Absolutely Pivoting

The Fed pivot no one is talking about (apart from Bridgewater)

I’ve been short long duration bonds with my husband Mitch since December last year. It’s been a high conviction trade over a bumpy ride, with that conviction getting tested thoroughly and repeatedly over the past 9 months. That’s enough time to grow a baby so I assumed it would be enough time for the market to fully grasp reality, but it appears they’re still undecided.

Don’t get me wrong, we’ve been able to secure a 6x with our options that expired in July which we’re stoked with but we still have 7% of our portfolio remaining in TLT puts expiring in October and March, just as the 30 year yield deflates back to 2.9% from it’s 3.4% June high.

We still have conviction in our short thesis, albeit battered and bruised, but the timing seems more difficult to calculate than ever before. It’s as if we’re back at December 2021 all over again questioning wtf is the market thinking?

Imagine that 90% of people disagree with you but you remain firm that you’re right and they’re wrong. What evidence do you hold to for conviction? Do you really understand that evidence? Could there be a blindspot in your knowledge or a gap in your understanding, causing you to jump to the wrong conclusion?

These questions come to mind every time we’re misaligned with the market, which between our bond short and our cannabis long seems to be the new status quo! Causing me to question further - what is reality? Is it the honest truth? Is it the version of the truth in your mind? Or is it the version of the truth in the majority of other peoples minds?

Before I get too existential let’s go back to the beginning of the story…

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2021

Mitch read Jens Parsson’s book “Dying of Money” as per Dr Michael Bury’s tweet recommendation in early 2021. It’s a great crash course breakdown of the death of a State ravaged by hyper-inflation. It’s also proven to be great background knowledge stored in Mitch’s brain bank coming into 2022, following the Fed’s creation of money to the tune of 25% of GDP in just 2 years.

Noticing that inflation was beginning to rear its head in mid 2021 Mitch’s radar went off and so our deep dive into the world of inflation began.

Hello books, podcasts, YouTube - we read, listened and tried to comprehend any information we could find all the way from conspiracy theories to the Schools of Economics, from the finest of Friedman and Summers to the soothsaying’s of Saylor and Snider, even quizzing everyone we knew over the age of 50 who’d experienced the previous inflationary episode in the late 1970’s.

Our devices were set to inflation alert from news articles to twitter-feeds but we knew we were in deep when the FOMC meeting’s and CPI releases became the most anticipated events of our month.

This period did not help my fascination with Bitcoin, seeing that the argument for higher inflation generally concluded with a pro-crypto solution. It drove Mitch nuts constantly talking me down from the ‘but what if Bitcoin…’ thought cliffs, where productivity goes to die. But the moment I saw the BS video released at the Bitcoin conference dissing Buffett & Munger I was done. Not cool. I got really pissed off and wrote this article.

Also, people were constantly parroting ‘our economy is too fragile to handle an interest rate above 2%’ which creates the unhelpful feeling of being damned either way so heck, why even bother?

But ultimately, the history books are clear - whenever inflation has risen above 5% it has taken an interest rate above CPI to bring it back down again, recession or not. Inflation has been under appreciated in the past to great detriment leaving an embarrassing legacy in its wake which no leader would choose to repeat. No one wants to be this guy…

Arthur Burns - Fed Chairman 1970-1978

By late 2021 it was clear that inflation was here and it was a serious problem. But to our surprise the Fed and markets continued to believe inflation was transitory caused from “supply chain disruptions”, the term which now sounds like a creepy chant etched in all of our psyche’s.

We saw this as a quickly closing window of opportunity to take a position which benefited from higher interest rates at a time when the markets were not pricing in any rate raises at all. Mitch of course went straight to Buffett’s advice for what to do in an environment when interest rates are on the rise - short bonds - so we began thinking of the best way to short bonds as our inflation hedge.

A twitter friend generously sent us this link to Buffett’s exact words to Becky Quick in 2016: “If I had an easy way and a non-risk way of shorting a lot of 20 or 30 year bonds I would do it … but it can’t be done in the kind of quantity that would make sense for us. But I think bonds are very overvalued I’ll put it that way.”

We were in late November 2021 with CPI nearing 7% when Powell finally started showing signs that he’s starting to take inflation as a real threat that’s not going to evaporate as soon as some container ships get unloaded, and the term ‘transitory’ was retired (although it will continue to haunt Powell as his Arthur Burns moment).

This was the first instance where the market and us were in strong disagreement. The market was still sticking to transitory inflation saying that the supply side was going to come back to normal and inflation was going to disappear, then any interest rate hiking cycle the Fed had started was going to be embarrassingly unwound.

This obviously made no sense to us having some background knowledge of how inflation has worked throughout all human history so although the market was saying ‘buy bonds!’ we started shorting them by buying puts on bond ETF’s in December 2021, having high conviction that interest rates would be higher from here. CPI was at 7%, FFR was at 0%, 30 yr was at 1.9% and TLT was at $149.

2022

In February 2022 inflation hit 7.5% and it was now showing up in food, energy, services and shelter. The market finally retired transitory inflation and TLT started its decent down to $135.

But just us soon as transitory left the conversation, two fresh narratives enter and disagreement between us and the market strikes again:

1. The curse of the dreaded ‘Yield Curve Inversion’

   The market was pointing to a flattening yield curve to signal a recession was imminent and higher rates would not be needed to cool inflation because a recession would crush demand and do the Fed’s job for them, then any interest rate hiking cycle the Fed had started was going to be embarrassingly unwound

2. Russia Invaded Ukraine

   This was not the same threat to our conviction that transitory inflation and yield curve inversion posed - this was real. A flight to safety would kill our bond short because bonds and gold are the favourite safe assets in times of fear, and war times are the most fearful

The curse made no sense to us seeing the Fed was still buying bonds at a ridiculous rate ($100B per month) and effectively controlling the yield curve, therefore it could be sending false signals or no signal at all. Additionally a recession wouldn’t be a definitive cure for inflation and higher unemployment numbers should be expected as par for the course. Thirdly, inflation is definitely here now.

I got frustrated and wrote this article about the curse and this article about recessions.

The war was different. Trying to stay logical whilst witnessing crimes to humanity streamed live across our screens is not something I wish to describe in words but we ultimately decided inflation posed the greater threat to America than the Russian invasion, and this event will only exacerbate inflationary pressure.

So naturally, whilst the market was saying ‘buy bonds!’ we HODL’d our short. TLT shot to $141 after the invasion but returned back to it’s gradual decline for the next 3 months bottoming out at $108 in June 2022. CPI was at 9.1%, FFR was at 1.75%, 30 yr was at 3.42%.

We sold our first batch of options in July 2022, cashing in a 6x return on 10% of the portfolio but we chose to still hold a 10% position in the newly sized portfolio expiring in October and March. We still want to be short bonds when the effects of QT (quantitive tightening) ramp up as the Fed shrinks their balance sheet, if just for the potential of a mechanical fault resulting in a spike.

August 2022 (Now)

Cries from the market of an impending recession have been accelerating for months. The talk has become so widespread even in the world of R&B GDP has replaced WAP…

Even whilst the job market continues to provide twice the amount of available jobs to available people, markets are calling for looser financial conditions and they think they’re going to be heard. Actually, they’re betting on it with markets rallying everywhere accept commodities.

And even though QT is accelerating into its second month, the market is buying 30 year bonds at 2.98%, whilst CPI is at 8.5% and FFR at 2.5%. TLT has rebounded to $117. I must be frustrated again because I’m writing this article.

However my frustration is not with the markets this time around - it’s with the Fed. They’ve sounded increasingly hawkish over the past 9 months, until now. Hinting at the last meeting in an off the cuff comment that we may be at a neutral rate and they won’t be giving us anymore forward guidance but will purely be reacting to incoming data.

The market is throwing a party because they think the Fed is about to, you guessed it, embarrassingly unwind its rate rising cycle.

We were a little confused. We didn’t know how to take this ‘pivot’. It sounds more Burns than Volcker but Powell has repeatedly stated that they will not hesitate to do what they need to do to combat inflation and bring it down to their 2% target, which he declared again only 2 weeks prior at the ECB forum.

So is the market right? Is the Fed pivot happening that they’ve been predicting for months as we stare down the face of recession and witness inflation evaporate? We of course don’t agree.

The Fed pivot no one is talking about

We think a pivot is in motion but it’s not the kind markets are hoping for.

Consider this possibility:

1. The Fed has realised that their target inflation rate of 2% is completely out of reach. But any hint that they’re expecting higher inflation for longer would cause chaos as markets attempt to price in long term high inflation for the foreseeable future, potentially taking the Fed’s ability to control rates out of their hands

2. The Fed has decided to give less guidance in future because the trade off they face now is high inflation with low unemployment or moderate inflation with higher unemployment. This is bad news no political leader would broadcast in advance but prefer to allow time to break reality to us slowly

3. Only when the Fed has actually achieved something to say they’ve tried to fight inflation, will they then ‘pivot’ to accept whatever level of inflation they’ve been able to get to - or “the new neutral rate”. Will this be 3%, 4%, 5%? This is currently an unknown as it hinges on where inflation will be in the future maybe 6, 12 or even 18 months from now

Inflation…

Inflation may have peaked at 9.1% but 8.5% is still a long way from their stated 2% target. Besides higher interest rates what other deflationary forces will bring costs down?

Energy costs have come down for the month of July thanks to the Strategic Petroleum Reserve (SPR) which is due to run out in October this year. In two months time when the SPR is drained, has the U.S resolved the energy supply issues with Russia or Saudi-Arabia? Or is there a chance the emergency release of fuel into the economy has only temporarily eased inflation in fuel costs?

Shelter equates to 30% of CPI. Have rents stopped rising? Sure housing sales have cooled but what about the structural supply/demand in-balance baked into the system? Plus the rising cost of commodities and labour to build new houses? With 70% of U.S home owners on fixed 30 year mortgages below 4%, any margin in rising rents will be printing cash in their pocket and the rising interest rates won’t even effect them.

The labor market continues to be strong with wages still on the rise which fuels more inflationary pressure into services. The risk of rising food costs are difficult to calculate between war, soil degradation and global warming but with 25% of the worlds wheat being produced in Russia and Ukraine it’s not unreasonable to think supply may be disrupted for a little longer.

We moved on from the term transitory nine months ago, but it seems transitory pricing is still in full swing.

Recession…

As the Fed empties liquidity from the system, inflation may begin to come down and growth will come down with it. That’s kind of the point. With an unemployment rate of 3.5% there is a long way to go before real economic pain causes the Fed to ease up. So it seems neither inflation or higher rates have been priced into the bond market, nor have lower earnings been priced into the stock market.

Sure the levels of debt in our system makes our time especially spicy and unpredictable, but people seem to be buying bonds on the the assumption that the Fed will be pausing their rate hikes and QT in a few months because they don’t want to harm growth.

Under the stark reality of the macro picture above I can’t understand why or how the Fed would pivot so quickly to protect growth before they’ve reached within 600 basis points of taming inflation.

But then again, what is reality?

Is it:

a) The honest truth

b) The version of the truth in your mind

c) The version of the truth in the majority of other peoples minds

As a long investor, you want b) to equal a) and when it does you want to go long, and it’s even better when c) is yet to catch up.

As a short investor, when you feel c) is heavily at odds with your a) + b) combo above, you want to short c) during a period where c) becomes your a) + b) combo in reality, or when the majority of other people change their minds to agree with your version of the truth. If you don’t time it correctly then it doesn’t matter if you’ll eventually be proven correct, you’re technically wrong.

The honest truth begins to only matter when you can time its arrival.

Also as a shorter, you have to be ok with remaining in the nitty gritty details of reality even when it makes absolutely no sense, and continue living as if everything’s normal with the world.

So even if our thesis about higher for longer inflation is correct, our trade will only be correct if the markets come to this understanding between now and March 2023. So all were thinking is, what will the Fed do between now and March? How will the majority of people interpret what the Fed does between now and March? How much will QT actually effect the bond market? At the moment, market sentiment is going the other way to our logic so we’re HODL’ing, again.

The long and short of it…

Do we think bonds are a buy? No. So we remain short TLT 0.00%↑

Do we think U.S cannabis MSO’s are a buy? Yes. So we remain long $AYR-A.CN

Do we think oil prices are going higher from here? It sure looks that way if the chronic underinvestment and structural shortages are anything to go by so we’ve just gone long OILU 0.00%↑

Looks like were solidly misaligned with the market again, brilliant.

*By the way this is NOT INVESTMENT ADVICE and I am NOT A FINANCIAL ADVISOR. If you didn’t realise already, our chosen portfolio construction makes for one incredibly bumpy ride and we change our minds ALOT. Good luck out there!