The Fed is likely keeping an eye on financial conditions, as it did during the last cycle. They are a real-time look into the financial economy, which is more forward looking than the lagging indicators of the real economy (inflation & employment). (THREAD)
Here we see financial conditions for this cycle and the previous four periods of tightening financial conditions (measured from the low point in the Goldman Sachs Financial Conditions Index). /2
So far, financial conditions remain very loose, but the USD is up and credit spreads are slightly wider. /3
The dollar and spreads are two components of the index (the others being short rates, long rates, and the stock market). /4
Remember, it was the blowout in financial conditions that forced the Fed to slow down in 2016, so financial conditions are likely going to be a key metric for the Fed’s glide path in the coming years. /END

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More from @TimmerFidelity

23 Nov
In some ways, the current Fed cycle reminds me of 2015-18. Take a look at this chart and I'll explain. (THREAD)
Back in late 2015, the Fed finally hiked rates for the first time. Back then there was a massive policy divergence between the US (which was normalizing) and the rest of the world (mainly Europe and China, which were spiraling down). /2
Just a few weeks after achieving lift-off, energy spreads blew out and the dollar soared, causing financial conditions to seize up. The Fed backed off, and this enabled the economy to ease back into mid-cycle. It was the great cycle extender. /3
Read 7 tweets
9 Nov
If the inflation surge persists, it could cause a further reset for nominal rates, which remain well below where they should be based on their correlation to inflation expectations. But the Fed’s gigantic balance sheet plays a role in keeping rates below normal. (THREAD)
If there is an inflation scare, the Fed could be forced to overshoot the neutral rate (R*) by tightening faster/harder, and in the process forcing rates to rise beyond what the economy can withstand. That would be your classic late-cycle policy error (three steps & a stumble). /2
The alternative scenario is that the Fed understands that today’s over-indebted economy is highly levered to low rates, and that it will just have to accept higher structural inflation and keep policy on the looser side of neutral. /3
Read 5 tweets
8 Nov
The Fed’s taper starts this month & should be a wrap by mid 2022. The rates market has experienced quite the whipsaw, at first pricing in more rate hikes sooner, then un-pricing some of them. As of Friday, the market expects the Fed funds rate to end 2022 at 0.53%. (THREAD) Image
A stunning disconnect: Even though the economy has roundtripped back to full capacity and inflation continues to run hot well beyond what was first considered transitory, the market does not expect the Fed to return to a neutral policy stance for years to come—if ever. /2
Consider the implications: Below, we see the neutral rate (R-star), the inflation-adjusted Fed Funds rate (blue), and the inflation-adjusted Fed Funds Shadow rate (which accounts for balance sheet shenanigans). /3 Image
Read 6 tweets
5 Nov
Bitcoin in recent weeks has beautifully fulfilled its premise as a hedge against declining purchasing power. (THREAD)
The chart above shows a hypothetical portfolio with 98% intermediate bonds and 2% Bitcoin. Even a small Bitcoin allocation could protect a conservative bond investor against a loss of purchasing power resulting from rising inflation and financial repression. /2
In 2018, the 2% allocation would have added almost 4 points of annualized volatility, while also amplifying drawdowns (i.e. the opposite of what a diversifier should do). But... /3
Read 4 tweets
5 Nov
Why should any investor own bonds at this point, given that they barely produce any nominal income, and are likely to lose value in real terms? Take a look at this chart, and we'll explore the question a bit more. (THREAD)
In recent years, the reason to go with a 60/40 portfolio was to diversify and protect. We can see this in the chart above. /2
60/40 produced about 2 percentage points less return per year than the S&P 500, but still a very respectable 9% – well above the inflation rate. It also helped investors sleep at night when the stock market was down (which it was about 40% of the time). /3
Read 8 tweets
4 Nov
Following up on the last thread regarding sector returns during periods of inflation: Here is the energy sector relative return during the four inflation regimes (1942-50, 1965-80, 1987-92, 2003-08): (THREAD)
And here is the retail industry group (GIC2). Consumer stocks can do OK at the start of an inflation wave, but apparently the lack of pricing power eventually takes over. /2
Next, the healthcare-equipment industry group. Huge winner during the 1940s, and did well during the 1960s and early '70s also—perhaps because both were war periods? Big pharma stocks were part of the Nifty Fifty, which carried the market into its peak in 1973. /3
Read 8 tweets

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