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Source: Bloomberg LP. As of 1\/19\/22.\u00a0<\/span>\u00a0<\/span><\/p>\n \u00a0<\/span><\/p>\n Markets have started off on a rough note to begin 2022. The fear of a reduction in market accommodation as the Fed pulls support and (likely) hikes rates has spooked markets. In response to rising rates, persistent inflation and a less friendly Fed, stocks have traded lower.\u00a0\u00a0<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n The S&P 500 is down almost -5% so far in \u201922 with only two sectors positive: Energy (XLE +15.86%) and Financials (XLF +0.51%). While the market selloff has been across the board, long duration assets, i.e., QQQs -7.88% & ARKK -19.92%, have gotten smoked. Bonds have performed poorly as interest rates have risen, having a positive correlation with stocks – this has led to a rough start for 60\/40 portfolios in \u201822.\u00a0<\/span>\u00a0<\/span><\/p>\n \u00a0<\/span><\/p>\n Political Pressures Are Mounting<\/span><\/i><\/b>\u00a0<\/span><\/p>\n <\/p>\n Source: CBS News. As of 1\/18\/22.<\/span>\u00a0<\/span><\/p>\n \u00a0<\/span><\/p>\n Until recently, the Fed thought that erring on the side of being overly accommodative was preferable because inflation was not a threat. While we are not at the point where inflation or inflation expectations are out of control, the risk is increasing and so erring on the side of hawkishness is now becoming more attractive. The political cost of faster tightening is also diminishing, as few politicians these days seem inclined to downplay the risk of inflation.<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n Inflation is now a political issue – President Biden recently indicated that bringing down inflation is now his top priority. We are hearing the same questions from Senators of both parties as they have questioned Powell aggressively at recent testimonies. The Fed is independent, yes, but they are also accountable to Congress and can\u2019t entirely ignore the direction of politics, especially in a mid-term election year.\u00a0<\/span>\u00a0<\/span><\/p>\n \u00a0<\/span><\/p>\n Fed\u2019s Gameplan: Aggressive Rate Hikes vs. Less Hikes and more Balance Sheet Reduction.\u00a0<\/span><\/b>\u00a0<\/span><\/p>\n \u00a0<\/span><\/p>\n Historically, well since QE began, the Fed\u2019s playbook has consisted of two tools to tighten market liquidity and combat inflation. They\u2019ve utilized interest rate hikes and balance sheet reductions.\u00a0<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n Right now, the Fed\u2019s balance sheet is nearly $9 trillion – Jerome Powell stated in his hearing earlier this week, \u201cIt\u2019s far above where it needs to be.\u201d He also reminded us that the Fed hasn\u2019t made any decisions on whether they would sell assets off their balance sheet, but also commented that they hadn\u2019t ruled it out, either – \u201cIt\u2019s something we will be looking at.\u201d\u00a0<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n Seems like most participants are focused on the Fed aggressively hiking rates this year (4 rate hikes are currently priced in) with lift off beginning in March, immediately following the end of QE. We\u2019ve even seen an increase in the possibility for a 50bps hike in March (<\/span>the last time the Fed hiked by 50 bps in one meeting was almost 22 years ago<\/span>). Could market assumptions be missing the mark? We think the likelihood of less hikes and more assets sales in \u201922 is a real possibility. A preferable one in our opinion for a softer landing.\u00a0<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n Back in 2010, Jim Bullard rallied the Fed troops to look at asset sales as the first order of removing accommodation from the markets BEFORE hiking interest rates. Rates didn\u2019t move until the end of 2015 and the asset sale discussion was put aside.\u00a0 In 2017, Janet Yellen termed the idea of balance sheet reduction as \u201cpaint drying\u201d where securities that matured weren\u2019t replaced, specifically no asset sales, as they would just roll off at maturity. To note, there actually was about $200bn in agency MBS sold off the Treasuries balance sheet (product of QE0 in \u201908) in early \u201911 \u2013 with no problem. So – it has (quietly) been done!<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n So why haven\u2019t asset sales been a more popular tool versus rates hikes as a mechanism to tighten policy? The answer gets a little complicated. Banks make free money on excess reserves and the higher front end rates go, the more money they make. For example, in \u201915, before liftoff there were $2 trillion in excess reserves in the system. Every 100bps hike in the Fed Fund\u2019s rate yields about $20bn in interest income for participating banks. As a side note, prior to \u201906, it was illegal for the Fed to pay interest on reserves. Banks lobbied and banks won and in \u201908 it become status quo for banks to get paid for their reserves (never let a good crisis go to waste?). Simply, monetary incentives drive the bank\u2019s plea for more rate hikes and less asset sales (if you think a little deeper, banks own many of the same FI instruments the Fed does and in turn would be selling \u2013 less buyers and more sellers probably leads to lower prices).\u00a0<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n Today, there are about $4 trillion in excess reserves (quick math 1% Fed funds rate = $40bn CASH MONEY) which makes banks profitability highly levered to rates rising.\u00a0<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n While this is all a bit technical and nuanced, the bottom line is these numbers are astronomical and in turn likely hard to hide from the public. Between Elizabeth Warren\u2019s distaste for bankers and conservatives\u2019 views of lowering the Fed\u2019s balance sheet, we could see a rare alignment of forces when it comes to handling the current monetary debacle. <\/span>\u00a0<\/span><\/p>\n \u00a0<\/span><\/p>\n So, What is the Solution?<\/span><\/i><\/b>\u00a0<\/span><\/p>\n \u00a0<\/span><\/p>\n Right now, the market is pricing in four rate hikes in \u201922. Many view an aggressive Fed as having the potential to derail the economic recovery too quickly by over tightening financial conditions. We believe this is the reason we\u2019ve seen a flatter yield curve. In addition, while current inflation is high, assuming as goods inflation slows and supply chain issues recover, it\u2019s reasonable to assume inflation slows substantially by the end of year. With that in mind, are four rate hikes, too much (I.e., hiking into slowing growth and inflation)?!\u00a0 We think there COULD be another, more amicable solution.\u00a0<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n If the goal is to remove accommodation, does it matter how the accommodation gets removed? We see a potential for fewer rate hikes and more asset sales. The Fed rule of thumb is for every $100bn in asset purchases\/ sales it is equivalent to an 8bps rate cut\/ hike. Can the Fed sell enough assets to offset the need of hiking rates 3-4 times in \u201922?\u00a0\u00a0<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n Potential Recipes<\/span><\/i>: Hike 3-4x in \u201922 (Status Quo at this point); Two rates hikes and $25bn per month in sales; One hike and $50bn per month in sales. Either way, in option 2 or 3, accommodation gets removed and the balance sheet starts to shrink from its elevated level. Overall, we think this could check multiple boxes: #1 keep the curve steep (inverted curve = BAD); #2 Slow the housing market (fueled by artificially low rates); #3 Appear as hard on big banks (looks good in the eyes of us small folk). Maybe crazy man Bullard was onto something?!<\/span>\u00a0<\/span><\/p>\n \u00a0<\/span><\/p>\n So, How High can Interest Rates Go?\u00a0<\/span><\/i><\/b>\u00a0<\/span><\/p>\n <\/p>\n Source: Strategas. As of 1\/19\/22.\u00a0<\/span>\u00a0<\/span><\/p>\n We\u2019ve been getting the same question from clients the last few weeks, \u201chow high can rates go?\u201d The move in rates to start \u201922 has been eye opening. 10s started \u201922 at 1.51% and currently sit at 1.86%, a 23% increase\u2026 in 19 days. So, how much higher can they go? Well, first we will state the obvious, being a bond market bear the last 40 years plus has been a widow maker trade. BUT if we had to guess, we\u2019d look to the 2.25% – 2.50% area for a test. Since yields peaked in 1981, the average rate rally has been about 245 basis points\u2026 245bps + the 2020 low in yields (about 50bps) gets us to 2.95%. If we limited the exercise to only the rate rallies in the QE era, the average move is 175bps. Again, 175bps + the low of 50bps = 2.25% (see graphic on pg. 2).\u00a0<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n Guessing short term interest rate fluctuations is a loser\u2019s game. However, the trend for higher yields firmly remains intact and until those changes, we look for rates to keep rising. In saying that, we don\u2019t really care! With inflation printing a 7 handle and interest rates below 2%, we are steering clear as much fixed income as possible in our portfolios \u2013 and we aren\u2019t just saying that — it\u2019s TRUE!<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n There is a lot to shake out over the next couple of months moving into March, but we believe the Fed must do something. Biden said it again last night, \u201cNeed to get inflation under control\u201d. Maybe there are other alternatives to aggressively hiking rates that could be \u201cless\u201d bad for risk assets? We think a more aggressive, well communicated balance sheet reduction could be it. Time will tell. <\/span>\u00a0<\/span><\/p>\n \u00a0<\/span><\/p>\n Disclosures<\/span><\/b>\u00a0<\/span><\/p>\n \u00a0<\/span><\/p>\n Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward looking statements cannot be guaranteed.<\/span><\/i>\u00a0<\/span>\u00a0<\/span><\/p>\n The S&P 500 Index is the Standard & Poor’s Composite Index and is widely regarded as a single gauge of large cap U.S. equities. It is market cap weighted and includes 500 leading companies, capturing approximately 80% coverage of available market capitalization.<\/span><\/i>\u00a0<\/span><\/p>\n This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.<\/span><\/i>\u00a0<\/span>\u00a0<\/span><\/p>\n Advisory services offered through Aptus Capital Advisors, LLC, a Registered Investment Adviser registered with the Securities and Exchange Commission. Registration does not imply a certain level or skill or training. More information about the advisor, its investment strategies and objectives, is included in the firm\u2019s Form ADV Part 2, which can be obtained, at no charge, by calling (251) 517-7198. Aptus Capital Advisors, LLC is headquartered in Fairhope, Alabama. ACA-2201-21.<\/span><\/i>\u00a0<\/span><\/p>\n","protected":false},"excerpt":{"rendered":" Source: Bloomberg LP. As of 1\/19\/22.\u00a0\u00a0 \u00a0 Markets have started off on a rough note to begin 2022. The fear of a reduction in market accommodation as the Fed pulls support and (likely) hikes rates has spooked markets. In response to rising rates, persistent inflation and a less friendly Fed, stocks have traded lower.\u00a0\u00a0\u00a0\u00a0 […]<\/p>\n","protected":false},"author":14,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_et_pb_use_builder":"","_et_pb_old_content":"","_et_gb_content_width":"","content-type":"","inline_featured_image":false,"footnotes":""},"categories":[20,130],"tags":[57],"class_list":["post-231115","post","type-post","status-publish","format-standard","hentry","category-blog","category-macro-updates","tag-fed"],"yoast_head":"\n![\"\"](\"https:\/\/aptuscapitaladvisors.com\/wp-content\/uploads\/2022\/01\/Biden-poll.png\")
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