Arthur Hayes: The Fed's policy shift may bring a storm to the market in September

Original title: Boom Times... Delayed

Original author: Arthur Hayes

Original translation: TechFlow

(The opinions expressed in this article are the author's personal opinions only and should not be used as the basis for investment decisions, nor should they be regarded as investment advice.)

Like Pavlov's dog in the conditioned reflex, we all think that the correct response to rate cuts is to "buy the f***ing dip" (BTFD). This behavioral response stems from the memory of low inflation in the Pax Americana era. Whenever there is a threat of deflation, which is bad news for financial asset holders (i.e. the rich), the Federal Reserve will decisively start the printing press. As the global reserve currency, the US dollar has created an easy monetary environment for the world.

The global fiscal policy response to the COVID pandemic (or the hoax you believe it is) has ended the era of deflation and ushered in an era of inflation. Central banks belatedly acknowledged the inflationary impact of COVID-19, adjusted monetary and fiscal policies, and raised interest rates. Global bond markets, especially in the US, believed in the central banks' determination to control inflation and therefore did not push yields to extremely high levels. However, it is assumed that central banks will continue to meet the expectations of the bond market by raising interest rates and reducing the money supply, which is very uncertain in the current political environment.

I will focus on the US Treasury market because the US dollar's role as the global reserve currency makes it the most important debt market in the world. Debt instruments issued in any currency will be affected by US Treasury yields. Bond yields reflect the market's expectations of future economic growth and inflation. The ideal economic state is economic growth with low inflation, while the worst state is growth with high inflation.

The Fed has managed to convince the Treasury market of its resolve to fight inflation by raising its policy rate at the fastest pace since the early 1980s. From March 2022 to July 2023, the Fed raised rates by at least 0.25% at each meeting. Even during that period, when the government's inflation index reached a 40-year high, the 10-year Treasury yield did not exceed 4%. The market believed that the Fed would continue to raise rates to curb inflation, so long-term yields did not surge.

U.S. Consumer Price Index (white), 10-year U.S. Treasury yield (gold) and federal funds rate cap (green)

However, all this changed at the Jackson Hole meeting in August 2023. Powell hinted that the Fed may pause its rate hikes at the September meeting. However, the shadow of inflation still hangs over the market, mainly because the increase in government spending is the main factor driving inflation, and this trend shows no signs of abating.

MIT economists found that government spending is one of the main reasons for pushing up inflation.

On the one hand, politicians know that high inflation will reduce their chances of re-election; on the other hand, providing benefits to voters through currency devaluation can increase their chances of re-election. If they only give benefits to their supporters, and these benefits are paid for by the savings of opponents and supporters, then it is politically advantageous to increase government spending. Therefore, they are difficult to be elected out of office. This is exactly the strategy adopted by the administration of US President Biden.

In peacetime, overall government spending has reached an all-time high. Of course, the "peace" here is relative and refers only to the feelings of the citizens of the empire; for those who have lost their lives to American weapons, recent years have hardly been peaceful.

If these expenditures were paid for by raising taxes, the problem would not be so serious. However, raising taxes is very unpopular with current politicians, so it has not happened.

Against this fiscal background, at the Jackson Hole meeting on August 23, 2023, Federal Reserve Chairman Powell said that he would pause interest rate hikes at the September meeting. The more the Fed raises rates, the more it costs the government to finance the deficit. By making deficit financing more expensive, the Fed can curb unbridled spending. Spending is the main driver of inflation, which the Fed wanted to curb with rate hikes, but ultimately chose to pause so the market would adjust itself.

After Powell's speech, the 10-year Treasury yield quickly rose from about 4.4% to 5%. This is surprising because even when inflation was as high as 9% in 2022, the 10-year yield was only around 2%; 18 months later, inflation was down to about 3%, but the yield was approaching 5%. Higher rates led to a 10% drop in the stock market and, more importantly, raised concerns that regional banks in the United States might fail due to losses in their Treasury portfolios. Faced with higher deficit financing costs, reduced capital gains tax revenue due to falling stock markets, and a potential banking crisis, "bad girl" Yellen stepped in to provide dollar liquidity to stabilize the situation.

As I mentioned in my article Bad Gurl, Yellen said the U.S. Treasury would issue more T-bills. This would shift funds from the Fed's reverse repurchase program (RRP) to T-bills and re-leverage the financial system. The announcement was released on November 1, 2024, driving a bull market in stocks, bonds, and cryptocurrencies.

From late August to late October 2023, Bitcoin prices were volatile. However, as Yellen injected liquidity, Bitcoin began to rise and hit an all-time high in March of this year.

Reverse Reflection

History will not simply repeat itself, but there are always similarities. I failed to fully appreciate this in my previous article, Sugar High, when I discussed the impact of Powell’s shift in wage policy. I was somewhat uneasy that I shared the same view as most people regarding the positive impact of the upcoming rate cut on risk markets. On my way to Seoul, I happened to check my Bloomberg Watchlist, which records the daily changes in RRP. I noticed that RRP had risen, which puzzled me because I would have thought it would continue to fall due to the US Treasury’s net Treasury issuance. I dug deeper and found that the rise began on August 23, the day of Powell’s policy shift. I also considered whether the surge in RRP could be due to quarter-end window dressing. Financial institutions usually put money into RRP at the end of the quarter and withdraw it the next week. But the third quarter does not end until September 30, so window dressing cannot explain this phenomenon.

Next, I considered whether money market funds (MMFs) chose to sell Treasury bills and park cash in RRP in pursuit of higher short-term US dollar returns due to the decline in Treasury yields. I have created a chart showing the yields on 1-month (white), 3-month (yellow), and 6-month (green) T-bills. The vertical lines in the chart mark several key dates: the red line represents the days when the Bank of Japan raised interest rates, the blue line represents the days when the Bank of Japan announced that it would not consider future rate hikes when the market did not react well, and the purple line represents the day of the Jackson Hole speech.

Money market fund managers need to decide how to get the best return between new deposits and expiring T-bills. The RRP yields 5.3%, and if T-bills yield slightly higher, funds will flow to T-bills. Starting in mid-July, the 3-month and 6-month T-bills yielded less than the RRP yield. However, this was mainly due to the unwinding of carry trades caused by the market's expectation that the yen would strengthen, prompting the Fed to possibly ease policy. The 1-month T-bills yield is still slightly higher than the RRP yield, which makes sense because the Fed has not yet clearly stated that it will cut interest rates in September. To test my guess, I plotted a graph of the RRP balance.

RRP balances typically fall before Powell’s speech at Jackson Hole on August 23. In that speech, he announced a rate cut in September (marked by the vertical white line in the chart). The Fed plans to cut the federal funds rate to at least 5.00% to 5.25% at its September 18 meeting. This validates market expectations for the 3-month and 6-month Treasury bills, while the 1-month Treasury bill yield also begins to close the gap with the RRP. The yield on the RRP does not fall until the day after the rate cut. Therefore, between now and September 18, the RRP offers the highest return among various income instruments. As expected, RRP balances rise immediately after Powell’s speech as money market fund managers try to maximize current and future interest income.

While Bitcoin surged to $64,000 on the day of Powell’s policy shift, its price has retreated 10% over the past week. I believe that Bitcoin is the most sensitive indicator of USD liquidity conditions. Bitcoin’s price fell when RRP balances rose to about $120 billion. RRP increases cause funds to stay on the Fed’s balance sheet and cannot be re-used in the global financial system.

Bitcoin is very volatile, so I admit that I may be reading too much into the price changes of the week. But my interpretation of events fits the actual observed price action so well that it is difficult to explain it as just random fluctuations. Testing my theory is actually quite simple. If the Fed does not cut rates before the September meeting, I expect Treasury bills to continue to yield less than RRP. Therefore, RRP balances may continue to increase, and Bitcoin may hover around current levels, and in the worst case, slowly fall to $50,000. Let’s wait and see. My shifting view of the market has given me pause on the buy button. I am not selling crypto because I am bearish on the market in the short term. As I will explain, my pessimism is only temporary.

Runaway Fiscal Deficits

The Fed has done nothing to rein in the main driver of inflation: government spending. Only when the cost of financing deficits becomes too high will the government reduce spending or raise taxes. The Fed’s so-called “restrictive policies” are nothing but empty talk, and its independence is just a nice story told to credulous disciples of economics.

If the Fed does not tighten policy, the bond market will correct itself. Just as the 10-year Treasury yield unexpectedly rose after the Fed paused its rate hikes in 2023, a Fed rate cut in 2024 could push yields dangerously close to 5%.

Why is a 5% 10-year yield so dangerous to the fake financial system of “Pax Americana”? Because this is exactly the tipping point where Yellen felt the need to step in and inject liquidity last year. She knows better than I do how fragile the banking system is when bond yields rise sharply; I can only guess at the extent of the problem based on her actions.

She has conditioned me, like a dog, to expect a certain reaction at a given stimulus. A 5% 10-year yield would put a stop to the bull run in the stock market. It would also reignite concerns about the health of the balance sheets of banks that are not “too big to fail.” Rising mortgage rates would reduce housing affordability, a major issue for American voters in this election cycle. All of this could happen before the Fed cuts rates. In this case, given Yellen’s unwavering support for Democratic “puppet candidate” Kamala Harris, the market could be hit hard.

Obviously, Yellen will not stop until she has done everything she can to ensure Kamala Harris is elected President of the United States. First, she may start to reduce the funds in the Treasury General Account (TGA). Yellen may even indicate her intention to drain the TGA in advance so that the market will react quickly as she expects and get active! Next, she may instruct Powell to stop quantitative tightening (QT) and perhaps even restart quantitative easing (QE). All of these monetary operations are bullish for risk assets, especially Bitcoin. If the Fed continues to cut interest rates, the amount of money injected must be large enough to offset the rising RRP balance.

Yellen must act quickly, otherwise the situation may deteriorate and lead to a full-blown crisis in which voters lose confidence in the US economy. This will be bad for Harris's election, unless a batch of mail-in ballots are miraculously discovered. As Stalin might have said, "It's not the people who vote, but the people who count the votes that count." I'm just kidding, don't take it seriously.

If this happens, I expect market intervention to begin at the end of September. Until then, Bitcoin may continue to fluctuate, while altcoins may fall further.

I once publicly stated that the bull market would restart in September, but I have changed my mind now, but this does not affect my investment strategy. I am still firmly holding and not using leverage. I will only add positions in some high-quality altcoin projects in the portfolio, whose prices are at a greater discount to what I think is fair value. Once fiat liquidity is expected to increase, the tokens of projects that have users willing to pay actual fees to use their products will rise sharply.

For those of you who are professional traders with monthly P&L targets or weekend investors using leverage, I am sorry to hear that my short-term market predictions are as unreliable as a coin flip. I tend to believe that those who control the system will eventually solve all problems by printing money. I write these articles to provide context for current financial and political events and to test whether my long-term assumptions still hold true, hoping that one day my short-term predictions will be more accurate.

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