I’ve been a bit busy with medical finals approaching, so I just wanted to give a super brief overview of my current investment decisions that I am looking at. (These are written as a notebook to myself on where I’m viewing the market rather than for an external reader)
Biden’s 3 trillion stimulus plan
Obviously, this continues the inflation narrative, but since he plans to finance a large portion of this through higher taxes, we could potentially see some capital outflow out of the US. However, I think it’s most likely that stocks will continue rising on inflation expectations but lose some gains to tax hike fears. While I think this is a good thing for the US economy as corporations pay very low taxes currently, it can damage the SP500. For this reason, I’m tentatively looking into inflation hedges that are not stocks.
The Lifting of the SLR ratio exemption
I suspect that fears over this were largely overblown. Although interest rates have largely continued to rise (after dipping after the FOMC press release), further research has shown that banks are unlikely to be affected by the re-enactment since they are currently well capitalized. (See previous article). Much like I said, the Fed needed some ability to curb inflation and return to a normal economy.
Fed perception manipulation
As previously mentioned, the Fed is absolutely ignoring inflation (despite constantly giving assurances that it’s not happening) because once it allows inflation expectations to rise, we can have hyperinflation. As long as the general populace doesn’t start investing like inflation is certain, the Fed can control markets.
Wells Fargo Capital Growth Ban
In part, I feel this will negate the SLR ratio. In effect, to “catch up” to other banks, Wells Fargo would likely add between $100 and 600 billion in loans to the economy, negating any downside from supposed contraction caused by mass sell-off of treasuries. Especially, with banks currently being rather risk-off (in expectation of rising inflation rates), banks are unwilling to offer risky loans, so they are taking treasuries instead. This buy back in treasuries will negate the SLR ratio exemption ending and help keep interest rates low. In the long term though, I don’t expect Wells Fargo to supply enough credit to curb rising interest rates that will still be below inflation in real terms (on US treasuries). In effect, the safest bet is rising inflation (especially in financial assets) even as the market accounts for it via rising interest rates.
Margin debt, interest rates, and hedge funds
I don’t believe much has developed on this front beyond what has previously been said. Obviously with rising interest rates, hedge funds are finding loans they took the risk on (assuming the Fed would act as a buyer of last resort) are losing value. With their overleveraged positions, they are unable to roll over this debt under a rising interest rate environment, and credit insurers are unwilling to insure them. This means that credit is becoming increasingly expensive, which could lead to a collapse as funds are margin-called. While there is not a direct correlation that high margin debt levels lead to a collapse, it could lead to less demand for equities if it is harder to obtain credit. In 1929, the unwinding of leveraged positions did not directly lead to the crash but likely contributed to it, much like in 2008 (with bad debt being magnified by leverage) and could cause a collapse of the economy as zombie companies fail. With opaque financial regulations, many hedge funds like Archegos are unknowingly overleveraged due to loose credit restrictions, priming markets for a correlated collapse as interest rates rise.
Credit Suisse Collapse?
CreditSuisse, which has historically had several problems with risk management (see XIV), has been in the news several times for capitalizing two spectacular melt-downs. With Greensill and Archegos, Credit Suisse has likely lost nearly $4 billion, around 8% of their total equity (assets-liabilities). While not a pressing concern currently (especially as global banks will likely bail them out should it come to pass), further investor fears about the bank could lead to capital problems and a collapse of the bank. In this case, central banks might lose control of markets despite highly probable efforts at using QE to bail out markets.
Low Demand from Borrowers; High Demand from Lenders at current rates
One interesting thing to note is that homeowners are not taking out more loans in fear of rising interest rates, implying that consumers are either unwilling to pay higher interests or likely fearful of a future economic meltdown. Because perceptions often shape how consumers act, this could imply that monetary velocity will remain low coming out of the pandemic. While this would largely not affect the value of the dollar against other currencies (since the dollars would be exported and inflate the supply in foreign markets to weaken the dollar), it could allow TIPS to pay a low interest without causing inflation as measured by the Fed’s CPI index. Furthermore, the reverse Repo market had a huge spike of $140.4 and 40 billion over the past two days, exceeding the repo operations performed in March 2020 at the height of the coronavirus epidemic (the Fed can only sell $500 billion). In a RRO, the Fed sells treasuries over a short term ranging from overnight to up to 14 days (4 weeks in certain cases) with the promise to buy them back at an interest rate (currently 0% meaning the Fed gets cash for free while lenders still get to collect interest on treasuries). In this case, it implies some demand for treasuries (which would lower rates), but this could be to short treasuries, and since the treasuries must be returned within the short term, means banks are not expecting the price of bonds to rise (as otherwise they’d buy them outright). Personally, it makes very little sense to me because banks can earn higher interest simply leaving deposits with the reserve, but the demand implies a short term bullish movement. Further research will be done to watch these, but as of April 1, 2021, the rates have declined once more. Negative repo rates on March 8 saw a brief rise in bond prices that quickly faltered, implying that demand for treasuries might actually be being used to hedge or short treasuries.
Interestingly, institutions appear to be long bond futures, but this could be due to hedging for when they sell off their bond positions. The markets are far more even on short duration treasuries. It is possible we will find support soon based on this analysis, not because the Fed believes deflation will occur, but simply because the Fed needs to keep interest rates low.
For more on the repo market, read this.
How I plan to enter the market
Currently, I’m not certain on whether stocks will rise; however, I believe volatility-adjusted, bitcoin will outperform the SP500. In effect, while bitcoin might see a greater gain or loss than the SP500, the potential gain outweighs the downside. For this reason, I am long bitcoin hedged against the SP500. On the other hand, I am also planning to wind out leveraged positions and hedge portfolios because the markets are starting to look tumultuous.
As suggested in this article, I believe the Fed will be forced to keep interest rates low for the foreseeable future due to the risk that leveraged funds pose to the markets if interest rates rise. Because of this, while interest rates will rise as investors look to obtain better returns elsewhere, they will not rise sufficiently to curb inflation due to the Fed’s unwillingness to take action. However, with tech stocks looking especially inflated, bond yields and expected stock returns are starting to both look rather unappealing, especially with Biden’s new taxes. For this reason, I am looking at alternative inflation hedges and would de-risk out of short bonds.
