Pain Before Pivot

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In early 2010 financial markets were pricing in that the improvement in conditions would allow the Fed to tighten rates 250bps over the subsequent year. It took 6 years before there was any tightening. The fundamental reason for the miss was that investors expected something only incrementally different from a typical business cycle upswing they had seen for decades rather than a radically different deleveraging cycle. They relied on their personal experience instead of studying past analogues to understand unfamiliar dynamics. Today's investors are falling into that trap again, only this time it’s likely to be much more painful for their portfolios.

This inflationary business cycle is unlike any of the business cycles of the last 30 years. But that doesn’t mean it's unheard of. If anything, it's relatively common. From the early 60s to the early 90s business cycles looked relatively similar to today - economic expansions led to rising inflationary pressures which in turn caused Fed tightening and an eventual downturn.

The table below looks at today’s cycle in that context. The current cycle rise in core inflation so far has been in the ballpark of these past cycles, but current priced-in tightening is a lot less, stocks have not fallen nearly as much, and there has been little deterioration in employment. These cycles show that once inflation gets going, it is very hard to break. And it requires much more pain before the pivot than what we have seen so far this cycle

Cumulative Drawdowns


Source: FRED St. Louis Fed, Yahoo Finance, and Unlimited calculations

Financial markets are pricing in something very different - essentially a quick modest tightening cycle followed by a reversal - an incrementally different repeat of post-crisis tightening waves many investors have personally experienced since the financial crisis. 

Since the financial crisis the Fed and other central banks have been responsive to growth conditions because inflation was subdued. Investors have come to expect a shift toward easing at the slightest sign of growth deterioration. The pricing of the curve aligns with this. After rates reach 3.25% (or effectively 3.75% if you include the QT rolloff based on Fed estimates), the inevitable slowdown in growth will cause the Fed to immediately reverse course early next year.


Fed Funds Data


Source: FRED St. Louis Fed, Yahoo Finance, and Unlimited calculations 

Equities are also pricing in a Fed response that will lead to a perfect landing where companies will not experience an earnings recession. The chart below shows the returns of the overall stock market (VTI) and then the returns excluding the discount rate impact (measured by VGLT). Once the bond market's impact on pricing is taken into account, stocks are flat on the year. It's not just an intermarket action story, forward S&P earnings estimates for 2023 are only down 2% so far (244 vs. 249 at peak).


Source: Yahoo Finance and Unlimited calculations

Probably the most breathtaking example of the market pricing ‘a return to recent normal’ is in the break-even inflation market. Current pricing suggests a return to inflation below 3% over the next 2 years, despite an accelerating recent reading of year-over-year at 9%.

US Headline Interest

Source: FRED St. Louis Fed, Bloomberg, and Unlimited calculations

Hedge fund managers are not expecting this cycle to play consistent with what is currently priced in. There is a clear tilt to expectations of higher inflation and tighter monetary policy. Using our return replication technology we can infer the positions these managers have at any point in time. What we see today is short bonds and long commodities in size that is the largest in 20+ years. Hedge fund managers are also slightly underweight stocks and credit relative to normal.

Current Hedge Fund Positioning

Source: Unlimited calculations

Back in 2010 when investors were wrong about the future path of monetary policy it ended up benefiting holders of 60/40 portfolios - as monetary policy came in easier than originally priced, assets soared starting a decade long boom in returns. Making such an error today will be much more costly. If the cycle dynamics play out similar to typical inflationary cycles 60/40 investors will face losses on both their stocks and their bonds as monetary policy comes in tighter than currently priced. Preparing for such a scenario will require a mindset change to recognize that while this cycle will be different from their personal experience, it isn't all that unusual.


For informational and educational purposes only and should not be construed as investment advice. The historical analysis discussed herein has been selected solely to provide information on the development of the research and investment process and style of Unlimited. The historical analysis should not be construed as an indicator of the future performance of any investment vehicle that Unlimited manages. No investment strategy or risk management technique can guarantee return or eliminate risk in any market environment. No Representation is being made that any investment will or is likely to achieve profits or losses similar to those shown herein.