Collated and compiled by TechFlow

Guest: Alfonso Peccatiello, macro expert, founder of The Macro Compass

Host: Ryan Sean Adams, co-founder of Bankless; David Hoffman, co-founder of Bankless

Podcast source: Bankless

Original title: Fed Rate Cut: What Will Happen to Markets?

Broadcast date: September 18, 2024

Background information

Jerome Powell and the Federal Reset are about to cut interest rates, 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 figure this out.

· Are these rate cuts timely or too little too late?

· Will the Fed cut by 25 basis points or 50 basis points?

· Will we have the recession or soft landing the Fed is hoping for?

· What happens to crypto assets?

We discuss all this and more with Macro Alf, one of the top thinkers in the macro space.

The Fed’s Policy Lag

In this podcast, David and Alfonso explore the Fed’s monetary policy and its impact on the economy.

· Alfonso noted that the Fed appears to be lagging behind in the current economic situation, especially in terms of interest rate cuts. 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 led to a rise in real interest rates to positive values, which has had different effects on borrowers and investors. For investors, high real interest rates make it more attractive to keep funds in cash, reducing the incentive to invest at risk. For borrowers, the burden is heavier because they have to repay their debts at higher interest rates, which slows down economic activity.

Risk of Over-Tightening

· David raised the question of whether the Fed is too slow in maintaining high interest rates, which could lead to a slowdown in the economy.

· Alfonso believes that the current situation is that the Fed may lag again in cutting interest rates. He warned that if the Fed continues to do nothing, the economy may be at risk of a sharp slowdown.

· Alfonso further emphasized that the degree of monetary policy tightening in the past 18 months has 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 effects. Therefore, although many people now believe that the economy can withstand high interest rates, in fact, the lagged effects of the policy may show negative effects in the coming months.

Economic Outlook for the Future

The podcast concludes with a discussion of where the economy is headed, with Alfonso noting that despite the current optimism, history shows that when economic conditions appear stable, it is often a sign of impending trouble. He reminds listeners that while current policies appear to be working, long-term lags cannot be ignored, and there may be greater economic challenges ahead.

Why Hasn’t the Economy Collapsed Yet?

During the podcast, Ryan asks a key question: Why hasn’t the economy collapsed despite the Fed’s tightest monetary policy in history? Alfonso explains why.

Alfonso points out that the current economic lag is very long, and this is due to a variety of factors. Typically, when interest rates rise, borrowers (such as households and businesses) borrow less, which reduces spending. However, the current situation is different. Since more than 90% of U.S. mortgages are 30-year fixed-rate, many households will not feel the impact of rising interest rates immediately. Their fixed-rate loans mean that even if new mortgage rates reach 7%, existing homeowners will not be directly affected because their loan interest rates are still low.

Corporate response strategies

For businesses, the situation is similar. 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 Federal Reserve raises interest rates, companies do not have to immediately bear higher borrowing costs. As a result, companies still maintain ample cash flow in the short term and may not reduce investment or spending due to rising interest rates.

The Impact of Fiscal Policy

Alfonso also mentioned that fiscal policy in 2023 also supported the economy. The Biden administration has implemented a large fiscal deficit, which has brought additional capital inflows to households and businesses. This fiscal stimulus has offset the tightening effect of monetary policy to a certain extent, so that the net wealth of companies and households has increased despite rising interest rates.

Bad News

In the podcast, Ryan and Alfonso discussed the meaning of bad news in the current economic situation. Ryan mentioned that the Fed's tools do not seem to work as expected, and the potential problems of the economy are like a tsunami approaching in the distance. Although there is no obvious impact now, the crisis is approaching.

Alfonso pointed out that in the past few years, the market's reaction to bad news is very different from now. In the pre-epidemic period, weak economic data was often seen as good news because it meant that there might be interest rate cuts and fiscal stimulus. However, Alfonso believes that the situation has changed now, and bad news has really become bad news.

Changes in the economic environment

Alfonso explained that in the past economic environment, the market was accustomed to treating bad news as "good news" because it usually meant that the 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 mean real risks because the Federal Reserve always supported the market behind the scenes.

However, the current situation is that the economy is close to the brink of recession, and the impact of bad news has become more obvious. Alfonso emphasized that when economic growth is weak, the tolerance for unemployment is reduced, and any economic data that is lower than expected may cause market panic. For example, the United States currently needs to create about 120,000 jobs per month to maintain a stable unemployment rate, while in fact, the private sector only creates about 100,000 jobs per month. This gap means that once there is bad news in the economy, the market will react quickly, causing the stock market to fall.

Memories of the past

Ryan asked when was the last time investors felt that "bad news was bad news." Alfonso replied that this situation can be traced back to the 2008 financial crisis. At that time, bad economic data meant that a recession was approaching, and the market sentiment changed fundamentally.

Signals from the bond market

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 the market's expectations for further easing policies by the Federal Reserve. However, the stock market often falls, showing the market's concerns about the future economic outlook. In this case, bad news is not just bad news, but exacerbates market uneasiness.

Alfonso emphasized that the impact of bad news has changed in the current economic situation, 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 need to re-examine this new economic environment.

Fed Rate Cut Prediction

In the podcast, David and Alfonso discussed the possibility of an imminent Fed rate cut. David mentioned the market's expectations for a rate cut, especially the discussion about 50 basis points.

Alfonso's View

Alfonso believes that the Fed is likely to choose to cut interest rates by 50 basis points. Here are a few reasons he gave:

· Missed opportunity: Alfonso pointed out that the Fed should have 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 Fed should clearly communicate the reasons for the rate cut, explain that this is to correct previous mistakes, and show that they realize that the economy is slowing and are ready to take more easing measures.

· Future meeting schedule: The next Fed meeting is in November. If the rate is only cut by 25 basis points this time, and the economy deteriorates further, they will have to wait until November to cut again, which is not wise risk management.

· Market expectations: Currently, the bond market is already pricing in future rate cuts, and the market expects a 250 basis point rate cut in the next year. If the Fed does not follow up, the stock market may feel nervous because they rely on the expectations of the bond market.

Nature of the rate cut

David asked if the Fed chose to cut by 50 basis points, whether this means they are acting quickly.

Alfonso said such a rate cut could be seen as a correction for the failure to cut rates in July, reflecting the Fed's emphasis on the economic slowdown.

Impact of the global economy

Alfonso also mentioned that the global economic situation is also affecting the Fed's decision-making, especially the impact of China's economic slowdown on the United States. He stressed that the Fed needs to be cautious in cutting interest rates while conveying their understanding of the economic situation and responses.

Alfonso believes that the Fed should take a 50 basis point rate cut to respond to current economic challenges and reassure the market through clear communication. He emphasized that the current 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 rate cut. Ryan asked Alfonso what he thought of the letter and whether it would affect the Fed’s decision.

Alfonso’s Analysis

Alfonso believes that Warren’s letter is actually a political bargaining strategy. Here are a few 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 Fed’s final decision of 50 basis points. By making a higher request, she hopes to prompt the Fed to take more aggressive rate cuts.

· Fed communication strategy: Alfonso noted that the Fed cannot communicate publicly during the dark period (i.e., the silent period before the decision-making meeting), but they will still convey information through the media. He mentioned that in the past, the Fed has communicated its intentions to the market through Nick Timiraos, a reporter from the Wall Street Journal.

· Market reaction: Alfonso mentioned that at the beginning of the dark period, the market expectation for a 50 basis point rate cut was only 10%, but with the report of Timiraos, this expectation quickly rose to 55%. This shows that the Fed is still able to influence market sentiment through the media during the dark period.

Stability and instability: Alfonso quoted the views of economist Hyman Minsky, pointing out that "artificial stability actually leads to instability." He believes that the Fed tries to avoid recession and market panic by controlling market volatility, but this practice itself may lead to greater instability.

Alfonso emphasized that as investors, we need to understand the rules by which the market operates and manage risk on that basis. He believes that the Fed is trying to convey their intention to cut interest rates by 50 basis points, and that Warren's letter is part of a political game and may not directly affect the Fed's final decision.

Market Reaction

In the podcast, David and Alfonso discuss the market's reaction to a possible Fed rate cut, especially the impact of Elizabeth Warren's request for a 75 basis point rate cut on the market and the Fed's decision.

Alfonso's Analysis

· Market expectations: Alfonso pointed out that the market has begun to price in the possibility of a 50 basis point rate cut by the Federal Reserve in September, and this expectation has reached 60%. He further stated that the market also expects a possible 25 basis point rate cut in November, and a higher probability of another 50 basis point rate cut in December. This shows that the market generally believes that the Federal Reserve will cut interest rates further in the coming months.

· Importance of economic response: Alfonso emphasized that the effect of rate cuts depends on the response of the economy. If the economy can quickly adapt to rate cuts, it may bring positive results. However, the positive effects of rate cuts usually take one to two years to appear, so the Fed's policies need to be forward-looking rather than just reactive.

· Performance of risky assets: David proposed that market participants pay attention to risky assets (such as cryptocurrencies), especially in the context of the Fed's rate cuts. Alfonso pointed out that rate cuts are usually good for risk assets, especially when the economy is in good shape and rate cuts are seen as support from the Fed. However, if the rate cut is in response to economic weakness, the reaction of risk assets in this case may be different.

· Historical example: Alfonso mentioned the example of Japan in the 1990s, pointing out that after the economic bubble burst, although the Bank of Japan quickly cut interest rates, the market did not recover as a result. This is because the rate cut is not a proactive measure to support the economy, but a passive response of the central bank in response to economic weakness.

· Alfonso believes that the impact of the Fed's rate cut policy on the market depends on the nature of the rate cut. If the rate cut is seen as 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 suppressed. Therefore, investors need to pay close attention to the Fed's policy trends and the actual performance of the economy in order to make corresponding investment decisions.

How to prepare

Understand the current market environment

· Performance of risky assets: Alfonso noted that if the economy enters a recession, risky assets (including cryptocurrencies and stocks) may be affected. As cryptocurrencies are increasingly seen as risky assets, they may be sold off to raise cash in a down market.

· Impact of deleveraging: In times of economic downturn, investors often face pressure to deleverage, which can cause all asset classes to increase correlation and show similar price movements. When investors need cash, they will not think too much about which asset to sell and will only choose assets that can be quickly converted into cash.

Strategy for portfolio adjustment

Maintain diversification and risk balance: Alfonso mentioned the "risk parity" strategy, which recommends that investors pay attention to the contribution of various types of assets to the overall portfolio risk, rather than simply allocating funds in a fixed proportion. For example, ensure that each asset contributes the same risk in the portfolio.

Reference to historical data: Historically, investors tend to underestimate the extent of the Fed's interest rate cuts. During recessions, the Fed usually takes more aggressive interest rate cuts, so bonds tend to perform well in such situations.

Recommended asset classes

Bonds: Bonds usually maintain their returns during recessions, especially when the Fed cuts interest rates. Although bond prices have risen, they are still a relatively safe investment option during economic slowdowns.

Gold: Gold usually performs well during economic uncertainty, and demand for gold may continue to rise as central banks continue to increase 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 Swiss Franc, which tend to remain stable during market turmoil.

Avoiding Big Losses

Focus on Risk Management: Alfonso stressed that investors should prioritize how to reduce risk in their portfolios rather than looking for hedging tools. Avoiding big losses is the first rule of investing, as big losses can lead to a difficult financial situation to recover from.

Reassessing Portfolios: When considering a possible recession, investors should review their asset allocation to ensure that they are not overly concentrated in high-risk assets.

Chances of a Recession

When discussing the likelihood of a recession, Alfonso offered his view on a recession in the next 12 months. He believes that the probability of a recession is about 50%. Here are a few key factors he analyzed:

The impact of fiscal policy

Rapid fiscal stimulus: Alfonso pointed out that the current political environment allows governments to act quickly to stimulate the economy when the economy weakens. This is different from past situations, such as during the 2008 financial crisis, when fiscal stimulus measures usually took 6 to 12 months to introduce. Today, the government's quick response can play a certain role in stabilizing the economy.

The level of leverage in the private sector

Lower leverage: Currently, the leverage level of the private sector is relatively low, which means that companies and households have a lighter debt burden. This situation means that the economy may not be hit as hard as in the past when facing a recession. In 2007, many households and companies had too high debt levels, which led to the intensification of the financial crisis.

Market expectations

Market probability of recession: The market's current expectations for a recession are 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 a possibility of underestimating risks.

Although Alfonso believes that the probability of a recession is about 50%, he believes that if it does happen, the magnitude and impact of the recession may not be as severe as in the past. This is mainly due to the government's quick response to the economy and the low leverage level of the private sector. Investors should consider these factors when evaluating the future economic situation in order to better adjust their investment strategies and risk management.

Currency Debasement

When discussing currency debasement, Ryan and Alfonso mentioned changes in the money supply and the impact of such changes on the economy and asset prices.

Currency Debasement Definition

Currency Debasement: Currency debasement generally refers to a decrease in the purchasing power of a currency, resulting in the same amount of money being able to purchase fewer goods and services in the future. Ryan mentioned that although the economy may experience a recession, currency debasement is a nearly inevitable phenomenon.

Changes in the Money Supply

Fiat Currency Systems: Alfonso noted that monetary policy has fundamentally changed since the United States abandoned the gold standard in 1971. Now, the issuance of dollars is no longer tied to a hard asset such as gold, which allows the government to create new dollars without limit.

The Impact of Inflation: As the dollar continues to increase, the risk of currency devaluation increases. Alfonso explains that when the government creates too many disposable dollars through deficit spending, the goods and services in the market cannot increase quickly enough, which eventually leads to rising prices, which is inflation.

The Role of Government and Banks

Government Deficit Spending: The government creates new disposable dollars through deficit spending. For example, the government may issue checks to citizens, increasing the money supply in the market. This practice has been going on for the past 30 years and has led to 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 the ability to lend based on the future cash flow potential of borrowers. This credit expansion further drives up asset prices.

Impact on asset prices

Real estate market: House prices continue to rise due to low interest rates and continued credit creation. The increased borrowing capacity allows people to purchase higher-priced properties even if wages have not increased significantly.

Comparison with gold: Alfonso also mentioned that the actual growth in house prices may not be obvious if measured against gold. This suggests that the increase in house prices is mainly due to the effects of the fiat monetary system rather than the intrinsic value growth of the property itself.

Monetary liquidity

The concept of monetary liquidity

The importance of the denominator: Ryan mentioned that the key to understanding the flow of money in the economy is the "denominator." He pointed out that the terms used by governments and central banks (such as quantitative easing, fiscal deficits, etc.) are actually describing the creation or destruction of money. In most cases, these measures are increasing the money supply.

The normalization of fiscal deficits

The transformation of fiscal deficits: Alfonso pointed out that fiscal deficits have changed from a "defect" in the past to a "feature" now. He believes that the government's deficit spending of one trillion dollars a year has become the norm, and this change has a profound impact on liquidity and the economy.

Impact on investors: This continued fiscal spending will support economic growth, but it 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 that investors should pay attention to

Government spending and deficits: Investors should pay attention to large government projects and stimulus plans, especially tens of billions of dollars in spending, as well as annual budget deficits. These data are public, and investors can understand the government's spending by looking at the monthly deficit data released by the U.S. Treasury.

Spending efficiency: In addition to focusing on the deficit itself, Alfonso emphasized the importance of spending efficiency. How the government uses these funds and where the funds go will directly affect the productivity and long-term growth of the economy.

The widening of social wealth gaps

The widening of wealth gaps: Alfonso also mentioned that the implementation of fiscal policies is exacerbating the wealth gap. As younger generations (such as millennials and Generation Z) gradually become the main voters, they are facing increasing economic pressures and may promote different policies and seek wealth redistribution.

Sustainability issues: He believes that the current economic system is not sustainable and there may be greater social and economic pressures in the future, prompting policy changes.

Depreciation-resistant assets

Classification of depreciation-resistant assets

Stock market: Alfonso mentioned that stocks are an important depreciation-resistant asset because companies are denominated in US dollars and can generate cash flow. He emphasized that although companies will grow in the long term, investors need to pay attention to valuations at the time of purchase and avoid buying stocks at too high prices. He suggested that investors choose high-quality companies and invest at reasonable valuations to ensure good returns in the next 10 to 20 years.

Allocation of risky assets

Aggressive assets: In the portfolio, Alfonso recommends allocating some risky assets, such as cryptocurrencies and gold. Although these assets do not have cash flow, they have different monetary characteristics and can provide diversification for the portfolio.

Defensive Asset Selection

Bonds: As defensive assets, bonds are often able to protect portfolios during recessions or deflationary periods, but in some cases (such as 2022), they may underperform.

Commodities: Alfonso also mentioned that commodities, as USD-denominated assets, can protect portfolios during inflationary periods and are therefore also defensive assets worth considering.

Macro Investment Strategies

Macro Hedge Funds: Alfonso shared his plans for his upcoming macro hedge fund. He believes that the current changes in the macro environment have brought great investment opportunities, and specific strategies can take advantage of these macroeconomic fluctuations and provide diversified sources of income for the portfolio.

Conclusion

Key Summary:

1. Fed’s decision:Alfonso believes that the Fed may adopt a 50 basis point interest rate cut to meet the current economic challenges. He reminded investors to pay attention to the market reaction under different economic environments, remain flexible, and not be stubborn in their own views.

2. The importance of asset allocation:In an uncertain market environment, the rational allocation of anti-depreciation assets (such as gold, stocks, cryptocurrencies, etc.) is the key to protecting the investment portfolio. Investors should adjust their investment strategies in a timely manner according to their own risk tolerance and market changes.

3. Keep learning and adapting: The market is changing rapidly, and investors need to constantly learn and adapt to the new economic situation. Alfonso's educational platform "Macro Compass" provides a wealth of resources to help investors understand the macro economy more deeply.

Finally, thank you to all the friends who listened. Remember, investing is risky and decisions need to be cautious. The future is full of uncertainty, but we will continue on this path of exploration. I hope everyone can keep an open mind and actively respond to challenges on this journey. Thank you for your support, and see you next time!

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