The Fed’s Invisible Moving Target

Retail · AUG 4TH, 2022

Andrew Krohn Kevin Kelly, CFA

Jason Pagoulatos

BTC ETH

DISCLOSURE: THE AUTHORS OF THIS REPORT HOLD POSITIONS IN BTC AND

ETH. THE AUTHOR HAS NOT PURCHASED OR SOLD ANY TOKEN FOR WHICH
THE AUTHOR HAS MATERIAL NON-PUBLIC INFORMATION DURING THE
RESEARCH AND DRAFTING OF THIS REPORT. THESE STATEMENTS ARE
INTENDED TO DISCLOSE ANY CONFLICT OF INTEREST AND SHOULD NOT BE
MISCONSTRUED AS A RECOMMENDATION TO PURCHASE OR SELL ANY
TOKEN OR TO USE ANY PROTOCOL. THE CONTENT IS FOR INFORMATIONAL
PURPOSES ONLY AND YOU SHOULD NOT MAKE INVESTMENT DECISIONS
BASED SOLELY ON IT. THIS IS NOT INVESTMENT ADVICE.
“A prudent speculator never argues with the tape. Markets are never wrong,
opinions are.” – Jesse Livermore

Making Sense of the Madness

Trying to decipher the driving forces behind a given market can be a tall order, let
alone that of the global macro-economic landscape. If you have spent time
scrolling Twitter recently, then you know there is no shortage of hot takes on
what might happen next. From perma-bulls to goblin town doomers and
everything in between, there is a gamut of varying opinions.
A general rule of thumb when trying to navigate a complex macroeconomic
environment is to take the simplistic approach: “Don’t Fight the Fed.” In today’s
environment, it seems as though any small comment from Mr. Powell can move
global markets. This dynamic was once again on display last week. Given
everything that has been occurring in both traditional markets and crypto
markets, it can be easy to get caught up in the noise. The point here is to not
neglect the bigger picture and to not only pay attention to what the Fed says but
more importantly what they do and why.

Last week the Fed raised interest rates by 75 BPS and markets exploded
upwards… doesn’t this seem counter-intuitive?

Indeed, this market reaction may seem counter-intuitive considering the

weakening economic data being reported. The Fed has now hiked interest rates
by 75 BPS in back-to-back meetings (with both matching the largest rate hikes
since 1994). Despite Jerome Powell stating that another ‘unusually large’ rate
hike may be necessary for September, this isn’t what traders clung to following
last week’s presser.
There is one comment in particular that likely gave investors much-needed
confidence: “We are now at levels broadly in line with our estimates of neutral
interest rates and after front-loading our hiking cycle until now we will be much
more data-dependent going forward.” In other words, the Fed is removing its
forward guidance and will strictly rely on economic data for future interest rate
adjustments. With this change of approach by the Fed and their disposition that
interest rates have now reached a level of neutrality, markets immediately
responded as the perceived takeaway was that the Fed may begin to temper
restrictive action.

A sharp surge in prices was witnessed across the board and was led by the
highest risk-on asset classes: Crypto and Tech stocks. The chart below
showcases the price action of crypto and major legacy indices since the moment
the rally began during the FOMC meeting last week.
A more technical reason for the sustained rally can be attributed to commodity
traders unwinding large bearish, inflation-driven positions. According to an
analysis completed by Global Research firm, Nomura, over the past month over
100$ billion worth of stock, bond, and commodities shorts have been closed
and/or liquidated.

So the question on everyone’s mind is, “Is this a bullish breakout or simply a bear
market rally?” Let’s look at a few holistic data points that might suggest the latter.

The Invisible Moving Target

The neutral rate of interest is a theoretical barometer of where economists

believe interest rates need to be so that monetary policy is neither restrictive nor
expansionary. The rate is dynamic in nature due to it being an estimate based on
a range of economic and financial factors. It is also not a metric that is typically
quoted by financial mediums as it can vary substantially based on the different
inputs and timeframes used in its calculations.

When the Federal Funds Rate is below the estimated neutral rate, then monetary
policy is considered to be expansionary. The economy tends to experience
higher growth and inflation while unemployment falls. On the other hand, when
restrictive policy is in place, the economy tends to see the opposite: slowing
growth, lower inflation, and a tick-up in unemployment. Over the past 20+ years,
when the Fed enacted restrictive policy, notable economic downturns arrive,
which have transpired into recessions.

How restrictive will the Fed be? It all comes down to inflation. Since they
have conceivably reached neutral interest rates, in theory, there should be
fewer hikes now with fewer cuts later.
The Fed stating that they will be fully data-dependent moving forward is a
double-edged sword. If they can not engineer inflation to fall aggressively,
then they will be forced to hike until something breaks.
Predictive markets tell us to expect a 50 BPS hike in September and then
four 25 BPS hikes thereafter. This would bring the Fed Funds Rate to 3.75%
by early 2023 and put it 125 – 150 BPS above the neutral rate (a comparable
range experienced to that of the Great Financial Crisis).
At the end of the day, the Fed is still facing an inflation monster. July’s CPI
print of 9.1% registered as the highest since the 1980s.
Within the last 20 years (before Oct-2021) the highest inflation has reached
is 5.6% and during the three recessions outlined above, average inflation
was only ~3%.
What remains to be seen is if the prior actions from the Fed and the implied
smaller, periodic hikes can significantly put a dent in inflation.
It is reasonable to assume that a target rate of 3.75% might not be enough.

Stock Market Cap vs. Real GDP

According to famous investor Warren Buffet, the stock market cap to GDP ratio is
“probably the best single measure of where valuations stand at any given
moment.” The chart below utilizes the Willshire 5000 (a weighted index that
seeks to capture 100% of the investable US market) and compares that against
the real gross domestic product.

The current stock marketcap-to-GDP ratio sits at 167%. Comparatively, the

historical average of this metric is near the 50%-60% range.
Generally speaking, the stock market is considered to be overvalued when
the ratio exceeds the 90-115% range and undervalued when the ratio falls
below the 50-75% range.
However recently, these valuation ranges have been contested due to the
ever-increasing trend above valuation. However, as you can see in the chart
above, the ratio exceeded 200% in November of 2021, the largest deviation
in history.
As mentioned above, we are currently at 167%, which from a historical
perspective is quite overvalued. For example, the Dot-Com bubble reached
a peak of ~150%.

Other Economic Indicators

One of the most important economic data points to consider when accessing if
the economy is in a recessionary environment is unemployment. Despite this
being near historically low levels, the US consumer sentiment index suggests a
trend shift may be on the horizon. To the point of not sounding redundant, we
cover this and other factors such as GDP contraction, wage deterioration, and
production slowdowns in our Market Insight report from last week. Whether or
not you believe the economy is in a recession, evidence continues to mount
suggesting that may be the case.

Closing Thoughts

The recent market rally is likely driven by the market’s interpretation of last
week’s FOMC meeting: No more forward guidance, tempering restrictive
policy, and being more data-driven.
According to the Fed, interest rates have now reached levels of neutrality,
meaning any further hikes will translate to restrictive action. Using historical
data, we can see when the Fed Funds Rate is above that of neutral interest
rates, recessions tend to occur.
Inflation, inflation, inflation. Can an interest rate target of 3.5% – 3.75% truly
stop the inflation monster? If not, the Fed will be forced to break something.
Economic factors such as stock market cap-to-GDP, consumer sentiment
with its relationship to unemployment, and declining GDP, implies the
current market move is a bear market rally.

Notable Upcoming Economic Events

Please note that this is purely for informational purposes only. Below you will find
key economic events on the horizon for US Financial Markets.

The most noteworthy events for next week are the CPI prints which will be
released on Wednesday, August 10th at 8:30 EST.
Other important takeaways will be the producer price and consumer
 sentiment indices. Those will be made public on Thursday and Friday
respectively.

Weekly Market Musings

The biggest news of the week is undoubtedly the Nomad bridge hack. As it
stands today, this is the 5th largest crypto exploit in history, with loss estimates
now totaling nearly $200 million.

1/ Nomad just got drained for over $150M in one of the most chaotic
hacks that Web3 has ever seen. How exactly did this happen, and
what was the root cause? Allow me to take you behind the scenes

— samczsun (@samczsun) Aug 1, 2022

To add insult to injury, a Solana private key exploit was uncovered Tuesday (8/2),
which affected over 15,000 wallets and totaled at least $4.4 million worth of
losses. Although investigations are still ongoing, the exploit does not appear to
stem from Solana’s core code but within several popular wallets services.

Widespread Solana private key compromise

– attacker is stealing both native tokens (SOL) and SPL tokens (USDC)
– affecting wallets that have been inactive for >6 months
– both Phantom & Slope wallets reportedly drained

— foobar (@0xfoobar) Aug 2, 2022

Inverted yield curves are battle-tested recession indicators. The 2Y-10Y spread
depicted below has inverted 28 times over the past 120 years, 22 of which led to
recessions. More recently, when this relationship has inverted, it’s correctly
forecasted the last 6 recessions.

The U.S. yield-curve inversion deepens.

 — Lisa Abramowicz (@lisaabramowicz1) Aug 3, 2022

US GDP fell for the second straight quarter according to data released by the
Bureau of Economic Analysis last week. As we discussed in our Market Insight
report from last week, when the White House revised the definition of a technical
recession from two consecutive quarters of negative GDP growth to a more
holistic approach, it sparked dramatic debate across the financial industry.
Regardless if the US is in a technical recession or not, the release of Q3 GDP in
October will be crucial in determining the health of the economy. The fact that
the Atlanta Fed has already cut estimates by 80 BPS isn’t a good start.

ATLANTA FED Q3 GDP NOW CUT TO 1.3% FROM 2.1%

— FXHedge (@Fxhedgers) Aug 1, 2022

Since the announcement of the estimated go-live date of ‘The Merge’, posted by
Ethereum Developer Tim Beiko, Ether has been on a tear. From then, ETH has
surged roughly 80% from ~$1,000 to ~$1,800. As one of the most anticipated
narratives in crypto history, this has driven speculators to more ETH-based
options.

Expectations for #themerge seem to grow hotter. For the first time
ever, $ETH overtook $BTC in options open interest. Currently, TVL in
Ether options is about 32% higher than in BTC ($5.7 bn vs $4.3 bn).
What a time to be alive!

— Everstake (@everstake_pool) Aug 2, 2022

In the last two crypto bear markets, it took BTC 60 weeks and 52 weeks
respectively (from each cycle’s high) to find its ultimate bottom. If past
performance equals future results, this would imply a BTC bottom in late
November/early December this year. Historically speaking, BTC bottoms are
formed by capitulation wicks and then experience extensive sideways price
action as the chart below showcases.

Based on history, don’t expect this situation to be resolved overnight.

You are here.

— ecoinometrics (@ecoinometrics) Aug 3, 2022

Definitely check out our Crypto Town Hall conversation on The State of Play
which features a panel of web 3 gaming gigabrains.

Recap from our gaming twitter spaces hosted by

@FTX_Access
and Delphi Gaming:⬇️

Quotes & more from

@Jihoz_Axie
,
@gabusch
,
@abearschmitt
,
@PlayIsFree
,
@pierskicks
,
@YanLiberman
and
@amytongwu
!

Crypto Town Hall: The State of Play.

— Delphi Digital
(@Delphi_Digital) Aug 3, 2022
In a recent episode of The Delphi Podcast, Tommy Shaughnessy sat down with
Jason Choi for an intriguing conversation about Tangent, a new crypto-native
investment firm. Tangent seeks to provide guidance and financial investment to
web3 founders and teams.

New conversation!
@Shaughnessy119
hosts
@mrjasonchoi
to talk
@tangent_xyz

We cover investing as an angel collective vs. going solo, sourcing

and filtering deals, potentially scaling Tangent’s structure & more.

— The Delphi Podcast (@PodcastDelphi) Aug 2, 2022

delphi-14786-597433