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The Year of the Bear
#34: Reflections on 2022 and thoughts on the year ahead.
Merry Christmas and Happy Holidays!
It’s been a long year, or at least it has felt like one1. As the calendar turns, it’s natural to take pause and reflect on the year that passed by.
In markets, 2022 was the Year of the Bear. After equity indices ticked their tops in December 2021, stocks tumbled for twelve months. The Fed hiked from the floor to four, sending duration down the drain and bringing housing sales to a standstill. Hucksters of digital assets have been exposed as ass-hats. But you already knew all of this.
Instead, I want to share three new reflections:
The Price of Money (Supply and Demand of Capital)
The Market is Not the Economy (Don’t Fight the Fed)
On Doomer-ism (The First Bull Running)
The Price of Money
We often talk about interest rates as being a policy choice of central banks, meant to influence financial markets and the real economy. In other words, we think of interest rates as the independent variable that causes a repricing of assets, reallocation of capital, and reconsideration of borrowing and lending.
But watching this tightening cycle over the past year, I’ve begun to rethink this understanding.
Interest rates are the price of money (capital). As in other markets, price reflects the intersection of supply and demand. Increasing the supply of capital will reduce the price of money, and vice versa.
The central bank does not set interest rates per se. Rather, the central bank adjusts the supply of capital. Interest rates are a dependent variable that, like stocks and bonds, react to the relative availability of money.
Central banks can only achieve zero percent interest rates by making near limitless money available. Conversely, central banks can only dramatically hike rates by dramatically reducing the availability of capital.
This is more than semantics.
The market cannot be “awash with liquidity” with short term rates at 4.3%. If the market was awash with liquidity, then interest rates would be at zero. Rather, short-term rates rising to 4.3% is a reflection of the rapid pace with which liquidity has exited the private market.
The Federal Reserve can add money with quantitative easing (QE) and remove it with quantitative tightening (QT). But the primary mechanism by which the Fed has removed liquidity in this cycle is through the Reverse Repo facility (RRP) and the interest it pays on commercial bank reserve balances (IORB)2. By offering attractive interest rates to banks and money market funds, the Fed pulls money out of the hands of the private financial market, reducing the availability of capital.
Stocks are not down because interest rates have increased. Rather, stocks have fallen and interest rates are rising because capital has suddenly become scarce.
As discussed on Twitter, this capital scarcity has forced certain financial institutions to begin tapping the Fed’s discount window - a lending facility which is typically only used in moments of crisis.
If the Fed wants to make good on its intended rate hikes in the coming year, it must remove even more money from the market. The trouble is we don’t know how much money the market has left to give before something goes wrong.
The Market is Not the Economy
Back in 2020 during the early days of the pandemic, it was impossible to ignore the divergence between the stock market and the real economy. And so, we heard ad nauseum that “the stock market is not the economy”. And surely this was true. To counterbalance the economic slowdown, the Fed flooded markets with capital, raising asset prices and lowering interest rates. Juicing the market was an explicit tool of the central banks.
In 2022, this dynamic worked in reverse. Over the year, we have witnessed huge job gains and consistently growing real consumption. Wage growth has exceeded inflation in recent months, and real incomes have turned up again. The Fed, worried about rising prices and an overheated labor market, has slammed on the brakes. Deflating asset prices is now an explicit tool to rein in the real economy.
In some ways, you could say that nature is beginning to heal. The largest beneficiaries of the pandemic monetary stimulus were asset holders - mostly rich people who had already benefitted from years of QE and ZIRP. The exacerbation of wealth inequality had become a glaring ethical concern of easy money regime.
It is no coincidence that those who are now yelling for the Fed to stop hiking are exactly those who saw their wealth expand dramatically over the prior two years. These cries will fall on deaf ears. A strong labor market with growing real wages and falling asset prices will begin to shrink the massive wealth gap.
For now, we can only speculate on the impact that the Fed’s emergency brake will bring to the economy next year. But until we see real economic declines, the Fed wants your assets to depreciate. It will likely succeed. Leading indicators or mere predications of a recession will not suffice to cause a change of course. In the meantime, don’t fight the Fed.
This last one is a bit personal. Back in April 2021, I joined Twitter as The Last Bear Standing because I truly felt like I was the last bear standing.
Early 2021 was the peak of an irrational exuberance, a speculative mania, a bacchanal of excess, that was indeed doomed to roll over. I could not understand how seemingly intelligent and knowledgeable folks (in person, online, and in the financial media) seemed to believe fairy tales about the future. The concept of valuation had lost all meaning, and the biggest grifters were elevated to demi-god status.
I wrote passionately because I could not keep it inside - like a prisoner who scrawls on his cell wall or a passer-by who screams out to a pedestrian stepping foot into oncoming traffic.
Sure enough, today all major indices are lower than when I joined Twitter3. Supposedly "risk-free" long-dated government securities have lost much of their value. The most speculative bubbles (SPACs, EVs, unprofitable tech, crypto, etc.) have popped. One of the best performing assets in the interim was the most hated a year ago - cash4.
Now, as we approach 2023, the bears have multiplied as sentiment has followed the market downwards - and so too have the predictions of imminent recession and doom. Today, Bulls are an endangered species. Increasingly though, I find myself taking a more measured and optimistic tone than other prognosticators, which is a bit ironic.
As I wrote two weeks ago, I don’t think the bottom is in yet. We don’t know what effect the Fed’s hikes will have on the real economy or financial markets. Liquidity, derivatives, and global instability all pose significant tail risks. A recession in 2023 seems like a reasonable predication (though we haven’t yet seen it show up in the data). Further, we haven’t seen the panic or capitulation that comes with the last leg down.
But, despite all that, I feel more confident in the long-term resilience and strength of the economy than I did a year ago (even if the Fed forces a recession) and have always believed in the long-term power of the market to compound wealth (even while I think your entry prices are critical).
Call it a hunch, but I think the market will find a floor at some point in the coming year. When that time comes, I’ll be the The First Bull Running.
As always, thank you for reading. If you enjoy The Last Bear Standing, like this post and tell a friend! And please, let me know your thoughts in the comments - I respond to all of them.
Technically speaking, most years are the same length.
The RRP literally pulls money out of the private market as money market funds lend money directly to the Fed. Meanwhile IORB “freezes” bank reserves by ensuring that no loans are made below the IORB rate, which slows credit creation, and effectively reduces capital availability.
I also got a lot things wrong - importantly, the precise timing of the bubble and the resilience of the underlying economy. In fact, much of the research I’ve published on Substack was initially driven by trying understand where my assumptions had failed - most notably the mechanics and importance of monetary and fiscal policy.
You guys remember TINA (There Is No Alternative)? It turns out there was an alternative, and it pays 4.3% today…