Treasuries from regulations like the Supplementary Leverage Ratio (SLR) which don’t exempt USTs from its calculations. All of this is happening at a time when the supply of US Treasuries has dramatically grown because of persistent budget deficits, forcing dealers to swallow bonds at auctions and testing their limits. Given the supply/demand imbalance, the marginal buyer of US Treasuries tends to be the leveraged hedge fund which gets involved in basis or swap spread trades and demands a hefty premium as compensation. And this fragile system holds until it doesn’t. In the last 10 days, several hedge funds were hit by margin calls given turbulent markets. To meet these margin calls, they had to de-risk their portfolios and sell every asset they could – including Treasuries. As Treasuries got caught in the deleveraging mania, basis trades and swap spreads suffered. The first stop losses in these highly leveraged trades were hit, and then a self-fulfilling VaR shock occurred. All hedge funds involved in the same trade had to deleverage at the same time without a marginal buyer of last resort. Ouch. And it’s not clear how this problem will get structurally fixed - so watch out! Thanks for reading and have a beautiful day, Alf (Founder & CIO of macro hedge fund Palinuro Capital)

The Fed has taken a significant step by officially initiating its cutting cycle, which holds profound implications for the financial world. ⚠️The #FOMC has cut the FFR by 50 Basis Points to a 4.75%-5% Range. ⚠️The latest projection of the Neutral Rate, R*, came in at 2.8% versus the previous estimation of 2.9% A cutting cycle might affect other central banks' stance on monetary policy because the US Dollar could devalue considerably going into 2025, making exports from other countries like Japan more expensive. For the past two weeks, business media has made a huge story out of a 25—or 50-basis point cut, but in my opinion, today's decision on the magnitude of the cut is meaningless. Financial conditions have eased considerably since July, so it should not be a surprise that the US economy might have already started to re-accelerate. The Atlanta Fed GDPNow is flashing a Real Growth Rate of 3% for the US Economy. If that materializes, it would mean that the US #Economy is already running 1% above its potential. Why financial conditions have already started to ease? Here are some examples: ✍️Mortgage Rates decreased from 7% in July to 6.15% today ✍️The 2-Year Yield decreased from 4.75% in July to 3.63% today ✍️The 5-Year Yield decreased from 4.06% in July to 3.47% today ✍️Housing Starts have picked up momentum What market participants have priced out is a resurgence of inflation during 2025. That scenario is entirely possible if the Dollar Index drops below 100. A cheaper dollar will make commodities and import prices more expensive for the US consumer, and a reduction in real income could squeeze even more of the low to middle class into the USA. Considering the decrease in US Treasuries for the past two months, I find US Government Bonds expensive across the yield curve at these levels. I think R* is well above what the Fed estimates because of factors like de-globalization, the reshoring of strategic industries, and increased protectionism. The terminal rate post-pandemic is between 3.5% and 4%, in my opinion, and that is where I think this cutting cycle will end. If I am proven right, bond investors must reprice government bond yields higher. How do we play a potential increase in inflation in a no-landing scenario? I tilted my portfolio as I outline here below: 👉Tilt the portfolio to over-weight energy and miners. 👉Have a marginal exposure to Gold and Silver. 👉Favor TIPs over US Treasuries 👉Increase allocation to US Value Stocks and International Stocks. 👉Lock-In US Investment Grade Credit at the belly of the yield curve where we can still get 4.8% to 5% yields, especially on issues at the Single-A Rating Enjoy the ride! #Finance #InterestRates #Economy #Investing

As expected, the Fed cut rates by 25 basis points and announced an end to quantitative tightening—both steps toward further easing. However, the meeting revealed some notable divisions within the Federal Open Market Committee. One member voted against the rate cut, while another favored a larger, 50 basis point cut. This dissent was a bit unexpected. Chair Powell also highlighted strong differences of opinion about a potential December rate cut and discussed the “neutral rate”—the level at which the Fed is neither stimulating nor restraining the economy. Powell suggested a range between 3 and 4%, higher than the 3% median estimate from FOMC members. These factors led markets to pause and reassess the likelihood and pace of future rate cuts. While markets still anticipate a December cut, the path ahead may be shallower than previously expected. Both stock and bond markets reacted with caution. For investors, this complexity is a sign that the Fed is weighing risks carefully—balancing the dangers of being too easy or too tough in today’s environment.  

The Fed cut rates by 50 basis points this week. A mantra circulating in Silicon Valley has echoed that the tepid exit markets will revive as a result of a laxer monetary policy. The last ten years’ data suggest the relationship is real & non-linear. When the Fed cuts rates - negative changes in the Fed Funds Rate (FFR) - US venture backed software exit activity increases by between 10% and 65%. If the FFR increases, M&A activity remains stable. The correlation explains about 25% of the variance, but it’s clear from the blue line, the relationship is non-linear. Rates are convex : a cut from 5% to 4.5% has less impact on the cost of capital than a cut from 1% to 0.5%. The same is true for exits. The relationship between deal value & FFR also has some correlation but it’s weaker at -0.36 correlation. Looking at the squiggly blue line in the middle of the chart, the perils of overfitting are clear. But there is a U-shaped pattern. When rates move meaningfully positive or negative, deal activity increases. Why? Rate decreases reduce the cost of capital spurring acquisition. Rate increases might heighten the imbalance between those with cash who can afford to buy & startups with limited balance sheets who must sell. So the right hand side of the chart may be “forced” M&A. There is nuance much that isn’t capture here : - impact on valuation multiples. Most likely, lower rates increase valuations & vice-versa since capital is less expensive with lower rates. - the data set is limited to about a decade during which rates were constant for half & then fluctuated wildly. - the non-linearity of the data isn’t captured by Pearson correlation. But there is some evidence within the data that laxer monetary policy will increase exit activity in the subsequent twelve months. I’m using PitchBook US venture backed software exit data & running Spearman correlations on data from 2010-2020 on the subsequent year’s change in the relevant field. The blue line is a loess curve.

Where do you think interest rates are going to go? Jamie Dimon has an idea. In his annual letter to JPMC shareholders, he indicates inflation is here to stay a while, and therefore, rates could go as high as 8% in the medium term. He said: "It is important to note that the economy is being fueled by large amounts of government deficit spending and past stimulus. There is also a growing need for increased spending as we continue transitioning to a greener economy, restructuring global supply chains, boosting military expenditure and battling rising healthcare costs. This may lead to stickier inflation and higher rates than markets expect." I can't argue with that. He has a point. Now, if you have to combat inflation, you need to raise interest rates. That isn't a risk-free move, as people in the CRE game know. Now what do you think happens if interest rates stay higher for longer? "A scenario where the federal funds rate hits more than 6% would likely entail more stress for the banking system and for highly leveraged companies... Rates have been extremely low for a long time, and it's hard to know how many investors and companies are truly prepared for a higher rate environment." This is a fantastic summary of our current moment. There is a lot of wishful thinking that interest rates will go back to the 2010-2022 period of QE and low rates. Many of the people trading actively in markets are under 37 and thus have no living memory of working on Wall Street when interest rates were not pressed down along the entire curve by aggressive Fed policy. For banks, for hospitals, for businesses - you need to incorporate scenario analysis into your annual financial plan. What if Fed Funds went to 6% and the 10y UST went to 8%? Would that break anything? Would you be prepared with a flexible balance sheet to absorb these rate changes and still operate normally? Considering this kind of extreme scenario in a relatively calm moment is a helpful exercise to allow organizations to position balance sheets for resilience and prepare necessary actions to take just in case. As financial planning gets underway at institutions this year, I think it's a very good idea to conduct scenario analysis to ensure you are protected. It's all about good risk management. Mr. Dimon claims JPMC is ready to thrive in any economic conditions: "While all companies essentially budget on a base case forecast, we are very careful not to run our business that way. Instead, we look at a range of potential outcomes for which we need to be prepared." Good advice. #fedpolicy #riskmanagement #interestrates

Fed Chairman Jerome Powell indicated that the Federal Reserve is preparing for interest rate cuts, emphasizing that the time has come for policy to adjust as inflation has significantly declined and the labor market is no longer overheated. In his speech at the Fed's annual retreat in Jackson Hole, Wyoming, Powell noted that while inflation is still above the Fed’s 2% target, the progress made allows the central bank to focus equally on maintaining full employment. He acknowledged the need to adapt policy based on incoming data and evolving risks, without specifying the timing or extent of the rate cuts. On Friday, he said, “The time has come for policy to adjust,” and added, “The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.” With the Federal Reserve signaling potential interest rate cuts, investors should consider adjusting their financial planning and portfolios to align with the changing economic environment. Here are some steps to consider: 1. Review Fixed-Income Investments: Interest rate cuts typically lead to lower yields on bonds, money markets, and CDs. However, existing bonds may increase in value as their higher rates become more attractive compared to new issues. If you prefer or need fixed income, now is the time to review your positions and consult with an experienced Sun Group Wealth Partners advisor. 2. Reevaluate Equities: Lower interest rates can boost equities, particularly growth stocks, as borrowing costs decrease and economic conditions potentially improve. However, it’s important to assess sector exposure, as some industries, like utilities may perform better in a lower-rate environment. This could be favorable for those who have been waiting for mortgage rates to come down. 3. Consider Dividend Stocks: With rates potentially decreasing, the appeal of dividend-paying stocks or notes might increase, especially those with strong fundamentals. These can provide a steady income stream as bond yields decline. 4. Stay Diversified: Maintain a well-diversified portfolio that can withstand various market conditions. Diversification across asset classes, sectors, and geographies can help manage risk during periods of economic adjustment. 5. Prioritize Financial Planning: Keep your budget in line, focus on needs vs. wants, and set up auto-savings/auto-investing for your important long-term goals such as retirement or education planning for your family. This is also a good year to explore your estate-planning needs. Sun Group Wealth Partners has significant resources to assist with your future planning. 6. Stay Informed: Continue to follow our weekly newsletter and watch our videos. Together, we can monitor the Federal Reserve’s communications and economic indicators. The timing and pace of rate cuts will depend on evolving data. Thank you, and please reach out if you have any questions.

  Fed still waiting, EM central banks are ahead of the curve   After Friday’s nonfarm payrolls report showed robust, above-consensus job creation in February, but also moderating wage growth that could help in the ongoing battle to cool #inflation, Federal Reserve policymakers continue to deliberate about when to pivot to interest rate cuts. Other recent data also reveals some loosening in the labor market, which the Fed acknowledged in its latest economic “Beige Book.” On balance, we think conditions in the #economy are consistent with further progress in lowering inflation toward the Fed’s 2% target. This makes it more likely we’ll see an initial rate cut in June.   Meanwhile, central banks in key emerging #markets (EM) have been ahead of the curve in controlling inflation effectively, with some able to start lowering their policy rates last year. Because of this, when the Fed makes its first move, the U.S. dollar should weaken versus EM currencies. A softer dollar is typically a positive for EM assets and would bolster the case for allocating to both EM fixed income and equities in diversified portfolios. Other reasons to consider EM investments include compelling valuations relative to the U.S., a recovery in EM corporate earnings growth and the outlook for China, where some economic green shoots are appearing.   For further insights, check out our latest CIO Weekly Commentary, “A developing story in emerging markets”: https://lnkd.in/gJKURdAk   Do you think EM assets are turning a corner and offer strong performance potential this year?

I've read many comments complaining that the FOMC didn't cut interest rates in June. One thing that I don't believe is appreciated is that a 25 basis point cut in rates is unlikely to spur much activity due to the concomitant existence of such profound economic policy uncertainty, due primarily to tariff policy. As evidence, I wanted to share an excerpt from Bloom (2014) concerning this issue (https://lnkd.in/gew8rQar). Thoughts: •As I've highlighted, economic uncertainty dampens the response that firms have to interest rate cuts. In layman's terms, what this means is that a 25-basis point cut in interest rates generates less capital investment when economic uncertainty is high versus when economic uncertainty is low. •Consider, for example, the situation facing a manufacturer that is considering expanding production. To do so, it must order machinery imported from the European Union. Let's imagine the lead time is 6 months. The fact said manufacturer cannot forecast what tariffs on EU machinery will be in 6 months means that cutting interest rates is less likely to spur that capital investment to occur. Implication: economic uncertainty regarding tariffs compounds negative effects of the tariffs by freezing firms in place. If economic uncertainty continues to remain as elevated as it currently is, eventual FOMC interest rate cuts will be less effective in spurring economic activity. Something to keep in mind as the FOMC still projects two cuts in 2025. #economics #markets #supplychain #supplychainmanagement #manufacturing

It's no secret that I have been expecting a 50 basis point rate reduction at the upcoming FOMC meeting (September 18). Here are a few additional thoughts ... The Fed can either decide to tighten financial conditions or not. The futures market is currently pricing a 59 percent probability of a 50-basis point rate cut. Thus, unless something changes, going 25 will tighten financial market conditions, pushing interest rates up. Monetary policy works through the financial markets. Tighter financial conditions should be avoided when the balance of risks between growth and inflation have shifted as they have now. If the downside risks to employment outweigh the upside risks to inflation, then the Fed should be leaning against tightening financial conditions, all else equal. What are the chances of a hawkish 50 basis point cut? Powell may be successful in pushing through a 50-basis point rate reduction, but the projections show only a total of 75 basis points of rate cuts for the entire year. That would imply officials see only one more cut for the year, a hawkish sign. I am skeptical this will matter in the end. A “hawkish 50” is as unlikely as a “dovish 25.” In the former case, the dots will not be that significant. Powell will use the press conference to downplay them and stress these are conditional estimates. I am always reminded of what Yellen said back in 2014: “I think that one should not look to the dot plot, so to speak, as the primary way in which the Committee wants to or is speaking about policy to the public at large.” This is one reason I think going 50 or 25 is important. A popular argument goes like this: because many cuts are priced into the market the size of the move this week is not that important. I get it but believe this understates the significance in a few important ways. For one, the Fed’s policy rate is linked to prime rates. It’s the Fed’s rate not expectations that determine small business loans and auto loan rates, for example. Next, a big upfront move is a signal that the Fed means business about getting back on sides while a 25-basis point move with rates still far from neutral implies they are willing to leave a restrictive policy in place for a long time. 

✂ MY WAY-TOO-LATE COMMENTS ON THE BIG, BOLD RATE CUT ✂ I was on a plane for the Fed's big 50-bp rate cut announcement yesterday. Now that I'm on the ground with a reliable internet connection, I'm ready to drop some thoughts: Yesterday's rate cut was a bold statement that shows the Fed’s dedication to supporting the job market before it needs serious intervention. This decision was a risk in itself. Historically, big (50+ basis point) rate cuts have happened in – or just before/after – recessions. Big rate cuts aren't easy to just brush aside. Dramatic rate cuts could make people think the economy is slipping through the Fed’s fingers. That's how you stir up panic. The Fed will always move slowly when it can. You can see this preference when you look at past rate-cutting cycles that happened outside of recessions. Control and confidence are lifelines when you're slowly turning a $29 trillion ship. And control/confidence is what Powell brought to the press conference, even with the big, bold rate cut. He classified the cut as just the first step towards “recalibrating” policy. He maintained a positive tone about the job market, and noted that inflation looked well on its way to the 2%. He emphasized the idea of gradual rate cuts ahead (data dependent, of course!), and at one point, he even insisted the Fed isn’t behind the curve. For what it's worth, I agree with Powell's evaluation of the economy (growth is OK). But can the Fed cut on its own controlled terms and maintain market confidence from here on out? While I hope they can, I'm not so sure. My biggest worry is that the Fed may be too flat-footed going forward in the name of control and confidence. We all know there's a thin line between confidence and arrogance. A 50 basis point cut won’t do much in isolation, and Fed member projections showed it could take about a year to cut two percentage points – basically down to neutral (where policy isn’t restricting or stimulating growth). As long as unemployment stays low, the risk of missing out on higher prices looks more probable than the risk of a big selloff. Any impact from one rate cut will probably show up in housing activity and consumer confidence first. But it's better to prepare for a rainy day before the clouds start to gather. (chart via Matthew Cerminaro)