Pavlovian Response
Pavlovian Response
The reaction to any weakness or dovish sentiment from the Fed results in the immediate purchase of assets, and inherently re-inflates asset/ commodity prices.
Highlights
13 years of monetary policy perpetuated by quantitative easing has created innate behavioral responses by the market.
Since their lows in early June, the CRB index is up +10.54%, Oil is +25%, and Gas prices (RBOB) are approximately +27.5%.
August Headline CPI is reported on September 13th. The next Fed rate policy meeting will be September 19th-20th. “So you are telling me that there’s a chance”.
Holiday Weekend!
In previous publications, I have spoken about behavioral relationships that exist within the current market environment. The origin of such psychology can be traced back to the Great Financial Crisis and 13 years of monetary policy perpetuated by the quantitative easing that followed. There is a mindset that lives amongst the newer generation of investors that the central bank will always be there to support asset prices. Most of those people, including myself, have no idea what it is actually like to see and live through real economic hardship. Even some of the old dogs on the street have learned from these bad habits. The Pavlovian response to any weakness or dovish sentiment from the Fed results in the immediate purchase of assets. I am writing again today because the feedback loop has yet to be broken. In April I wrote, Cycles Constantly Cycle (Link Here), and below is an excerpt.
Inflation is a problem→ Fed tightens while growth is slowing→ USD strengthens→ Asset and commodity prices go down→ Market begs for rate cuts or Fed pivot→ USD weakens→ Market rushes to buy the former bubbles→ Commodity prices reflate→ Inflation is persistent→ Fed tightens further.
This loop has gone in circles ever since the tightening cycle began in late 2021. Most recently the banking crisis opened a window for this feedback loop to repeat all over again. To no surprise against weak inflation comparisons, the US saw headline inflation re-accelerate for the first time in July (+3.2%) vs. June (+3%), following 12 consecutive months of declines. Core PCE +4.2% (July) vs. +4.1% (June). Inflation is sticky and remains above the Fed’s long-term 2% inflation rate objective. Jay Powell reiterated his goal at the recent Jackson Hole meeting, and his stance has not changed.
Macro
The recent pain trade for the market and the American consumer has been Oil/ Gas prices higher, inflation higher (again), and long-term rates higher. All are associated as a component of their own loop.
Since the lows in early June, the CRB index is up +10.54%.
Trading View CRB Index
Oil is +25% from early June.
Trading View Oil
Gas prices (RBOB) are approximately +27.5% higher since early June.
Trading View Gas (RBOB)
There is no coincidence that we got a 1-month acceleration in July based on the increase in these commodity prices. Generally, Oil flows through to CPI at a one-month lag, which increases the likelihood that the August inflation report also demonstrates the second straight month of accelerating inflation. I have no clue whether this will be a sustained trend past the period of time that we just discussed, but here is why this is important.
August Headline CPI is reported on September 13th. The next Fed rate policy meeting will be September 19th-20th. “So you are telling me that there’s a chance”.
Recently, the market has been celebrating early labor market weakness. This in its own right is perverse behavior that stems from the Pavlovian conditioning following years of quantitative easing.
The people, “This sucks, I am losing my job, the standard of living is declining, and I do not know how I will pay for my rent”.
Wall Street, “Yes! The job market is getting weaker! People are starting to lose their jobs, which means the Fed can start cutting rates and our asset prices will go higher. BUY MORE”!
Bluntly, my view: this is F**** up.
Some readers may think that I am being dramatic, but this is the behavior that I have witnessed. On the aforementioned labor market weakness, interest rates traded lower over the last 2-weeks. There is a headline unemployment report today, and I have no clue what is going to happen or how the market will react. I will find out shortly.
What is important is in my view, unless this job report is a complete atomic bomb and the market starts legitimately crashing, it will not induce the Fed to start cutting rates. What I highlighted above that is important is there is a strong probability for inflation to accelerate again in August. Remember, the August headline CPI is reported on September 13th, and the next Fed rate policy meeting will be September 19th-20th. Powell will be faced with a tough decision once again if inflation starts to move away from his 2% objective. Every rate increase at this point adds fuel to the fire. Elevated rates remain problematic for Real Estate Investors who need to pay off existing loans and refinance (discussed in my publication High Standards). The pain trade specifically for commercial real estate investors rates higher for longer.
Conclusion
The trap is set. Do not raise rates, and risk secular inflation similar to the 1970’s or continue to raise rates and drive the economy into a ditch. Previous policy mistakes and easy money have created no safe way out of the current predicament. In the event that the “more inflation route” is taken, perhaps short-term those who own assets will benefit once again, however further hardship will be induced upon the American people. If the economy is driven into the ditch then there will be larger levels of unemployment and a different form of hardship. Neither is a desirable outcome.
13 years of monetary policy perpetuated by quantitative easing has created innate behavioral responses by the market. Inherently, these reactions perpetuate more inflation.
Since their lows in early June, the CRB index is up +10.54%, Oil is +25%, and Gas prices (RBOB) are approximately +27.5%.
August Headline CPI is reported on September 13th. The next Fed rate policy meeting will be September 19th-20th. “So you are telling me that there’s a chance”.
In my view, this recent rally in equities has been a reaction function to a 2-week trade of lower interest rates. The pain trade has its rates higher until it is not. The VIX (See chart below) is at incredibly low levels and essentially pricing no risks or uncertainty. If/when people start losing their jobs, there is a much higher level of uncertainty around everything. Raising cash into this recent equity strength poses a prudent measure to obtain more liquidity and earn a +5% risk-free return. I maintain my position that a short position in High-Yield Credit is a great way to hedge the long side of the portfolio. After booking gains in the HYG short, I added it back this Tuesday. I also got a little sporty and added some VIX calls yesterday. A little goes a long way. All with patience and time. Stay liquid.
Trading View Gas (VIX)
Happy Friday,
Aaron David Garfinkel
Resources
Macro Optics (https://macro-optics.com)
Tradingview (https://www.tradingview.com)
Dumb and Dumber (Link within discussion)
Very good Aaron