Rising Rate Environment Meets Market Reflexivity

Almost nothing looked good yesterday & the market was off a couple percent across the board, giving a third straight down day. Longer duration bonds have pulled back from recent highs, with the market suggesting the Fed won’t hike many more times this cycle.

something happened October 3rd when Powell said the US was “still quite a ways from neutral.”

The self-reinforcing reflexive capital-attracting-cycle of Powell’s hard money stance hit the point of saturation. At that point the yield curve started to invert (or at least kink) and risk assets sold off hard. Powell finally tightened too much.

Now, this is where it got really interesting. Those who had taken Powell’s comments at face value were convinced that he wouldn’t shift policy simply because the stock market dipped a little. After all, in the grand scheme of things, financial markets were still elevated. What’s 350 S&P points when the stocks market is up 2300 over the past decade? Surely Powell will not cave at the first dip.

Wrong. He folded like a lawn chair.

Some of the biggest critics of easy money policy like Kevin Warsh & Stanley Druckenmiller are writing joint op-eds asking the Fed to stop raising rates. Even the editorial board of the WSJ is chiming in with the same:

The case for pausing in its interest-rate march back to “normal” starts with the Fed’s mandate to control prices with low unemployment. There’s simply no sign of an inflation breakout.The Fed’s favorite inflation measure, the PCE deflator, has been falling for months. The dollar is strong, both against gold and the world’s other major currencies. Gold sold for about $1,250 an ounce on Monday but six months ago it was about $1,300. Other commodity prices that are often inflation canaries, such as oil and farm products, are also down. … The larger argument for a pause is that the Fed is unwinding the largest monetary experiment in modern history. Central banks around the world are moving away from multi-trillion-dollar bond purchases and zero-interest rates, and they’re doing it without a road map. What is the “normal” interest rate in this post-crisis world? We don’t know, and we doubt the Fed does either.

Paul Tudor Jones mentioned how ugly the recent dynamics have been: 

“Using the Goldman Sachs commodity index as a baseline, Jones said prices are down 15 percent over the past 40 days. That gives the Fed no impulse to rate rates” … “He said he would “buy the hell out of” a downturn that could come with the drop, and expects the upswing will come after the Fed indicates that it will pause.”

Kevin Muir also thinks we are close to done with seeing rate hikes.

I don’t have the answers to what should be done, but I have an educated guess on what will be done. And it’s obvious the days of relatively hawkish US monetary policy are behind us. The surprises will not be how high Powell takes rates, but rather, how quickly he gives up on that idea and reverses course.

That, in turn, means we might be seeing the early days of a cyclical bull market in bonds.

Last week I sold out of almost everything I was holding other than some Google, a small Funko stake, and a small bit of Disney & Apple I’ve been holding for about a year.

I imagine when the market gets the likely memo on the Fed’s change of heart more speculative plays will go up the most. Maybe the memo was already heard premarket, as US markets are up even as Xi pledged to “stay the course”

“The past 40 years eloquently prove that the path, theory, system and the culture of Socialism with Chinese Characteristics … are completely correct, and that CPC theory line and policy that have since taken shape are completely correct.” -Xi Jinping, president, China

I don’t believe Overstock is a great company, but if I were betting on domestic stocks turning up some of the stuff like that which is really beaten down could easily jump dozens of percent. If it appears a recession is not on the horizon from a Fed rate ramp something like Enova International might also outperform.

Chinese stocks have been beaten down enough to start looking appealing. Even as Google disbanded censored Chinese search engine project Baidu hit new 52-week lows. The big risk with Chinese shares is that they’re being artificially kneecapped (ad policies with Baidu, money market regulations for Ant Financial’s Alipay & WeChat, video game approval regulations for WeChat, even the very ugly rape headline risk the CEO of JD faced a few months back) in order to bring them home.

Consider the July 2016 take-private of Qihoo 360, an internet security firm. The founders squeezed out U.S. shareholders at $77 a share, reflecting a value of $9.3 billion. In February 2018, they relisted Qihoo on the Shanghai Stock Exchange at a valuation north of $60 billion. That’s a 550% return. Qihoo’s chairman personally made $12 billion upon relisting, more than he claimed the entire company was worth 18 months earlier.

If one doesn’t want exposure to the Chinese expropriation risk & wants to play some larger names then some of the more debt saturated names with recurring revenue streams like AT&T might make decent short-term positional trades.

Zillow isn’t far from where it was when there was major insider buying & eBay is still quite beaten down. Anyone looking to buy a slug of ecommerce to better compete with Amazon (Walmart? Google?) would have a great destination in eBay.

Target has also pulled back significantly. They’re off 28.8% from their 52-week highs & are trading at a P/E of under 11 at a price per share they hit back in 2007. If the yield curve steepens while rate hikes stop some of the regional banks might also be good plays.

Some emerging markets might also offer great returns if the Dollar weakens significantly.

The simple fact is that apart from the most disciplined systematic manager (who is about to get fired), no one is underweight US assets. … If I am correct, then we don’t need these other countries to be terrific investments. All we need is asset allocators to return closer to their benchmark weighting and the US dollar will decline. And in fact, if all this move ends up being is a return from overweight to benchmark, then the currencies that were hated the most – the ones that investors were most eager to sell in exchange for dollars – will be the ones that rise the most.

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