All Eyes on the SEP at September FOMC Meeting

Neil Azous sets the landscape ahead of the September FOMC meeting. In this podcast Neil sounds a word of caution on treasuries at current levels and warns not to ignore typically bullish fourth quarter seasonals when it comes to stocks.

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Email:  nazous@rareviewcapital.com   

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Note: Any performance figures mentioned in this podcast are as of the date of recording (September 14, 2023).

Summary – IBKR Podcasts Ep. 104

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Andrew Wilkinson

Welcome to another IBKR podcast. I’m your host, Andrew Wilkinson. This week’s guest is Rareview Capital’s chief investment officer; A huge welcome, Neil Azous. How are you, Neil?

Neil Azous

I’m great. Thank you for having me. As always, Andrew, great to be here with you guys.

Andrew Wilkinson

You’re very welcome. Must mean that there’s an FOMC meeting coming up. So, how do you see things heading into next week’s Federal Reserve meeting? And what’s the market pricing now for the Federal Reserve Neil?

Neil Azous

Sure. So firstly, Andrew, the Federal Reserve is in its blackout period prior to the September 20th FOMC meeting. Following the Fed’s annual Jackson Hole Symposium in late August, the Federal Reserve Hot Dog spectrum spoke in unison. They signaled no hike for the upcoming FOMC meeting, and the market Andrew could not agree more. For example, the probability of an interest rate hike is only 3%. Historically, it’s very rare for the Fed to deviate from the market pricing when they go into that blackout period prior to the meeting. So, we view the upcoming meeting as a fait accompli. That is, something that’s already happened or been decided. And then you have to ask the question, what’s next? Well, the next probability of an interest rate hike at the November 1st meeting is down to 32%. And finally, the probability of an interest rate hike at the December 13th meeting is a paltry 7%. So, if you add up that cumulative probability, Andrew, it’s less than a 40% chance of one hike now by the end of the year in market pricing language. That’s the same thing as saying the hiking cycle is over when there’s only a one in three chance of hiking. After that, the market is pricing the first interest rate cut now between May and June of 2024. And as a reminder, historically, the Fed has cut an interest rate 6 1/2 months after the last hike. So, in this case, if July of this summer was truly the last hike, it wouldn’t be the first cut for another 10 or 11 months from now. So, that’s the very definition of higher-for-longer. The Fed has engineered the market where it wants to be, but at the same time it highlights that the asymmetry is if the Fed pulls forward, cuts from June or May of June of next year, in by three or four months to match that historical average of 6 1/2 months after the last hike.

Andrew Wilkinson

So basically, they may, they may not. I think that sums up very well that everybody believes that the top of the the hiking cycle is somewhere insight. We’ve also got the Summary of Economic Projections to be published alongside the meeting Neil. How important is that report? It’s a quarterly report. What narrative would you be looking for within what’s known as the SEP?

Neil Azous

Sure. That’s a pretty fair question, Andrew, because the market is still pricing, as I said, a one in three chance of a hike by the end of the year. So, one way to help reconcile that is through the summary of economic projections or AKA the SEP or Sep as you just referred to it, which the Fed publishes only at their quarterly FOMC meetings, so in this case, next week. And therefore, I guess I would say it takes on a higher importance than normal. My view is that the Fed will quote unquote thread a needle. I believe the likely balance is for the Fed to show no additional hikes in 2023, but less easing in 2024. IE higher for longer. And also, they could incrementally reduce their inflation forecast in those projections. And collectively, this allows for several things. Firstly, it gives the Fed time to see the impact of the lagged effects of monetary policy to the end of this year. And secondly, it does not allow the market to preempt easing and loosen financial conditions. That’s a good balance.

Andrew Wilkinson

Well, that brings me perfectly onto my question about the 10-year yield, Neil, that’s a very powerful point you made at the end there. So, we’ve seen the 10-year yield rise to about 4.35% probably the highest in this cycle. That’s not necessarily what I would expect heading into basically the end of monetary tightening. Is that what you expected? What do you make of longer-term yields at these levels?

Neil Azous

Yeah, sure. I appreciate this question more than you know Andrew as it’s critical for portfolio construction. So, therefore, just bear with me for a minute in this discussion. It’s a bit longer than some of the other questions you just asked. So, broadly speaking, the market is still trying to discover, quote unquote, the terminal rate on the 10-year U.S. Treasury or what yield level will it ultimately top out at for this cycle? And and I’m personally not pushing back on what the market is saying. And for example, we’re maintaining a maturity profile for our fixed income investments below 5-years as a result of that, and here’s why. I want you to think about this in a traditional accounting T-square format, where supply is the liability and demand is the asset. So, what are the primary supply and demand inputs currently? Well, on the supply side, as you know, we have significant U.S. Treasury supply and continued US deficit expansion. The deficit horse has left the barn. And secondly, we have further currency weakness in Japan and China and as a result of those countries being forced to defend their currencies, one thing they do is sell down their foreign fixed income holdings, including U.S. Treasuries. So, the supply profile is not great. And also on the demand side, that profile is also less than optimal currently. I mean there’s a long list, but if you if you go down it, you’ll see that overseas official investors, they’ve been focusing on buying their US paper in short term T-bills. The banks here in the United States as you know are not adding to their securities portfolios at the moment. You know from the leftover regional bank issues earlier in the year. There are some countries that are running a budget surplus all of a sudden, such as Japan and Germany, so they’re no longer trading with the surplus to be able to buy more foreign fixed income. You start to continue to go down the rabbit hole, Andrew, and it just keeps going in the same direction. So, for example, systematic strategies, they remain short and they’re signal to be short is deeply embedded. You look at discretionary macro strategies. They have no conviction. P&L is not great this year, so there’s not a lot of cushion to buy fixed income. Then the big real money asset managers, they’ve been trading from the long side all year and continue to lose money. So, they’re kind of in wait and see mode. And really the only marginal, you know buy and hold investor of duration is US households. But if you just take a smell test and and think about it in practicality or you know what’s prevailed over the last 10-years? Low interest rates: So, optically a 5% coupon sounds a lot better than a 4% coupon for a baby boomer. So, they’re a little bit hesitant to buy, right now as well. OK, this is what I meant to bear with me. Now the analysis should not be purely be qualitative or the bean counting that I just went through on that list. You should have an essential input that’s also less pedestrian and more quantitative. And that’s utilizing models, Andrew, that identify how much of a premium a 10-year Treasury should command for the length of time of that 10-year risk and they’re called term premium models. And currently the term premium models that we use show an incremental 30 to 40 basis points of further cheapening in the 10-year U.S. Treasury. I mean, put another way, you said the yield is at 4.35%, the high in the cycle, that probably belongs closer to 4.75%, and now Andrew, there are many models and you can debate the efficacy of each one, including the ones that we use or construct. But the critical take away is that most currently are skewed towards a further cheapening in the 10-year yield up to that 4.75% range. So collectively, Andrew, between that supply and demand T-square that I sketched out and these term premium models, it’s still too early to extend the maturity profile of a risk-free portfolio, as yields on the long end are still headed higher, albeit incrementally.

Andrew Wilkinson

Neil, can I ask you what keeps you awake at night these days from an economic perspective?

Neil Azous

There’s not one data point or segment of economics that keep me awake at night Andrew. However, like most other citizens of this land right now, I’m concerned that the deficit horse has left the barn and it’s never coming back, and it doesn’t really matter whether a Democrat or a Republican is in charge. They’re just going to spend and they’re going to spend big. And the worst part, Andrew, about that risk profile is that the Federal Reserve becomes less relevant in shaping policy and will be forced into a long-term defensive posture regarding defending interest rates, meaning when you combine the executive branch of the government with both bodies, we now have over 500 people with very little business or economics experience setting policy instead. The Fed not being able to solve for that I think will be at a critical theme over the next decade or so. And it might put us in this rolling environment of having to defend inflation versus interest rates you know, every two to four years. It’s just a completely different profile. So that keeps me up at night as to who is in charge of that profile.

Andrew Wilkinson

But you’re still getting a lot of sleep! And finally, Neil, do you want to tip your hat on the outlook for the stock market for the remainder of 2023?

Neil Azous

Of course Andrew. I’m always happy to share with you what our crystal ball is saying. So firstly, a caveat, I have no idea what happens between now and the end of the third quarter or over the next one to three weeks. But here are my current inputs that lead me to be pretty constructive or bullish on equities into the end of the year. As I sketched out earlier in this conversation. The Fed hiking cycle is likely over. That’s important. #2 economically, we’re still benefiting from what I call the trampoline landing or the stimuli that rarely gets mentioned or included in market analysis, despite the fact that the fiscal support is over $1 trillion currently amongst a number of programs. Thirdly, I still believe that the overriding economic theme is still in disinflation, and as inflation falls into the 2 to 3% range over the next several months, historically the stock market’s multiple typically expands two to four turns when it transitions down from a 3 to 4% inflation range. So, I’m not sure why this time would be different, especially as it coincides with the last quarter of the year, which brings me to the next supporting data point, which is Q4 seasonals. I learned a long time ago to not cloud the issues Andrew with the facts and the facts are that the Q4 seasonal period is typically bullish regardless of what the underlying disease of the month club is or other negative data points. So, that combination is meaningful to me. And finally, I look at a lot of different metrics here, and one that we construct is our own composite of volatility across stocks, bonds, foreign exchange and crude oil and that composite has now fallen in the last several weeks, well below its long-term average. You know that total combination just keeps me constructive or bullish or certainly very open-minded Andrew about that typical fourth quarter rally that mystifies people.

Andrew Wilkinson

My guest today has been Neil Azous, CIO and founder at Rareview Macro. Thank you very much, Neil!

Neil Azous

My pleasure. Thank you. Andrew, talk to you guys soon.

Andrew Wilkinson

OK. Thank you very much, folks. Don’t forget, listen out for more from us at IBKRpodcasts.com. And don’t forget, wherever you download your podcasts, please do leave us a review. Bye for now everybody.