In this podcast, David and Alfonso discussed the monetary policy of the Federal Reserve and its impact on the economy.
Edited & Translated by: DeepTechFlow
Guests: Alfonso Peccatiello, macro expert, 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
Jerome Powell and the Federal Reserve are about to cut interest rates, but the question on everyone's mind is… what will happen next?
Alfonso Peccatiello, known as "Macro Alf," a macroeconomic analyst and investment strategist, joined the group 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?
Are we heading towards the economic recession or a soft landing that the Fed hopes for?
What will happen to crypto assets?
We discussed all of these with Macro Alf, who is one of the top thinkers in the macro field.
Fed's Policy Lag
In this podcast, David and Alfonso discussed the Federal Reserve's monetary policy and its impact on the economy.
Alfonso pointed out that the Federal Reserve appears to be lagging in the current economic situation, especially in terms of rate cuts. He mentioned that the Fed's primary task is to maintain economic stability, despite its formal targets of controlling inflation around 2% and maintaining a healthy labor market.
Alfonso explained that the Fed has been focused on suppressing inflation over the past two years, leading to real interest rates rising to positive values, which has different impacts on borrowers and investors. For investors, high real interest rates make holding cash more attractive, reducing the incentive for risk investments. For borrowers, the burden increases as they have to repay debts at higher rates, slowing down economic activity.
Risks of Overly Tightening
David raised the question of whether the Fed is being too slow in maintaining high rates, which could lead to an economic slowdown.
Alfonso believes that the current situation is that the Fed may be lagging again in terms of rate cuts. He warned that if the Fed continues to do nothing, there could be a significant risk of a sharp economic slowdown.
Alfonso further emphasized that the degree of monetary policy tightening over the past 18 months has exceeded the levels of 2006 and 2007, indicating that the current policy is highly restrictive. He mentioned that historically, the impact of monetary policy usually has a delay, which may take 12 to 15 months to show effects. Therefore, although many people now believe that the economy can withstand high rates, the lag effect of the policy may have negative impacts in the coming months.
Future Economic Outlook
- The podcast concluded with a discussion of the future economic outlook. Alfonso mentioned that despite the current market optimism, historical experience shows that when the economic situation appears stable, it often signals the impending problems. He reminded the audience that although current policies seem effective, the long-term lag effects cannot be ignored, and there may be greater economic challenges in the future.
Why Hasn't the Economy Collapsed Yet?
In the podcast, Ryan raised a key question: despite the historically tight monetary policy implemented by the Fed, why hasn't the economy collapsed yet? Alfonso explained the reasons for this phenomenon.
Alfonso pointed out that the current economic lag effect is very long, due to various factors. Typically, when interest rates rise, borrowers (such as households and businesses) reduce borrowing, leading to reduced spending. However, the current situation is different. As over 90% of U.S. mortgages are 30-year fixed-rate, many households do not immediately feel the impact of rising rates. Their fixed-rate mortgages mean that even if new mortgage rates reach 7%, existing homeowners would not be directly affected because their loan rates remain low.
Corporate Response Strategies
- For businesses, the situation is similar. Many large companies (such as Apple and Microsoft) adopted strategies to extend debt maturities before the pandemic, borrowing long-term debt at low rates. This means that even if the Fed raises rates, companies do not immediately bear higher borrowing costs. Therefore, businesses still maintain ample cash flow in the short term and may not reduce investment or spending due to rising rates.
Impact of Fiscal Policy
- In addition, Alfonso also mentioned that the fiscal policy in 2023 has supported the economy. The Biden administration implemented large fiscal deficits, bringing additional funds to households and businesses. This fiscal stimulus partially offset the tightening effects of monetary policy, increasing the net wealth of businesses and households even as interest rates rise.
Bad News
In the podcast, Ryan and Alfonso discussed the implications of bad news in the current economic situation. Ryan mentioned that the Fed's tools seem not to be working as expected, and the potential problems in the economy are like a tsunami approaching from a distance. Although the impact is not yet apparent, the crisis is looming.
Alfonso pointed out that in the past few years, the market's response to bad news is different from now. Before the pandemic, weak economic data was often seen as good news because it meant possible rate cuts and fiscal stimulus. However, Alfonso believes that the situation has changed, and bad news has truly become bad news in the current environment.
Changes in the Economic Environment
Alfonso explained that in the past economic environment, the market was accustomed to viewing bad news as "good news" because it often meant that the Fed would take measures to support the economy. He mentioned that from 2013 to 2019, the market generally did not see bad news as a real risk because the Fed was always there to support the market.
However, the current situation is that the economy is on the edge of a recession, and the impact of bad news has become more apparent. Alfonso emphasized that when economic growth is weak, the tolerance for unemployment decreases, and any economic data below expectations could trigger market panic. For example, the U.S. currently needs to create approximately 120,000 jobs per month to maintain a stable unemployment rate, but the private sector is only creating about 100,000 jobs per month. This gap means that any bad news in the economy could quickly lead to a stock market decline.
Past Memories
- Ryan asked when investors last felt that "bad news is bad news." Alfonso replied that this situation can be traced back to the 2008 financial crisis. At that time, bad economic data meant that a recession was imminent, and the market sentiment underwent a fundamental change.
Signals from the Bond Market
Alfonso also mentioned that the current bond market is sending signals. Bad economic data leads to bond price increases and yield decreases, reflecting the market's expectation of further easing by the Fed. However, the stock market often declines in response, showing the market's concern about future economic prospects. In this situation, bad news is not just bad news; it exacerbates market anxiety.
Alfonso emphasized that in the current economic situation, the impact of bad news has changed, and the market can no longer easily overlook bad news. As economic growth slows, the market's response to bad news will become more sensitive, and investors need to reassess this new economic environment.
Fed Rate Cut Predictions
- In the podcast, David and Alfonso discussed the possibility of the Fed cutting interest rates. David mentioned the market's expectations for rate cuts, especially the discussion about a 50 basis point cut.
Alfonso's View
Alfonso believes that the Fed is likely to choose a 50 basis point rate cut, and here are a few reasons he provided:
Missed Opportunity: Alfonso pointed out that the Fed should have cut rates in July, but failed to act in a timely manner. Now that the economic situation has worsened, they should not continue to be stubborn but should make up for their previous mistakes.
Communication Strategy: He believes that the Fed should clearly communicate the reasons for the rate cut, explaining that it is to correct previous errors and to show that they are aware of the economic slowdown and are prepared to take more accommodative measures.
Future Meeting Schedule: The next Fed meeting is in November, and if they only cut rates by 25 basis points this time, and the economy deteriorates further, they will have to wait until November to cut rates again, which is not a wise risk management approach.
Market Expectations: Currently, the bond market has already priced in future rate cuts, with the market expecting a total of 250 basis points of rate cuts over the next year. If the Fed does not follow through, the stock market may become nervous because it relies on the expectations of the bond market.
Nature of the Rate Cut
David asked if a 50 basis point rate cut by the Fed would mean they are taking swift action.
Alfonso stated that such a rate cut could be seen as a correction for not cutting rates in July, reflecting the Fed's concern about the economic slowdown.
Global Economic Impact
Alfonso also mentioned that the global economic situation is also influencing the Fed's decision, especially the impact of China's economic slowdown on the United States. He emphasized that the Fed needs to be cautious in cutting rates and needs to convey their understanding of the economic situation and their response measures.
Alfonso believes that the Fed should take a 50 basis point rate cut to address the current economic challenges and to reassure the market through clear communication. He emphasized that the current rate cut is not just a response to the economic slowdown but also a precautionary measure against potential future risks.
Elizabeth Warren's Open Letter
- Ryan mentioned that Senator Elizabeth Warren recently wrote an open letter to the Fed, calling for a 75 basis point rate cut. Ryan asked Alfonso for his thoughts on this letter and whether it would influence the Fed's decision.
Alfonso's Analysis
Alfonso believes that Warren's letter is actually a political bargaining strategy. Here are a few points he made about this:
Political Bargaining: Alfonso believes that Warren's proposal for a 75 basis point rate cut is actually an attempt to influence the Fed to ultimately make a 50 basis point decision. By proposing a higher requirement, she hopes to prompt the Fed to take more aggressive rate cut measures.
Fed's Communication Strategy: Alfonso pointed out that the Fed cannot openly communicate during the blackout period (the period of silence before the decision-making meeting), but they still convey information through the media. He mentioned that in the past, the Fed has used journalist Nick Timiraos from The Wall Street Journal to convey their intentions to the market.
Market Reaction: Alfonso mentioned that at the start of the blackout period, the market's expectation for a 50 basis point rate cut was only 10%, but with Timiraos's reporting, this expectation quickly rose to 55%. This indicates that the Fed can still influence market sentiment through the media during the blackout period.
Stability and Instability: Alfonso quoted economist Hyman Minsky's view that "artificial stability actually leads to instability." He believes that the Fed's attempt to avoid economic recession and market panic by controlling market volatility may itself lead to greater instability.
Alfonso emphasized that as investors, we need to understand the rules of how the market operates and manage risks based on that. He believes that the Fed is working to convey their intention to cut rates by 50 basis points, and Warren's letter is part of political maneuvering and may not directly influence the Fed's final decision.
Market Reaction
In the podcast, David and Alfonso discussed the market's reaction to the potential Fed rate cut, especially the impact of Elizabeth Warren's proposal for a 75 basis point rate cut on the market and the Fed's decision-making.
Alfonso's Analysis
Market Expectations: Alfonso pointed out that the market has already begun to price in the possibility of a 50 basis point rate cut by the Fed in September, and this expectation has reached 60%. He further stated that the market also expects a 25 basis point rate cut in November, and there is a higher probability of another 50 basis point rate cut in December. This indicates that the market generally believes the Fed will further cut rates in the coming months.
Importance of Economic Response: Alfonso emphasized that the effectiveness of rate cuts depends on the economic response. If the economy can quickly adapt to the rate cuts, it may lead to positive results. However, the positive effects of rate cuts typically take one to two years to materialize, so the Fed's policy needs to be forward-looking rather than just a passive response.
Performance of Risk Assets: David raised concerns about market participants' focus on risk assets (such as cryptocurrencies), especially in the context of a Fed rate cut. Alfonso pointed out that rate cuts are usually favorable for risk assets, especially when the economy is doing well, as rate cuts are seen as support from the Fed. However, if rate cuts are aimed at addressing economic weakness, the response of risk assets in such a scenario may be different.
Historical Cases: Alfonso mentioned the example of Japan in the 1990s, noting that despite the rapid rate cuts by the Bank of Japan after the burst of the economic bubble, the market did not recover. This was because the rate cuts were not an active measure to support the economy but a passive response to economic weakness.
Alfonso believes that the impact of the Fed's rate cut policy on the market depends on the nature of the rate cuts. If rate cuts are seen as support for the economy, the market may react positively; but if rate cuts are seen as a remedial measure for economic weakness, the market response may be subdued. Therefore, investors need to closely monitor the Fed's policy direction and the actual performance of the economy to make appropriate investment decisions.
How to Prepare
Understanding the Current Market Environment
Performance of Risk Assets: Alfonso pointed out that if the economy enters a recession, risk assets (including cryptocurrencies and stocks) may be affected. As cryptocurrencies are increasingly seen as risk assets, they may be sold off in the market downturn to raise cash.
Impact of Deleveraging: During economic downturns, investors often face pressure to deleverage, leading to increased correlation among all asset classes, showing similar price movements. When needing cash, investors do not consider which assets to sell but choose assets that can be quickly liquidated.
Adjustment Strategies for Investment Portfolios
Maintaining Diversification and Risk Balance: Alfonso mentioned the "risk parity" strategy, advising investors to focus on the contribution of various assets to the overall risk of the investment portfolio, rather than simply allocating funds in fixed proportions. For example, ensuring that each asset contributes an equal amount of risk to the portfolio.
Reference to Historical Data: Historically, investors have often underestimated the extent of Fed rate cuts. During economic recessions, the Fed typically takes more aggressive rate cut measures, so bonds often perform well in such situations.
Recommended Asset Classes
Bonds: During a recession, bonds typically maintain returns, especially in the context of Fed rate cuts. Although bond prices have already risen, they remain a relatively safe investment choice during an economic slowdown.
Gold: Gold usually performs well in times of economic uncertainty, and with central banks continuing to increase their gold reserves, the demand for gold may continue to rise.
Safe-haven Currencies: During economic crises, investors often turn to safe-haven currencies such as the Japanese yen and the Swiss franc, which typically remain stable in market turmoil.
Avoiding Significant Losses
Focus on Risk Management: Alfonso emphasized that investors should prioritize reducing risk in their investment portfolios rather than seeking hedging tools. Avoiding significant losses is the primary principle of investment, as significant losses can lead to difficult financial situations.
Reassessing Investment Portfolios: When considering the possibility of an economic recession, investors should review their asset allocations to ensure they are not overly concentrated in high-risk assets.
Possibility of Economic Recession
- When discussing the possibility of an economic recession, Alfonso presented his view on the likelihood of an economic recession within the next 12 months. He believes the probability of a recession is approximately 50%. Here are several key factors he analyzed:
Impact of Fiscal Policy
- Rapid Fiscal Stimulus: Alfonso pointed out that the current political environment allows the government to take swift action to inject more funds into the economy when it weakens. This is different from past situations, such as during the 2008 financial crisis, when the implementation of fiscal stimulus measures typically took 6 to 12 months. Today, the government's rapid response can help stabilize the economy to some extent.
Leverage Levels in the Private Sector
- Lower Leverage Levels: Currently, the private sector has relatively lower leverage levels, meaning that the impact on the economy during a recession may not be as severe as in the past. In 2007, many households and businesses had high levels of debt, leading to the exacerbation of the financial crisis.
Market Expectations
Market's Probability of Recession: The market's current expectation of a recession is between 35% and 40%, lower than Alfonso's 50% assessment. This indicates that market participants have relatively high confidence in the future economy, but there may also be a possibility of underestimating the risk.
While Alfonso believes the probability of an economic recession is approximately 50%, he also believes that if it does occur, the severity and impact of the recession may not be as severe as in the past. This is mainly due to the government's ability to respond quickly to the economy and the relatively lower leverage levels in the private sector. When evaluating the future economic situation, investors should consider these factors to adjust their investment strategies and risk management.
Currency Depreciation
When discussing currency depreciation, Ryan and Alfonso mentioned the changes in the money supply and the impact of these changes on the economy and asset prices.
Definition of Currency Depreciation
- Currency Depreciation: Currency depreciation typically refers to the decrease in the purchasing power of a currency, resulting in a reduction in the amount of goods and services the same amount of currency can buy in the future. Ryan mentioned that although an economic recession may occur, currency depreciation is an almost inevitable phenomenon.
Changes in the Money Supply
Fiat Currency System: Alfonso pointed out that since the United States abandoned the gold standard in 1971, there has been a fundamental change in monetary policy. Now, the issuance of the US dollar is no longer tied to hard assets such as gold, allowing the government to create new dollars without restrictions.
Impact of Inflation: With the continuous increase in the US dollar, the risk of currency depreciation increases. 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 rapidly, ultimately leading to price increases, i.e., inflation.
Roles of the Government and Banks
Government's Deficit Spending: The government creates new disposable dollars through deficit spending. For example, the government may issue checks to citizens, increasing the money supply in the market. This practice has been ongoing for the past 30 years, leading to currency depreciation.
Credit Creation by Banks: Banks inject credit into the economy through loans (such as mortgages). Alfonso explained that banks create new money based on the potential future cash flow of borrowers, further driving up asset prices.
Impact on Asset Prices
Real Estate Market: Due to low interest rates and continuous credit creation, property prices continue to rise. Even though wages have not significantly increased, the improved borrowing capacity allows people to purchase higher-priced properties.
Comparison with Gold: Alfonso also mentioned that if property prices are measured against gold, the actual growth in property prices may not be significant. This indicates that the rise in property prices is mainly due to the impact of the fiat currency system rather than intrinsic value growth of the properties themselves.
Monetary Liquidity
Concept of Monetary Liquidity
- Importance of the Denominator: Ryan mentioned that understanding the flow of funds in the economy is crucial, and the key lies in the "denominator." He pointed out that the terms used by governments and central banks (such as quantitative easing, fiscal deficits, etc.) are actually describing the creation or destruction of money. In most cases, these measures are aimed at increasing the money supply.
Normalization of Fiscal Deficits
Transformation of Fiscal Deficits: Alfonso pointed out that fiscal deficits have shifted from being a "defect" in the past to a "feature" in the present. He believes that the government's annual trillion-dollar deficit spending has become the norm, and this change has profound implications for liquidity and the economy.
Impact on Investors: This sustained fiscal spending 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 Investors Should Focus On
Government Spending and Deficits: Investors should monitor large government projects and stimulus plans, especially expenditures in the hundreds of billions of dollars and annual budget deficits. This data is publicly available, and investors can understand the government's spending by reviewing the monthly deficit data released by the U.S. Department of the Treasury.
Efficiency of Spending: In addition to focusing on the deficit itself, Alfonso emphasized the importance of spending efficiency. How the government uses these funds and where the funds flow will directly impact economic productivity and long-term growth.
Widening Wealth Disparity
Exacerbation of Wealth Disparity: Alfonso also mentioned that the implementation of fiscal policies is exacerbating wealth disparity. As the younger generation (such as millennials and Gen Z) gradually become the primary voters, they are facing increasing economic pressures, which may drive different policies seeking wealth redistribution.
Sustainability Issues: He believes that the current economic system is not sustainable and may lead to greater social and economic pressures in the future, prompting policy changes.
Anti-depreciation Assets
Classification of Anti-depreciation Assets
- Stock Market: Alfonso mentioned that stocks are an important anti-depreciation asset because companies are priced in dollars and can generate cash flow. He emphasized that while companies will grow over the long term, investors need to pay attention to valuations at the time of purchase and avoid buying stocks at excessively high prices. He advised investors to choose 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 the investment portfolio, Alfonso recommended allocating some risk assets, such as cryptocurrencies and gold. These assets may not have cash flow but possess different currency characteristics, providing diversification for the portfolio.
Selection of Defensive Assets
Bonds: As a defensive asset, bonds typically protect investment portfolios during economic recessions or deflationary periods, but in certain situations (such as 2022), they may not perform well.
Commodities: Alfonso also mentioned that commodities, as assets priced in dollars, can protect investment portfolios during periods of inflation, making them a worthwhile consideration as defensive assets.
Macro Investment Strategies
- Macro Hedge Funds: Alfonso shared his plans to launch a macro hedge fund. He believes that the current macroeconomic environment changes bring significant investment opportunities, and specific strategies can be used to capitalize on these macroeconomic fluctuations, providing diversified sources of returns for investment portfolios.
Conclusion
Key Summary:
Fed's Decisions: Alfonso believes that the Fed may adopt a 50 basis point rate cut to address current economic challenges. He reminds investors to pay attention to market reactions in different economic environments, maintain flexibility, and avoid being rigid in their views.
Importance of Asset Allocation: In uncertain market environments, properly allocating anti-depreciation assets (such as gold, stocks, cryptocurrencies, etc.) is crucial for protecting investment portfolios. Investors should adjust their investment strategies in line with their risk tolerance and market changes.
Continued Learning and Adaptation: The market changes rapidly, and investors need to continuously learn and adapt to new economic situations. Alfonso's education platform "Macro Compass" provides rich resources to help investors gain a deeper understanding of macroeconomics.
Finally, thank you to all the listeners. Remember, investment involves risks, and decisions should be made cautiously. The future is full of uncertainties, but we will continue to move forward on this exploratory path. I hope everyone can maintain an open mindset and actively face challenges on this journey. Thank you for your support, and see you next time!
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