(Another great piece of analysis from 3D/L's Benjamin Lavine)
Over the past few weeks, we’ve had the pleasure of speaking with institutional investors and capital markets specialists concerning the changed monetary course the U.S. market is embarking upon – a course consisting of higher interest rates and lower liquidity assuming the post-COVID recovery is not entirely derailed by the Omicron variant. Unfortunately, we were left with more questions than answers as the 2022 outlook remains murky at best in the face of a market environment marked by lower liquidity and persistently high inflation.
But first, following the December Federal Reserve meeting and press conference, Wall Street strategists have, more or less, bought into the Fed’s projection of a cessation of balance sheet purchases to be followed with three rate hikes in 2022 (Figure 1).
Figure 1 – A Return to Normalcy as Fed Projects an End to Balance Sheet Purchases and the Beginning of a Rate Hike Cycle
However, based on the market’s reaction post the December Fed meeting (drop in equity prices and bond yields), the fixed income market is not buying into the Fed’s 2022 timetable where Fed Funds futures are projecting a rate path lower than the Fed’s dot-plot forecast (Figure 2).
Figure 2 – The Market Is Not Buying What the Fed Is Cooking in 2022
Source: The Daily Shot, 12/17/2021
Perhaps the markets are anticipating that the Fed will end up having to reverse itself once market volatility threatens financial stability and/or a more restrictive Fed policy threatens the post-COVID recovery. The bull case would be for the Fed to engineer a soft landing into a ‘Goldilocks’ economy that sees a slowdown in inflationary pressures while maintaining economic growth and employment gains. A bear case would suggest that the Fed has let inflationary pressures build up too long consigning current Fed policy to remain behind the inflation curve eventually forcing an even more hawkish posture.
An old saw on Wall Street suggests that investors buy the first rate hike and sell towards the end of the rate hike cycle as Fed policy invariably pushes the U.S. economy into recession. Indeed, according to Barclays strategists, over the past four major policy tightening cycles, U.S. equities have rallied over the medium term. This assumes earnings growth, rather than Fed policy, remains the dominant determinant for future market gains. Even though 2022 earnings growth for S&P 500 companies is expected to cool down from the 20%-plus growth of 2021, expectations are for high single digit growth in 2022.
Yet, the impetus for this blog piece isn’t so much how Fed tightening will impact public market sentiment but rather sentiment at the periphery, namely assets and liabilities operating outside the immediate purview of public exchanges and regulatory bodies.
On the asset side, think digital assets such as cryptocurrencies and non-fungible tokens (NFTs), not systemic risks in of themselves but which are being used for collateralized lending potentially at levels well beyond what one could expect to borrow on margin through a traditional brokerage account. On the liability side, think non-bank lending, whether private market lending (a.k.a. leveraged loans) or buy now – pay later consumer lending.
Not since 4Q2018 has the market experienced a significant withdrawal in Fed accommodation and liquidity. Given the subsequent abrupt reversal by the Fed in contracting its balance sheet and raising interest in the face of market volatility, the market has been conditioned to the persistent buttress of Fed-induced liquidity through its balance sheet purchases (now north of $8.7 trillion) and reverse repo operations (just over $1.1 trillion). We may soon find out what ultimately happens to both public and private risk appetite when Fed accommodation is expected to be withdrawn in 2022.
The challenge, as we realized in our investor conversations, is that the full extent of risk posed by Fed tightening is difficult to quantify outside of some compelling anecdotes. How truly has market speculation grown during the post-COVID recovery, especially in the decentralized meta universe of digital assets and cryptocurrencies? An example of one compelling anecdote: according to Bloomberg, luxury brand companies from Rolex to Louis Vuitton are tripping over themselves to tap into the lucrative NFT market where an avatar flossing a virtual Birkin bag at an exclusive metaverse party has as much bragging power as the real thing.
Would withdrawal of Fed accommodation and market liquidity actually adversely impact the appetite for NFTs whose underlying value seem to be driven more by emotion than fundamentally-driven expected returns? The challenge is that NFT appetite, as part of the transition from real world to ‘meta’ consumption, has only occurred during an unprecedented period of monetary expansion and near record low real (inflation-adjusted) interest rates.
As we were all scratching our heads during our conversations with other ‘out-of-touch’ boomers and gen-Xers, we agreed that we will only find out how ephemeral market liquidity becomes, whether in the public or in the shadows, when that ‘payment due’ moment finally comes. Precipitating the 2008 Great Financial Crisis was the payment due on 2/28 negative amortizing loans for subprime borrowers that cascaded into payment due moments for property speculators, homebuilders, banks, credit default swap insurance underwriters, and CDO-squared funds. Precipitating the 2000 Dot-Com collapse was the payment due moment for cash-burning internet companies that could no longer rely on financing from their equipment vendors to fund working capital needs. What exactly will precipitate the collapse of the next speculative bubble, arguably if there is even a bubble to burst?
So, here we sit on the precipice of a new monetary regime as expansion in the Federal Reserve Balance sheet has pushed excess liquidity into the depositor base (Figure 3), which has yet to fully manifest itself into the broader economy via loan growth to fund capital expenditures and other hard spending (Figure 4).
Figure 3 – Bank Deposits Have Grown with the Federal Reserve Balance Sheet, Now at $8.7 Trillion On Its Way to $9 Trillion By the Time Tapering Ends Next March
Figure 4 – US Deposits-To-Loans Ratio: Commercial Loan Issuance Has Not Kept Pace with Deposit Growth Leading to Excess Bank Deposits That Have Yet to Find Their Way into the Real (or Meta) World
This is where the story may start to get interesting. In one of our conversations, a middle market banker suggested that excess bank reserves are being put to work outside the regulatory capital sphere, perhaps at the holding company level. Multi-family housing and private capital market activity, maybe even digital assets. To what extent has that excess liquidity truly found its way beyond the boring business of making consumer and business loans? This is all challenging to verify and may only be seen until after the Fed embarks on its tightening cycle.
This is not to suggest that the depositor base is at risk as banks hold sufficient regulatory capital reserve levels. But what happens to the excess liquidity in the event the Fed not only tapers the balance sheet (and perhaps even shrinks it) but also raises interest rates hoping to put a lid on inflationary pressures? What will the true knock-on effects be when that depositor base also shrinks alongside the liquidity withdrawal? Granted this may all be hyperbolic Chicken Little speculation, but we just don’t know whether and to what degree another shadow financial system may exist outside the public regulatory purview.
Based on the disconnect between the Fed and futures market, investors are betting that the Powell Put will prevail and that the Fed would immediately pivot in the face of market disruptions, just like it did after the market volatility in late 4Q2018. But, if the Fed does follow through on its projected course of tightening monetary policy, we may eventually see what the knock-on effects will be. The major difference between now versus 2018 is inflation, which doesn’t give the Powell Put a lot of room to be exercised. 2022 should turn out to be an interesting year for both the real world and the meta universe.
