The financial system is in a continuous state of evolution, with the roles of Central Banks and governments also undergoing significant changes. Since the events of 2008 and the Covid pandemic, Central Banks have taken a more active role in providing liquidity as needed. Presently, they have various programs at their disposal for deployment if necessary.
From our perspective, Quantitative Easing (QE) is somewhat negative, as it injects superfluous reserves into the system, whereas Quantitative Tightening (QT) returns useful collateral to banks. Over time, the fact that Mortgage-Backed Securities (MBS) became guaranteed by the government, coupled with programs like the BTFP, has effectively rendered several assets similar to money. Thus, if the Fed decides to either discontinue the BTFP or alter its terms rather than renew it – given that currently it’s supporting stressed banks while also essentially handing free money through a spread trade, and if QT is resumed once the RRP is fully utilized, we foresee a tightening of liquidity conditions.
As the US and other governments persist in their printing and stimulating efforts when debt loads are high, paradoxically, higher interest rates can be stimulating to an extent. The additional income for bondholders, along with government injections of funds, are cancelling the impact of higher interest rates to an extent. Despite potential challenges for the private sector in securing bank financing, as many refinanced at much lower rates than the current rates, the effects of higher interest rates have remained even more muted. However, that doesn’t mean that higher rates won’t eventually have an effect, and we believe that this year their effect will be felt and that’s why inflation will remain lower than expected by many. Consequently, if the Fed begins to cut rates, resumes QE and paused the BTFP, it could mean reduced financial flows to the private sector.
A critical factor here will also be the Treasury's approach to debt issuance, particularly whether it opts for T-bills or long duration Treasuries. As the Fed and the Treasury have taken numerous steps to enhance liquidity and support markets, and given that it's an election year, with the Fed’s likely preference to avoid Trump's re-election, they may not aggressively target inflation reduction. Although Inflation ended the previous year at 3.4%, significantly above the Fed’s target of 2%, we don’t think that the Fed will really try to push the economy off a cliff in an election year to push inflation down by 1.4%. Based on how things currently look, there is the potential for inflation to drop to 3% or lower in the next month, which still allows for the Fed to cut rates in March. While we do anticipate a future spike in inflation, we don't see it happening soon very soon, nor do we believe the current fiscal policy is so lax as to cause a rapid inflationary surge.
Based on market trends and positioning, it appears commodities might experience a final leg down before rallying again. Geopolitical tensions and climate change also contribute to inflationary pressures, and these will probably keep playing a more and more important role over time. If inflation driven by shortages re-emerges, it could adversely affect stocks and liquidity, as it will be different from monetary inflation due to monetary debasement. As pushing the economy into a recession will not resolve wars or issues in agricultural production, and the lagging effects of interest rate hikes are just starting to be felt, along with the fact that we are in an election year, we think it’s more likely that both the Treasury and the Fed could do whatever it takes to support markets. That’s why at least for now, I believe we'll see several some cuts in 2024, resumption of QE, more T-bill issuance, and resumption of the BTFP.
Here we’d like to emphasize, that although we do think there's a political element to all that, it’s not all just political, and they might not have the anticipated impact everyone is expecting. Not only that, but the fear of inflation and the fear of the Fed/Treasury seeming like they are acting too political when the stock market is at ATHs and inflation above their target, might force them to be less accommodative than the market expects them to be. The truth of the matter is that once the RRP is depleted, the government may face challenges in funding itself if banks don't buy bonds, or if the Fed doesn't step in. Deflation/a recession are also risks, considering the rapid and intense shift in rates globally, while the world economy is visibly in bad shape, despite how strong the US economy has been. Let’s not forget that the M2 money supply in the US has gone down for 2 years in a row, while real rates are at +2%. Although a massive recession seems unlikely, based on everything we have mentioned, as well as with stocks at all-time highs, it’s possible that we might see a rise in unemployment, along with a rise in inflation at some point in Q2-Q3 in 2024.
To close things up, regarding the stock market, it seems to be rallying due to rising liquidity and anticipating additional rises in liquidity. Previously, we thought stocks might peak slightly above their 2021 all-time highs, but now there appears to be room for a higher rally before reaching a top. We are not forecasting a final peak, but rather a significant correction 2-3% higher from here. As the market seems to be factoring in a lot of positive outcomes, like the ones we have mentioned before, and it might prove to be right, it is possible that this could be derailed by unforeseen event, or due to overly bullish sentiment as the market is getting way too far ahead of itself. Last week, sentiment was a lot less bullish than two weeks ago, and that’s what has allowed it to rally further with ease, but there is no guarantee this can last much longer. Let’s not forget that markets tend to top when the best news come out, and nothing looks like could make it go down. Therefore, we do see a potential top in Q1, either next week around the Fed and Treasury announcements, or in March, when the Fed really either cuts or doesn’t cut, whether it really resumes or doesn’t resume the BTFP, and what it decides to do with QE/QT once the RRP is drained.
From our perspective, Quantitative Easing (QE) is somewhat negative, as it injects superfluous reserves into the system, whereas Quantitative Tightening (QT) returns useful collateral to banks. Over time, the fact that Mortgage-Backed Securities (MBS) became guaranteed by the government, coupled with programs like the BTFP, has effectively rendered several assets similar to money. Thus, if the Fed decides to either discontinue the BTFP or alter its terms rather than renew it – given that currently it’s supporting stressed banks while also essentially handing free money through a spread trade, and if QT is resumed once the RRP is fully utilized, we foresee a tightening of liquidity conditions.
As the US and other governments persist in their printing and stimulating efforts when debt loads are high, paradoxically, higher interest rates can be stimulating to an extent. The additional income for bondholders, along with government injections of funds, are cancelling the impact of higher interest rates to an extent. Despite potential challenges for the private sector in securing bank financing, as many refinanced at much lower rates than the current rates, the effects of higher interest rates have remained even more muted. However, that doesn’t mean that higher rates won’t eventually have an effect, and we believe that this year their effect will be felt and that’s why inflation will remain lower than expected by many. Consequently, if the Fed begins to cut rates, resumes QE and paused the BTFP, it could mean reduced financial flows to the private sector.
A critical factor here will also be the Treasury's approach to debt issuance, particularly whether it opts for T-bills or long duration Treasuries. As the Fed and the Treasury have taken numerous steps to enhance liquidity and support markets, and given that it's an election year, with the Fed’s likely preference to avoid Trump's re-election, they may not aggressively target inflation reduction. Although Inflation ended the previous year at 3.4%, significantly above the Fed’s target of 2%, we don’t think that the Fed will really try to push the economy off a cliff in an election year to push inflation down by 1.4%. Based on how things currently look, there is the potential for inflation to drop to 3% or lower in the next month, which still allows for the Fed to cut rates in March. While we do anticipate a future spike in inflation, we don't see it happening soon very soon, nor do we believe the current fiscal policy is so lax as to cause a rapid inflationary surge.
Based on market trends and positioning, it appears commodities might experience a final leg down before rallying again. Geopolitical tensions and climate change also contribute to inflationary pressures, and these will probably keep playing a more and more important role over time. If inflation driven by shortages re-emerges, it could adversely affect stocks and liquidity, as it will be different from monetary inflation due to monetary debasement. As pushing the economy into a recession will not resolve wars or issues in agricultural production, and the lagging effects of interest rate hikes are just starting to be felt, along with the fact that we are in an election year, we think it’s more likely that both the Treasury and the Fed could do whatever it takes to support markets. That’s why at least for now, I believe we'll see several some cuts in 2024, resumption of QE, more T-bill issuance, and resumption of the BTFP.
Here we’d like to emphasize, that although we do think there's a political element to all that, it’s not all just political, and they might not have the anticipated impact everyone is expecting. Not only that, but the fear of inflation and the fear of the Fed/Treasury seeming like they are acting too political when the stock market is at ATHs and inflation above their target, might force them to be less accommodative than the market expects them to be. The truth of the matter is that once the RRP is depleted, the government may face challenges in funding itself if banks don't buy bonds, or if the Fed doesn't step in. Deflation/a recession are also risks, considering the rapid and intense shift in rates globally, while the world economy is visibly in bad shape, despite how strong the US economy has been. Let’s not forget that the M2 money supply in the US has gone down for 2 years in a row, while real rates are at +2%. Although a massive recession seems unlikely, based on everything we have mentioned, as well as with stocks at all-time highs, it’s possible that we might see a rise in unemployment, along with a rise in inflation at some point in Q2-Q3 in 2024.
To close things up, regarding the stock market, it seems to be rallying due to rising liquidity and anticipating additional rises in liquidity. Previously, we thought stocks might peak slightly above their 2021 all-time highs, but now there appears to be room for a higher rally before reaching a top. We are not forecasting a final peak, but rather a significant correction 2-3% higher from here. As the market seems to be factoring in a lot of positive outcomes, like the ones we have mentioned before, and it might prove to be right, it is possible that this could be derailed by unforeseen event, or due to overly bullish sentiment as the market is getting way too far ahead of itself. Last week, sentiment was a lot less bullish than two weeks ago, and that’s what has allowed it to rally further with ease, but there is no guarantee this can last much longer. Let’s not forget that markets tend to top when the best news come out, and nothing looks like could make it go down. Therefore, we do see a potential top in Q1, either next week around the Fed and Treasury announcements, or in March, when the Fed really either cuts or doesn’t cut, whether it really resumes or doesn’t resume the BTFP, and what it decides to do with QE/QT once the RRP is drained.