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Monetary Policy, Money, and The BIG Picture
The Bigger Picture
Hello all (for the new subscribers, please go read the “About” section for disclaimers and previous articles for context)
I was recently on a private webinar where Stan Druckenmiller and Scott Bessent interviewed Edward Chancellor about his recent book, the Price of Time. If you don’t know who any of those guys are, just think of them as the MJ and Kobe of hedge funds and money management. Scott and Stan understand the economic system incredibly well, distance themself from the crowds, and think big picture. Their foresight is uncanny.
In comparison, most people on Wall Street focus on short-term momentum, narratives, and headlines to inform their decisions. The limitation of this is you never truly understand how the mechanics of the monetary and economic system work. Granted, most people don’t really need to know these things since most AUM allocations are passive and have zero timing components. The trade-off of not knowing these things is that you are constrained to the returns of the index.
Again, none of these things are bad or wrong, they just have trade-offs. My job is taking advantage of these trade-offs and exploiting them just like a plumber or electrician would fix something in my house since I don’t have specific knowledge in that field.
When I think about developing specific knowledge and monetizing it, I am trying to understand everything about money, the monetary system, and broad macroeconomics. That’s why I was on that webinar and why I have been reading the Price of Time by Edward Chancellor.
If you want to read an excellent book on money, the history of interest rates, and monetary policy then I would most certainly recommend the book.
How the system works and why it matters:
As I stated in my first Substack, I spend a lot of time researching and innovating new ways to understand the world and gain some type of informational advantage. This book, along with numerous others, is part of my research.
So how do we think about money and monetary policy? Well, first we need to understand that there is an economic system and a monetary system that are distinct but they do interact dynamically through the economic cycle. The FED is primarily involved in the monetary system and can have an indirect impact on the economic system. The main thing to remember is that these two systems can sometimes get out of wack or be in a state of extreme disequilibrium.
2020 was a great example of the underlying economic system being in shambles while the monetary system was running hot. Because of the FED’s injection of liquidity, we saw the market rally with incredible momentum in 2020. As we entered into 2021, the economy reopened and the FED continued to increase the amount of liquidity in the system. This is where things got out of wack.
When you have the underlying growth and cash flows of the economy exponentially increase from reopenings at the same time the FED is holding rates at 0, EVERYTHING goes up. This is why we saw the AMC and GME short squeeze occur. It wasn’t simply because of Robinhood traders. The liquidity in the system facilitated short squeezes across numerous junk stocks. Does it make sense now why people called it “The Everything Bubble”? When you open an entire economy while holding rates at 0, of course, everything is going to do well!
This is the power of liquidity!
One of the exceptional points that the author of the Price of Time made was that low inflation allows easier monetary policy to occur. When inflation is low, there isn’t a constraint on the FED to hike rates and tighten monetary policy. Remember, the FED has been doing QE and easy monetary policy for the last decade and inflation didn’t occur. It’s when inflation in the economic system occurs that the FED has to tighten liquidity in the monetary system.
So what does all of this mean for 2023?
Think about it like this, the FED held rates at the lower bound while we had a full growth cycle during 2021. This was procyclical monetary policy, usually, the FED hikes rate as growth accelerates. Now the opposite is occurring. The FED is holding rates at an elevated level while growth slows. If you think we saw crazy things happen when the liquidity spigot was turned on, just wait till we get to the full effect of elevated rates and a growth rate cycle downturn.
If you read the book you will begin to understand that one of the consequences of the FED hiking is the risk of collateral being damaged in the system. If you are trying to conceptualize this, just think of last year in the UK when the Bank of England was hiking interest rates and pension funds functionally got margin calls because the sovereign bond market was going off a cliff.
See most people don’t even think about these things until they happen. The job of a money manager or trader is to actively imagine different scenarios where events like this can happen and make redundancy plans accordingly. That is why I read books like the Price of Time and was on that webinar.
Bigger Picture Thinking:
As I stated above, the majority of Wall Street doesn’t think about these things because they are in passive products that are tracking the index. And like I said, that is completely fine, it just has trade-offs. It just so happened that the trade-off in the UK scenario was the possibility of an entire pension fund blowing up.
This is part of the reason why I am sharing some of my thoughts here. You get to see what I am thinking and the different scenarios I am imagining. So let me provide a couple of thoughts and scenarios that have been going through my mind recently:
With growth slowing and the FED holding the discount rate at an elevated level, both the negative liquidity impulse and deteriorating cash flows are likely to put significant downward pressure on broad-risk assets.
We have not seen any delinquencies yet. Monetary policy has time lags because even after the FED has hiked rates, debt needs to roll over before the higher interest payments begin to impact companies. These time lags usually induce a false sense of security in market participants.
Stocks and bonds could still move in tandem until the level of core inflation decelerates which would put further pressure on investors because there isn’t an offsetting position in their portfolio. Diversification is the only free lunch but the majority of positioning doesn’t have correct diversification as evidenced by the performance during 2022. If you want more on this idea of diversification, there is a great book called Beyond Diversification.
If inflation doesn’t decelerate enough into the end of the year, there is a risk that long-term inflation expectations become unanchored which will constrain the FED to do another round of rate hikes.
Historically, the labor market makes sharp nonlinear moves due to the underlying mechanics. It has characteristics similar to the VIX index than it does to a trending asset. This means that when the unemployment rate begins to move up, it is likely to make a sharp move.
Broad market participants and financial news outlets propagated the idea of recession into the end of 2022. This positioning is getting shaken out in the current bear market rally. As the FED holds the discount rate flat, slowing growth dynamics will begin to be the primary factor moving risk assets. We still don’t know the speed of the decelerating growth which means a chop in risk assets is possible as well.
As I noted above, these are all thoughts of possible outcomes. As the data changes, I update my view. The key thing is knowing WHY something is happening because that allows you to update your view in an informed manner. None of us know the future but we can know how to manage risk under uncertainty.
When we think about these ideas in the context of a portfolio, it’s not incredibly complicated. Basically, you think about the current regime we are in with growth, inflation and liquidity. Then you ask, what are the highest expected returns for various assets in that regime? Then you make decisions based on the personal goals or constraints you have.
As you should know from the disclaimer, NONE of this is investment advice! Most people don’t want to think about risks in life because it makes them uncomfortable. Those same people don’t want to make decisions about risk because if they are wrong, they need to take responsibility. Again, this is ok! It simply means there will be trade-offs for decisions. Part of my job is that I really enjoy the challenge of taking risks so I get paid for it. It is like any other good or service in the economy. However, just like if I have a bad plumber or electrician “fix” my system, they could cause additional expenses in the future if they do it incorrectly. It is the same with investment products and money managers.
Thanks for taking the time and reading!