Overall economic expert and founder of The Macro Compass Alfonso Peccatiello and Bankless co-founders Ryan Sean Adams and David Hoffman discussed the potential impact of the Federal Reserve's interest rate cut on the market, and provided an in-depth analysis of future economic trends and market reactions.
Background information
Ball and the Federal Reset are on the verge of a rate cut, but the question on everyone's mind is...what happens next?
Alfonso Peccatiello, known as "Macro Alf," is a macroeconomic analyst and investment strategist who joins the group to help us solve this problem.
- Are these rate cuts timely or too little too late?
- Will the Fed cut interest rates by 25 basis points or 50 basis points?
- Will we have the recession or soft landing the Fed hopes for?
- What will happen to crypto assets?
We discussed all this and more with Macro Alf, one of the top thinkers in the macro space.
The U.S. Federal Reserve’s policy lags
In this podcast, David and Alfonso discuss the US Federal Reserve's monetary policy and its impact on the economy.
- Alfonso pointed out that the U.S. Federal Reserve seems to be lagging behind in the current economic situation, especially when it comes to cutting interest rates. He mentioned that the Fed's main task is to maintain economic stability, although its official goal is to control inflation around 2% and maintain a healthy labor market.
- Alfonso explained that the Fed's focus on curbing inflation over the past two years has caused real interest rates to rise into positive territory, which has had mixed effects on borrowers and investors. For investors, high real interest rates make it more attractive to park money in cash, thereby reducing the incentive for risky investments. And for borrowers, the burden increases because they must repay their debt at higher interest rates, which slows economic activity.
Risks of overtightening
- David asked whether the U.S. Federal Reserve is too slow to maintain high interest rates, which may lead to an economic slowdown.
- Alfonso believes that the current situation is that the U.S. Federal Reserve may be lagging again in cutting interest rates. He warned that if the Federal Reserve continues to be inactive, the economy could risk a sharp slowdown.
- Alfonso further emphasized that the degree of monetary policy tightening in the past 18 months exceeded the levels in 2006 and 2007, which means that the current policy is very restrictive. He mentioned that historically, the impact of monetary policy is usually delayed and may take 12 to 15 months to show its effect. So while many now believe the economy can withstand higher interest rates, in reality the lagging effects of policy may show up in the coming months.
future economic outlook
The podcast finally discussed the future economic direction. Alfonso mentioned that although the market is generally optimistic at present, historical experience shows that when the economic situation seems stable, it is often a precursor to upcoming problems. He reminded the audience that although current policies appear to be effective, the long-term hysteresis effects cannot be ignored, and greater economic challenges may be faced in the future.
Why hasn’t the economy collapsed yet?
In the podcast, Ryan asks a key question: Why hasn’t the economy collapsed despite the Federal Reserve’s tightest monetary policy in history? Alfonso explains why.
Alfonso noted that the current economic lag is very long and is due to a number of factors. Typically, when interest rates rise, borrowers (such as households and businesses) borrow less and therefore spend less. However, the current situation is different. Since more than 90% of U.S. mortgages are 30-year fixed rates, many households will not immediately feel the impact of rising interest rates. Their fixed-rate loans mean that even if new mortgage rates hit 7%, existing homeowners won't be directly affected because their loan rates will still be lower.
Corporate response strategies
The story is similar for businesses. Many large companies, such as Apple and Microsoft, adopted a strategy of extending debt maturities before the epidemic, borrowing long-term debt at low interest rates. This means that even if the U.S. Federal Reserve raises interest rates, companies do not have to immediately bear higher borrowing costs. Therefore, companies will still maintain ample cash flow in the short term and may not necessarily reduce investment or expenditure due to rising interest rates.
The impact of fiscal policy
In addition, Alfonso also mentioned that fiscal policy in 2023 also supported the economy. The Biden administration has implemented massive fiscal deficits, sending additional inflows of money to households and businesses. This fiscal stimulus offsets the tightening effect of monetary policy to a certain extent, causing the net wealth of businesses and households to increase even as interest rates rise.
bad news
In the podcast, Ryan and Alfonso discuss the implications of bad news in the current economic climate. Ryan mentioned that the tools of the US Federal Reserve do not seem to be working as expected, and the underlying problems in the economy are like an approaching tsunami in the distance. Although there is no obvious impact now, the crisis is approaching.
Alfonso noted that over the past few years, markets have reacted very differently to bad news than they do now. In the pre-pandemic period, weak economic data was often seen as positive news because it meant that interest rate cuts and fiscal stimulus were likely. However, Alfonso thinks things have changed now and the bad news has really become bad news.
changes in economic environment
Alfonso explained that in past economic environments, the market was accustomed to treating bad news as "good news" because it usually meant that the U.S. Federal Reserve would take measures to support the economy. He mentioned that from 2013 to 2019, the market generally believed that bad news did not represent real risks because the Federal Reserve was always behind the scenes to support the market.
Now, however, as the economy approaches the brink of recession, the impact of the bad news has become even more pronounced. Alfonso emphasized that when economic growth is weak, the tolerance for unemployment is reduced, and any economic data that is lower than expected may trigger market panic.
For example, the United States currently needs to create about 120,000 jobs per month to keep the unemployment rate stable, but in fact, the private sector only creates about 100,000 jobs per month. This gap means that when there is bad news about the economy, the market will react quickly, causing the stock market to fall.
past memory
Ryan asked when was the last time investors felt "bad news is bad news." Alfonso replied that this situation dates back to the 2008 financial crisis. At the time, bad economic data meant a recession was imminent, and market sentiment fundamentally changed.
bond market signals
Alfonso also mentioned that the current bond market is also sending signals. Bad economic data will cause bond prices to rise and yields to fall, reflecting market expectations for further easing by the U.S. Federal Reserve. However, the stock market often falls accordingly, showing concerns about future economic prospects. In this case, bad news is not just bad news, but adds to market uneasiness.
Alfonso emphasized that in the current economic situation, the impact of bad news has changed, and the market can no longer easily ignore bad news. As economic growth slows, the market will be more sensitive to bad news, and investors will need to re-examine this new economic environment.
U.S. Federal Reserve rate cut forecast
In the podcast, David and Alfonso discuss the possibility of an imminent rate cut by the Federal Reserve. David mentioned the market's expectations for a rate cut, especially the discussion about 50 basis points.
Alfonso's point of view
Alfonso believes that the US Federal Reserve is likely to choose to cut interest rates by 50 basis points. Here are several reasons he gave:
- Missed opportunity: Alfonso noted that the Federal Reserve was supposed to cut interest rates in July but failed to act in time. Now that the economic situation has worsened, they should not continue to be stubborn but should make up for their previous mistakes.
- Communication strategy: He believes that the US Federal Reserve should clearly communicate the reasons for cutting interest rates, explain that it is to correct previous mistakes, and show that they are aware that the economy is slowing and are prepared to take more easing measures.
- Future meeting schedule: The next Fed meeting is in November. If they only cut interest rates by 25 basis points this time and the economy deteriorates further, they will have to wait until November to cut interest rates again. This is not wise risk management.
- Market expectations: Currently, the bond market is already pricing in future interest rate cuts, with the market expecting a 250 basis point interest rate cut in the next year. If the Fed doesn't follow suit, stocks could be nervous because they rely on bond market expectations.
The nature of the rate cut
David asked if the Fed chooses to cut interest rates by 50 basis points, does that mean they are acting quickly.
Alfonso said such a rate cut could be seen as a correction from the failure to cut rates in July and reflected the Federal Reserve's emphasis on the economic slowdown.
global economic impact
Alfonso also mentioned that the global economic situation is also affecting the U.S. Federal Reserve's decision-making, especially the impact of China's economic slowdown on the United States. He emphasized that the U.S. Federal Reserve needs to take a cautious approach when cutting interest rates while conveying their understanding of the economic situation and response measures.
Alfonso believes that the US Federal Reserve should adopt a 50 basis point interest rate cut to deal with the current economic challenges and calm the market through clear communication. He emphasized that the current interest rate cut is not only a response to the economic slowdown, but also an insurance measure against potential risks in the future.
Elizabeth Warren's open letter
Ryan mentioned that Senator Elizabeth Warren recently wrote an open letter to the Federal Reserve, calling for a 75 basis point interest rate cut. Ryan asked Alfonso what he thought of the letter and whether it would affect the Fed's decision-making.
Alfonso's analysis
Alfonso believes Warren's letter was actually a political bargaining tactic. Here are some of his thoughts on this:
- Political bargaining: Alfonso believes that Warren's request for a 75 basis point rate cut is actually an attempt to influence the Federal Reserve's final decision of 50 basis points. By raising higher demands, she hopes to prompt the U.S. Federal Reserve to take more aggressive interest rate cuts.
- The Federal Reserve’s communication strategy: Alfonso pointed out that the Federal Reserve cannot communicate publicly during the dark period (that is, the silent period before decision-making meetings), but they will still convey information through the media. He mentioned that in the past, the US Federal Reserve had communicated its intentions to the market through Nick Timiraos, a reporter for the Wall Street Journal.
- Market reaction: Alfonso mentioned that at the beginning of the dark period, the market's expectation for a 50 basis point interest rate cut was only 10%, but with Timiraos' report, this expectation quickly rose to 55%. This shows that the US Federal Reserve can still influence market sentiment through the media during the dark period.
Stability and instability: Alfonso quoted economist Hyman Minsky’s view that “artificial stability can actually lead to instability.” He believes that the US Federal Reserve is trying to avoid economic recession and market panic by controlling market fluctuations, but this approach itself may lead to greater instability.
Alfonso emphasized that as investors, we need to understand the rules of how the market operates and conduct risk management on this basis. He believes that the Federal Reserve is working hard to convey their intention to cut interest rates by 50 basis points, and Warren's letter is part of a political game and may not directly affect the Federal Reserve's final decision.
market reaction
In the podcast, David and Alfonso discuss the market's reaction to a possible rate cut by the US Federal Reserve, especially the impact of Elizabeth Warren's request for a 75 basis point rate cut on the market and the US Federal Reserve's decision-making.
Alfonso's analysis
- Market expectations: Alfonso pointed out that the market has begun to price in the possibility that the US Federal Reserve will cut interest rates by 50 basis points in September, and this expectation has reached 60%. He further said that the market also expects a possible 25 basis point interest rate cut in November, while there is a higher probability of another 50 basis point interest rate cut in December. This indicates that the market generally believes that the US Federal Reserve will further cut interest rates in the coming months.
- Importance of economic response: Alfonso stressed that the effectiveness of rate cuts depends on how the economy responds. If the economy can adapt quickly to interest rate cuts, there could be positive outcomes. However, the positive effects of interest rate cuts usually take one to two years to emerge, so the Fed's policies need to be forward-looking rather than just reactive.
- Performance of Risk Assets: David raised market participants’ focus on risky assets such as cryptocurrencies, especially in the context of interest rate cuts by the U.S. Federal Reserve. Alfonso pointed out that interest rate cuts are usually beneficial to risk assets, especially when economic conditions are good, and interest rate cuts are seen as support from the Federal Reserve. However, if the rate cut was in response to economic weakness, risk assets might react differently.
- Historical example: Alfonso mentioned the example of Japan in the 1990s, pointing out that after the economic bubble burst, the market did not recover despite the Bank of Japan's rapid interest rate cuts. This is because the interest rate cut is not a proactive measure to support the economy, but a passive response by the central bank in response to economic weakness.
- Alfonso believes that the impact of the Federal Reserve's interest rate cut policy on the market depends on the nature of the rate cut. If the rate cut is seen as a support for the economy, the market may react positively; but if the rate cut is seen as a remedy for economic weakness, the market reaction may be restrained. Therefore, investors need to pay close attention to the policy trends of the US Federal Reserve and the actual performance of the economy in order to make corresponding investment decisions.
How to prepare
Understand the current market environment
- Performance of Risk Assets: Alfonso noted that if the economy enters a recession, risk assets, including cryptocurrencies and stocks, may be affected. Because cryptocurrencies are increasingly viewed as risk assets, they may be sold off to raise cash when markets fall.
- The impact of deleveraging: During economic downturns, investors often face deleveraging pressures, which causes all asset classes to become more correlated and exhibit similar price movements. When investors need cash, they don’t think too much about which assets to sell and will only choose assets that can be converted into cash quickly.
Portfolio Adjustment Strategy
Maintain diversification and risk balance: Alfonso mentioned the "risk parity" strategy, suggesting that investors focus on the contribution of various assets to the overall portfolio risk, rather than simply allocating funds in fixed proportions. For example, ensuring that each asset contributes the same amount of risk in the portfolio.
Reference to historical data: Historically, investors tend to underestimate the magnitude of interest rate cuts by the U.S. Federal Reserve. During recessions, the Federal Reserve typically cuts interest rates more aggressively, so bonds tend to perform well in such situations.
Recommended asset classes
- Bonds: Bonds often maintain their gains during recessions, especially if the Federal Reserve cuts interest rates. Although bond prices have risen, they remain a relatively safe investment option during an economic slowdown.
- Gold: Gold typically performs well in times of economic uncertainty, and demand for gold is likely to continue to rise as central banks continue to add to their gold reserves.
- Safe-haven currencies: During times of economic crisis, investors tend to turn to safe-haven currencies, such as the Japanese yen and the Swiss franc, which tend to remain stable during times of market turmoil.
Avoid big losses
Focus on risk management: Alfonso emphasized that investors should prioritize how to reduce risk in their portfolios rather than looking for hedging instruments. Avoiding large losses is the first principle in investing, as large losses can lead to a financial situation that is difficult to recover from.
Reevaluate your portfolio: When considering a possible economic downturn, investors should review their asset allocation to ensure they are not too concentrated in higher-risk assets.
Possibility of recession
Discussing the possibility of a recession, Alfonso offered his view on a recession within the next 12 months. He believes the probability of a recession is about 50%. Here are a few key factors in his analysis:
The impact of fiscal policy
Rapid Fiscal Stimulus: Alfonso noted that the current political environment allows governments to act quickly and spend more money to stimulate the economy when the economy weakens. This differs from past situations, such as during the 2008 financial crisis, when fiscal stimulus typically took six to 12 months to be rolled out. Today, the government's quick response can go some way to stabilizing the economy.
Private sector leverage levels
Lower Leverage: Currently, private sector leverage is relatively low, meaning businesses and households have less debt burdens. This situation means that when the economy faces a recession, the impact may not be as severe as in the past. In 2007, debt levels for many households and businesses were too high, exacerbating the financial crisis.
market expectations
The market's probability of recession: The market's current expectation for recession is between 35% and 40%, which is lower than Alfonso's 50% judgment. This shows that market participants have relatively high confidence in the future economy, but there may also be the possibility of underestimating risks.
Although Alfonso puts the probability of a recession at about 50%, he believes that if it does occur, the magnitude and impact of the recession may not be as severe as in the past. This is mainly due to the government's ability to respond quickly to the economy and the low level of leverage in the private sector. Investors should consider these factors when evaluating future economic conditions in order to better adjust investment strategies and risk management.
currency devaluation
When discussing currency devaluation, Ryan and Alfonso mentioned changes in the money supply and the impact of such changes on the economy and asset prices.
Currency devaluation definition
Currency Depreciation: Currency depreciation usually refers to a decrease in the purchasing power of a currency, resulting in the same amount of currency being able to purchase fewer goods and services in the future. Ryan mentioned that although the economy may experience a recession, currency devaluation is an almost inevitable phenomenon.
changes in money supply
- Fiat Currency System: Alfonso noted that since the United States abandoned the gold standard in 1971, monetary policy has changed fundamentally. Now, the issuance of U.S. dollars is no longer tied to hard assets such as gold, which allows governments to create new dollars without limit.
- Impact of Inflation: As the dollar continues to increase, the risk of currency depreciation increases. Alfonso explained that when the government creates too many disposable dollars through deficit spending, goods and services on the market cannot increase quickly enough, ultimately leading to higher prices, known as inflation.
The role of government and banks
- Government deficit spending: Governments create new disposable dollars through deficit spending. For example, the government might issue checks to citizens, increasing the supply of money in the market. This practice has continued over the past 30 years, resulting in currency devaluation.
- Credit creation by banks: Banks inject credit into the economy through loans, such as mortgages. Alfonso explained that banks create new money by assessing their lending capacity based on a borrower's future cash flow potential. This credit expansion further drives up asset prices.
Asset Price Impact
Housing Market: Home prices continue to rise due to low interest rates and continued credit creation. Even without significant wage growth, increased borrowing capacity has allowed people to purchase higher-priced properties.
Comparison with gold: Alfonso also mentioned that if housing prices are measured in gold, the actual growth in housing prices may not be significant. This suggests that the increase in house prices is primarily due to the influence of the fiat currency system rather than an increase in the intrinsic value of the property itself.
currency liquidity
The concept of monetary liquidity
The importance of the denominator: Ryan mentioned that when it comes to understanding the flow of money in the economy, the key is the "denominator." He pointed out that terms used by governments and central banks (such as quantitative easing, fiscal deficit, etc.) actually describe the creation or destruction of money. In most cases, these measures increase the money supply.
The normalization of fiscal deficits
The transformation of the fiscal deficit: Alfonso pointed out that the fiscal deficit has changed from a "flaw" in the past to a "feature" now. He believes that government deficit spending of one trillion dollars per year has become the norm, and this change has had a profound impact on liquidity and the economy.
Impact on investors: This continued fiscal spending will support economic growth, but may also bring inflation and market volatility. Investors need to pay attention to how these policies affect bank reserves, inflation, economic growth and market performance.
Indicators investors should pay attention to
Government Spending and Deficits: Investors should pay attention to large government programs and stimulus packages, especially tens of billions of dollars in spending, as well as annual budget deficits. The data is publicly available, and investors can get a sense of government spending by examining monthly deficit data released by the U.S. Treasury Department.
Spending efficiency: In addition to focusing on the deficit itself, Alfonso emphasized the importance of spending efficiency. How governments use these funds, and where they go, will have a direct impact on the economy's productivity and long-term growth.
The widening social wealth gap
Rising wealth disparity: Alfonso also mentioned that the implementation of fiscal policies is exacerbating wealth disparity. As younger generations (such as Millennials and Generation Z) gradually become the main voters, they face increasing economic pressure and may promote different policies and seek to redistribute wealth.
Sustainability issues: He believes that the current economic system is not sustainable, and there may be greater social and economic pressure in the future, prompting policy changes.
Anti-depreciation assets
Classification of anti-depreciation assets
Stock Market: Alfonso mentioned that stocks are an important anti-depreciation asset because companies are denominated in U.S. dollars and can generate cash flow. He emphasized that although the company will grow in the long term, investors need to pay attention to the valuation at the time of purchase and avoid buying shares at too high a price. He advised investors to select quality companies and invest at reasonable valuations to ensure good returns over the next 10 to 20 years.
Risk asset allocation
Offensive assets: Within a portfolio, Alfonso recommends allocating some risk assets such as cryptocurrencies and gold. Although these assets have no cash flows, they have different monetary characteristics and can provide diversification to an investment portfolio.
Defensive asset selection
- Bonds: As defensive assets, bonds often protect portfolios during periods of recession or deflation, but in some cases, such as 2022, they may underperform.
- Commodities: Alfonso also mentioned that commodities, as dollar-denominated assets, can protect a portfolio during periods of inflation, so they are also worth considering as a defensive asset.
Macro investment strategy
Macro Hedge Fund: Alfonso shares his plans for an upcoming macro hedge fund. He believes that the current changes in the macro environment have brought about huge investment opportunities, and these macroeconomic fluctuations can be exploited through specific strategies to provide diversified sources of income for the investment portfolio.
Conclusion
Key takeaways:
- The US Federal Reserve's decision: Alfonso believes that the US Federal Reserve may adopt a 50 basis point interest rate cut to deal with the current economic challenges. He reminded investors to pay attention to market reactions in different economic environments, remain flexible, and not to be stubborn in their own views.
- The importance of asset allocation: In an uncertain market environment, a reasonable allocation of anti-depreciation assets (such as gold, stocks, cryptocurrencies, etc.) is the key to protecting your investment portfolio. Investors should promptly adjust their investment strategies based on their own risk tolerance and market changes.
- Keep learning and adapting: The market is changing rapidly, and investors need to constantly learn and adapt to new economic conditions. Alfonso’s educational platform “Macro Compass” provides a wealth of resources to help investors gain a deeper understanding of macroeconomics.
