A possible melt-up before a possible crash?

Abraham George Market Musings

The average retail investor who watches the Fed does not think much beyond what the Fed is doing in terms of monetary policy: Did the Fed raise rates? Cut rates? Leave rates unchanged? or make any announcements as to how they will guide interest rates forward? But there is a lot going on at the Fed discount window that we don’t pay that much attention to. There has been talk of tapering the $120 bio a month in treasury and MBS (Mortgage Backed Securities) purchases. But there is no sign of any action from the Fed. In cowboy language, “It’s all hat and no cattle”.

But there is a lot of action in the repo market. This is where the big banks go to get and make very short-term loans. A normal repo (short for repurchase agreement) is when a borrower sells short-term government securities overnight in exchange for cash. They agree to repurchase the securities the next day and return the cash. A reverse repo, on the other hand, is when the market gives the Fed cash. In exchange, the Fed gives back a security - in this case a treasury bill. All this is the “plumbing” of the financial system.

The reverse repo market has been flashing some unusual activities. Last Monday, the banks collectively parked around $600 bio at the Fed overnight in exchange for T-bills. Even though money market funds earn no interest parking cash with the Fed overnight, when you have $ 4 trio in total assets (current money market fund assets), no interest is better than negative interest.

Don’t think any bull market has ended because there was too much money in the system. At least not directly. Indirectly, the Fed has pumped so much money into the the financial system that yields have nowhere to go but down and asset prices have nowhere to go but up.

It is in this light that hedge fund manager Paul Tudor Jones calls it “the craziest mix of fiscal and monetary policy since the Federal Reserve was created” in 1913. We cannot dismiss his thinking. The May Consumer price index (CPI) showed that prices are rising at an annualized rate of 5%. Core inflation items which excludes volatile items like food and energy is rising at 3.8% per year. That’s the fastest since 1992.

The Fed story is that this is all ‘transitory’. It is the most frequently used word in all Fed statements. The Fed believes it’s related to the re-opening of the global economy after the pandemic. Demand has surged but supply has not caught up. As this anomaly plays out prices will return to a more normal rate of inflation. This is the Fed story and they are sticking to it.

While veterans like Paul Tudor Jones and Druckenmiller believes that these changes are structural. We have entered a new age of bigger government deficit and debt, adding fuel to prices. The Fed and other central banks have pushed themselves to a corner that they cannot fight back easily. They cannot taper or end support for the bond market without triggering a market crash. The million dollar question is when will the crash happen. Eventually it will but my bet is after a small fall markets are going to rise again putting all fears aside and the crash will happen when all are bulled up. If you are uneasy about stocks now, try moving part of your portfolio to oil and gas. As we have mentioned many times before, given the circumstances, that’s the only no-brainer trade. Buying copper as well is a good idea. As for me, I still like to stay invested in certain selected equity sectors.

Abraham George is a seasoned investment manager with more than 40 years of experience in trading & investment and portfolio management spanning diverse environments like banks (HSBC, ADCB), sovereign wealth fund (ADIA), a royal family office and a hedge fund.