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Million Dollar Mailbag Are risk assets whistling past a financial graveyard? Market signals may be getting crossed with bonds down a lot and stocks and crypto down not very much. It feels like the range of outcomes for all markets is unusually wide right now. And tail risks are unusually fat. If I had lifelines to take like in Slumdog Millionaire, I’d be using them all right now. Q: Why is the market fighting the Fed? That is the $1,000,000 question of the year, yes. It seems daring to ignore a market doctrine as time-honored (and alliterative!) as “Don’t Fight the Fed,” but that is what we’re doing. Powell keeps telling us he wants asset prices lower and with 10-year yields up to 2.6% the bond market is starting to oblige. But stocks continue to have a mind of their own: The S&P is still up nearly 10% from a year ago when 10-year Treasurys yielded less than 1%. You wouldn’t generally expect stocks to be up after Treasury yields have nearly tripled. On the one hand, I think nothing could be less unexpected than this cycle of Fed tightening, so surely it must be priced in at this point? On the other hand, I’m old enough to remember people worrying about a bubble in tech stocks for a full two years before the dotcom crash. And then worrying for even longer about a bubble in house prices before the GFC crash. So, markets can and do crash on things that are entirely obvious in hindsight. Q: So you think a crash is coming? No, I still have enough faith in the theory of efficient markets to believe that prices already reflect the Fed tightening to come. (Full disclosure: If markets do crash, I’ll be citing my previous answer to say I told you so.) But even if a full cycle of tightening is priced in, QT could still prove to be a slippery slope of unexpected consequences. That’s what Joseph Wang is thinking: He sees 10-year rates at 4% by year-end and a high risk that the Fed will ultimately be forced to resort to yield curve control. I struggle to imagine that outcome, but that is likely just a failure of imagination on my part. Belief in the hive-mind of markets is one of my best-loved ideas. As per Charlie Munger, this might be the year I have to destroy it. Q: What is QT, anyway? QT is quantitative tightening: It’s when the Fed sells all the bonds it’s been buying during quantitative easing. I’ll use my phone-a-friend to explain the details. But the bottom line is that, yesterday, the FOMC said they’ll be selling $95 billion of bonds per month. Q: $95 billion? That sounds like a lot. It’s almost $100 billion! Which is scary. But not quite, so not too scary. It’s like pricing a yogurt at 99c instead of $1. How much should we sell? 100 billion? Sounds like a lot. Let’s do 95 billion. I’d feel better if they said $97.34 billion. Then I’d think they’ve at least given it some thought. Maybe used a spreadsheet. Done some math, even. $95 billion makes it sound like they’re just making it up as they go along. Which is probably what they’re doing: They are going to sell however much they have to to get asset prices down. But not too down. It’s far more art than science. Q: Is inflation good or bad for stonks? For stonks? Definitely bad. The meme stock, SPAC and spec-tech craze (i.e., stonks) was largely a product of excess liquidity and the Fed is now committed to draining that excess from markets. For stocks? It depends. Stocks in companies that have pricing power will do well. So far, that seems to be most companies: US corporates have been able to keep prices rising faster than costs, as evidenced by record high profit margins for the S&P. But the longer inflation stays elevated, the harder it will be for companies to keep costs down: Employees will start demanding raises and fixed-cost capital investments eventually have to be replaced at higher prices. The market has been surprisingly resilient at least in part because inflation is good for stocks in the short-term. And rate rises should keep things from getting out of control in the medium-term. In theory, at least. Q: How about for crypto? For a while it looked like our new asset class was going to be just higher-beta speculative tech, in which case we’d be at the mercy of TradFi interest rates. But bitcoin has successfully decoupled from ARKK, which, for my money, is the single best news of the year. And the message from the rest of crypto is similar, I think, with correlations between altcoins low. Things are moving up and down mostly on their own merits (or perceived merits), not on what’s happening with rates or risk assets. Lots of people have been eagerly waiting for institutional money to come in and inflate crypto prices. But institutional money is flighty. (See: Asian Tigers’ FX crisis, late ‘90s.). A much better outcome would be for the asset class to grow mostly with retail and crypto-native money. Crypto is still a risk asset, so it won’t ever be immune to what’s happening with other risk assets. But it’s feeling more and more like the next crypto crash will be a crypto-native one. Which is great. Q: So you think crypto is going to crash? Sure. Eventually. And I think eventually may have edged a little closer with the announcement of the 4Pool this week. Secretary Yellen is right to be highlighting stablecoins as a risk. Because bank runs happen when what people think is money turns out not to be money. And DeFi is full of things that purport to be money, but that are not. Stablecoins are only just getting going, however, and we’re not anywhere close to the levels of interconnectedness that cause contagion crashes in TradFi. So I’m hopeful that the inevitable DeFi crash will be from much higher levels.
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