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Ride of the Volkyries’ Main Points- Part 2
Previously on ZH: Part 1
Here are the five main points Pozsar wrote summarized for readers
1- WHAT STRIKE CALL IS THE FED TARGETING?
First: the Fed is now in the business of writing a call option on risk assets – not just stocks, but housing and crypto as well. Whether we think of the FOMC’s target level for the stock market and financial conditions as a call option or still as a put option just with a lower strike price is semantics. The big question of course is that if the Fed is indeed writing a call option, what is the level that it targets? Does the Fed want to see the S&P give up only a part of its post -Covid gains or all of them ? Or does the Fed want to wipe off some of the gains that accumulated before the pandemic?
We think the fed isn’t targeting stock price. It’s targeting inflation. And unless stocks drop too fast, they will be content to wait to stop the descent. Still, they must be using some historical reference as Pozsar opines.
TARGETS NOT CAPS
Next, Zoltan’s questions about call strikes started our thought process going as options people. Please note he is talking about areas below the market, not above it. The Fed is not looking to cap rallies, it is looking to lower prices. The call strike being sold is in the money. This is a concept Pozsar may have actually thought of but cannot say out loud.5 The call they are figuratively selling is below, not above the market. Speculators trade out of the money options. “Players” of which the Fed is the ultimate, trade ITM options. Here’s tactically why that makes more sense than most 20 year old portfolio managers will understand. If you are trying to time Fed call-selling by looking for rallies to slow down and be capped, you may not make it. The Fed is now a downside momentum trader.
Our aim today is to highlight the risk that we might be dealing with a Fed that won’t be intimidated by curve inversions and asset price corrections, but will be emboldened by them to do more
People should be thinking of where we are going, not timing bounces to sell longs.6
2- HELICOPTER DROPS MUST STOP
We’ve had several rounds of QE, and during the most recent round, we combined QE with fiscal policy and the government implemented Friedman’s notion of “helicopter drops of money”.
The most recent round of QE was super-charged with fiscal stimulus during a time where they thought it was needed. But like most good ideas, it had its own Waterloo. More accurately, QE and Fed policy ran into diminished returns and exaggerated unintended consequences.
Our comment is: in a state run bureaucracy, when a policy is working, you don’t fix it. When it works less, you do it more. This is much of how Gov’t policy is done. Incumbency rightfully affords them this luxury. But like a slow-turning aircraft carrier (or the Titanic), pivoting is delayed.6
QE overstayed its welcome; we need a round of negative wealth effects; we need “shock therapy”
Large slow-moving policy has advantages and disadvantages. Unfortunately the diminishing returns were not reversed soon enough. The lookout may have had other things on his mind7.
3- BRACE FOR HIGHER UNEMPLOYMENT
[P]rice stability, full employment, and financial stability are not possible to achieve all at the same time. Something has to give. The Fed appears to have chosen price stability as the priority: it wants slower growth and higher unemployment;…
For years the Fed was able to achieve full employment and financial stability almost simultaneously. That was in part a function of those technologically driven tailwinds keeping goods-inflation down which Pozsar described in his Bretton Woods 3 submission.
Now that those goods supply-chain tailwinds have become headwinds, Zoltan believes the first mandate of full employment may have to suffer a bit to get the second mandate of price stability inline.
Central banking with a multitude of mandates is a bit like the life of a working parent: it is impossible to deliver 110% at work, 110% at home playing with Barbies or doing dishes, and 110% at the tennis court as well (if you are lucky to find the time to play).
We need to give a little wealth to get a little price stability now is what it sounds like. Too much of a good thing is bad sometimes maybe. Dynamic equilibrium is important and things like long term rates statistically need to regress to the mean once in a while. which by the way is the third Fed mandate8.
Therefore, lowering the priority of one mandate (employment) and raising the priority of their second ( stable prices) will help to restore balance to the third mandate.
There is also a medical phenomena that may apply here called a Paradoxical reaction; Where too much use of a medicine/policy eventually brings the opposite effect on the patient as the body/mkt adapts and gets used to the medication. In finance terms, the correlation then inverts and fixing one worsens the other much sooner. The system is not in balance. Phrases like “unintended consequences” get used to cover risk mgt. errors soon thereafter
4- STRONG BALANCE SHEETS CAN BE BAD?
There can be a recession precisely because balance sheets are so strong, and if we follow the line of argument above, strong balance sheets mean the Fed needs to lean against the wind harder to shock demand lower.
Admittedly, this is not obvious to us, and we are a little lost in translating his idea. Our best guess is: People are just too comfortable leaning on wealth for expenditures and not income from work. Kind of like too much Wealth Effect fostering unsustainable behavior maybe.
In human terms, you lose appreciation for something and take it for granted if you never vary. Maybe it’s just best to tie this to the idea Pozsar contends that volatility is needed to be injected into things. Stop taking your wealth for granted. 9
5- INCREASE VOLATILITY BY DESIGN
The Fed has two types of buttons to push to release its payloads of volatility: talking tough (a string of rate hikes, a string of 50 bps hikes, and maybe even 75 bps if things don’t cool down), and shifting from passive QT to active QT, where the Fed control s the amount of duration each dollar of balance sheet shrinkage delivers into the market, as opposed to the refunding decisions of the Treasury.
The “talking tough” part is easy enough to understand. The second part, Active QT is interesting. In February the author called for an active QT in which the market didn’t get spoon-fed Fed tactical plans as part of his Volcker moment concept. Market volatility would then be a by-product of increasing uncertainty in market participants; basically a little self-clearing market behavior is needed.
The Fed needs to take the training wheels off the algos and the momentum front-runners that rely on tactical predictability. Not unlike a shift back to stock versus flow approach used since the GFC maybe?
What is interesting to us is the fact Pozsar acknowledges the Fed has not yet needed to go to active QT and says: “we argued for the Fed to do the latter (active QT) but the former (verbal) strategy is working wonderfully for the moment”.
Rallies could beget more forceful pushback from the Fed
He basically is saying: they may not have done it yet, but be assured they will do it if stocks rally again. They are trying to convey that they will use those “tools” if needed. That tool is one unused yet. Be careful.
BOTTOM LINE: SPEND LESS AND BE HAPPY
Boiling down his message at the end he opines: (emphasis ours)
The Fed…won’t rest in its pursuit of tighter financial conditions until yields shift higher, stocks fall more, and housing turns as well. Furthermore, consider the idea that the Fed is pursuing demand destruction through negative wealth effects…
Paraphrasing his last point: Strong private balance sheets raise recession risk, and that wealth may force the Fed’s hand to shock risk assets more to make sure we actually get a recession or at least a very hard landing. In doing this, they think inflation will be better controlled.
Pozsar’s perfect one sentence explanation for our own cliff-notes: The Fed is pursuing demand destruction through negative wealth effects. Everything else is details.
HOW LOW DO STOCKS HAVE TO GO?
The writer does not give a target, but an overview into some thought process.
At 4,000, the Fed does not seem content, and in the grand scheme of things, this is where the Fed would change its tune if it would still be writing a put. At 3,500, we would have lost all of the post -pandemic gain s in market wealth, but that level for stocks still feels like a put option, just with a lower strike price. At 2,500, we would lose not only all of the post -pandemic gain s, but would eat into some of the pre -pandemic gains too. And if something indeed happened to the supply of labor post -pandemic (and some of that is wealth related), then to cool price pressures, maybe a pre -pandemic wealth level is appropriate indeed.
This all again reinforces the idea that the call being sold by the Fed is in-the-money. The target is the call being sold, not some nebulous technical out of the money strike. When you mean business, you sell the most deltas you can with the least volume.
As a thought exercise using 3500 as an indifference point:
If during the heart of the pandemic the Fed had asked: “What would you give to know if at the end of this pandemic, 2 years hence your portfolio would be unchanged from pre the pandemic drop?” The answer we suspect back then (admittedly in hindsight) would include various small appendages.
So that is our indifference point. if the Fed can keep stocks at the pandemic unchanged level of approximately 3500 and get inflation in line, then they did their job most admirably. Anything less, while likely still acceptable by the masses, is just not a good look on Powell’s resume.10