The Market Is Trying To Hold Two Opposing Ideas At Once

Informed Tip of the Week: With winter weather arriving across much of the country, you might find yourself with some small house damage like a leaking pipe or water seeping through the roof. You definitely should get it repaired before it becomes worse, but should you file a home insurance claim? Not always. We explain how to decide here.

The test of a first rate intelligence is the ability to hold two opposing ideas in mind at the same time and still retain the ability to function.

F. Scott fitzgerald

We are living in a F. Scott Fitzgerald market. What does that mean? Markets right now are full of obvious contradictions that logic says can’t hold (other than perhaps in some quantum superposition state).

The biggest of these is the difference between the short term and long term markets for interest rates, but I will explore some others as well. Somebody is going to be really wrong. Let’s try to figure out who.

What Short Term Rates Are Saying

Fed funds markets are pricing in FOUR interest rate hikes this year (as of the time I started writing. It may be different now, especially if you are reading after the Fed meeting). Now, funds markets have been too hawkish many times over the last ten plus years, anticipating rate hikes that never materialize. That said, a ~85% probability of four hikes is a very aggressive forecast that reflects a lot of confidence.

This suggests high confidence in strong economic growth and/or high inflation. In other words, it means markets believe the Fed is behind the curve and risks losing control of monetary policy.

What Long Term Rates Are Saying

The ten year Treasury, while higher than where it started the year, is still below 2%. To put it in some context, before Covid, 1.75% was very near the historic bottom for long rates (there were some brief dips to 1.5% but they lasted for only weeks). The ten year went to 3% briefly in 2013 and 2018 when inflation was essentially non-existent.

So why shouldn’t it be at least 3% now, if not much higher given the inflation fears? Long rates this low imply one of two things – there is no inflation or there will be a recession. In other words, exactly the opposite of what Fed Funds markets are suggesting.

What If Short Rates Are Right

Let’s say the Fed goes through with four hikes. Is there any chance the ten year remains below 2%? No.

Why? Because if the Fed raises that much, either they’re wrong on inflation so long term rates need to be higher or they’re trying to cool down an overheated economy which means long rates should be higher.

The market is instead staying the yield curve will flatten. This only happens when the market is worried about recession. Here the contradiction lies.

The Scenario Analysis

Are you starting to see the problem? Let’s go through the different possible outcomes.

1) The Fed raises four times because the economy is so strong

Result: The yield curve should steepen due to the Fed chasing strong growth. If inflation slows but we are looking at 3-4% GDP growth, the ten year should be at least 3% and probably closer to 5% especially as the Fed would be signaling QE, ZIRP, and all the other easy money policies are finally over which would raise the risk premium.

2) The Fed raises four times because inflation is higher than expected

Result: The yield curve would steepen even further than the first case as markets would lose confidence in the Fed. The ten year would easily go to 5% and possibly beyond.

3) The Fed raises once or twice and the market worries about a slowing economy

Result: Think of this as another taper tantrum. The Fed stops hiking and the short rate futures are wrong. The ten year may stay reasonably steady, call it 2%. If the panic really gets going, the ten year could rally to 1.5% or below as markets get cautious and worry about recession.

4) The Fed raises rates twice, markets freak out, but the Fed keeps going with all four hikes

Result: In this case, we have a policy mistake where the Fed goes through with four hikes but lays the seeds for a recession. This would result in both the short and long term rate markets being right, but we have a new problem…equity markets would be down 20% or more. So the only way both bond markets can be right is a major policy error that means the stock market is wrong.

Trying To Solve For Too Many Unknowns

So now we have to add the third variable…equity markets (and really, a fourth, credit markets, but they will correlate with equities).

If it’s difficult for both short and long rate markets to be right, it’s near impossible for both to be right AND equity markets to be correct. As discussed, stocks would be a lot lower if bond markets are correct.

In that scenario 3, equity markets would also be lower. Anything that causes the Fed to abort expected rate hikes implies a growth scare and growth scares are terrible for risk markets like equities, credit, crypto, etc.

In fact, even in the first two scenarios, equity markets likely go lower because higher long rates mean stocks are worth less as well as the aforementioned end of easy money that encouraged risk taking.

The problem for the Fed is they are trying to solve an equation with two unknowns. If they raise rates enough to quell inflation, the market panics and they feel pressured to stop. If they decide they need to break the market’s fall, then they risk inflation getting out of hand.

The reason volatility has picked up recently is the market is struggling to find a new equilibrium. There is no clear solution which allows everyone to win which is why the Fitzgerald quote seems so apropos.

About the only scenario I can create where equity markets do well is inflation comes in better than expected, economic growth is good, but not so good that the Fed needs to hike four times, and thus long term rates can stay around 2%. It is a very small needle to thread.

What’s Most Likely

I would put my wager on scenario three. The Fed starts to raise, the market keeps selling off causing a growth scare, and the Fed gets scared of the markets being scared and stops hiking.

This will end the equity selloff and lead to a short term rally, but, unless the Fed returns to an aggressive stance like purchasing assets, it’s probably only preventing things from getting worse rather than providing renewed momentum for a bull market.

The Fed would either have to accept more inflation than they would like or hope that structural inflation issues resolve themselves faster than expected to give them breathing room.

If they accept more inflation, then we will see higher long rates, damage to growth stocks, and a real growth scare as the market worries about inflation’s impact on profits.

Is There A Way To Hedge?

There most definitely is. In fact, there are many. You have to decide which one is right for you.

If you believe we will have a growth scare and the Fed won’t hike as much, you can hold your long bonds and short the Fed Fund futures. If that growth scare creates a rally in long bonds, you win on both sides.

If you think Fed futures are right, you can short the ten year while owning the Fed futures or buying equity puts as a hedge.

We can probably come up with some other structures too, but, as you can see, the way to function while holding two opposing views is to use financial markets to hedge one of those views!

Bonus Content: A Solution to NFL Overtime

If you watched Sunday’s Bills-Chiefs game, you saw an all time classic but with a disappointing ending. A dramatic fourth quarter led to overtime where the NFL rule is if the team that wins the coin toss scores a touchdown, the game is over. If they score a field goal (or nothing), the other team gets a chance to score and win.

The Chiefs scored a touchdown to end the game without the Bills getting the ball which was a deflating ending for a lot of people who wanted to see how long the teams could trade scores.

Today, I offer a slightly altered overtime rule. You can only end the game on the first possession of overtime by scoring a touchdown AND making a two point conversion.

So, if you get the ball first and get a TD, you have two options:
a) kick the extra point and go up 7, but the other team gets a chance to tie (or win with their own two point attempt).
b) go for two and if you make it, then game over. If you fail, you’re up 6 and the other teams gets the ball with the chance to win with a TD and extra point.

Why is this better? First, it lowers the odds of the team who receives the kickoff winning, without the other team touching the ball, by 50% (two point attempts are successful about 50% of the time) so it makes the coin toss less important.

Second, it adds a whole new layer of strategy for coaches. Do you go for the kill but expose yourself to losing if you miss or do you take the safe 7 and trust your defense?

I’ve run some rough math and the odds are pretty much the same either way, so it’s really an emotional choice, but it definitely adds more drama than the current “win the coin toss, score, game over” which feels unfair to most.

The Math For Those Interested

If you want a quick rundown of the math. If you score on the opening kickoff, going for two means you have a 50% chance of ending the game vs. a 50% chance of continuing. If you fail and it continues, you have say a 1/3 chance of allowing a TD so 2/3 of the time you still win (it’s a bit more complicated than that but accept that for now). 50% at 100% and 50% at 2/3 is a 5/6 chance of winning or 83%.

If you kick the extra point, you have the same 2/3 chance of stopping the other team and you win. On the other 1/3 of chances, the other team scores and ties the game. At that point, it is 50/50 of who will score next to win (again, not totally accurate but close enough for now). So, 2/3 at 100% and 1/3 at 50% again gives you a 5/6 chance of winning.

There are definitely assumptions we can quibble over but you can see it is pretty close and we have created a far more satisfying outcome. Someone please start a Twitter campaign and make this happen!