Neil Azous of Rareview Capital explains the inevitable reality of how bond market participants price in interest rate cuts even before the Fed’s tough love for the market is done.
Note: Any performance figures mentioned in this podcast are as of the date of recording (September 1, 2022).
Summary – IBKR Podcasts Ep. 35
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.
Welcome everybody to today’s podcast. I am delighted to have back on the program again, Neil Azouss, founder and Chief Investment Officer at Rareview Capital Management, which is a registered investment advisor. Neil, welcome back. How are you?
Thank you, Andrew. Always great to be with you and Interactive Brokers.
You’re always very welcome on this channel, sir. Now, let’s just get straight into it. We talked about the Fed and all things fixed income when we talked to Neil Azous. Our last podcast aired in I think the middle of June and the FOMC had raised rates by a surprising at the time, 75 basis points. I think that lifted it to 1.75%. One of the things, Neil, you highlighted at that time was the cumulative misery within consumer confidence data. Tell us, how have things changed in the third quarter?
Thanks for bringing that word or that phrase back up, cumulative misery. So just quick background on that, the concept comes from the idea that we don’t know what’s in front of us and so it’s a combination of war, economics, the inflation, the interest rate hiking cycle. We just don’t know what that end is like and so we call it a cumulative misery. Where in past episodes, even in the financial crisis or in the pandemic, we had end results, meaning we knew when we were going to get a vaccine in the pandemic or some version of that. We knew that the Fed was there to ringfence it. Right now, we’re just kind of left out in the wilderness and that’s where that term cumulative misery comes from.
So, what’s different today on September 1st versus mid-June or near the end of June? There are several things, but overall, there’s still a level of that cumulative misery. But first off, just on a light note, it’s the summertime. People are outdoors, so on the margin they’re a little less gloomy as they forget about their worries for a while.
The second thing is gasoline prices. They’ve come down for somewhere around 70 days in a row primarily based on the Biden administration releasing the strategic petroleum reserves so that’s had the desired effect. Very interestingly as a reminder, gasoline matters. The recent consumer confidence data releases show that this is the number one impact on sentiment. It’s truly amazing how much just getting from A to B in a car still matters. So that’s a big change.
And then thirdly, and this is very important for people and relating this cumulative misery phrase back to the markets, or capital markets if you will … that at the end of July, right in the middle of our last interview here or podcast, the Federal Reserve passed quote, unquote, their so-called “neutral interest rate,” which is the equilibrium level where the economy is just trucking along. It’s not overheating and it’s not too weak. And that happened at the end of July when they raised the interest rate another 75 basis points or three-quarters of a percent and therefore what that’s really like in Fed speak terms, is the transition from the early cycle to the late cycle. So, using a sports metaphor, it’s like the halftime or the 7th inning stretch in baseball.
So there’s some semblance now that the end is closer than the beginning and that has a big impact on that term cumulative misery because we can see potentially light at the tunnel. Whereas prior to being below the neutral rate, we didn’t know when that light at the end of the tunnel could be seen.
Well, you talk about warm weather, lifting confidence, where we’re heading towards the autumn, the fall and the winter, and a big problem behind all of this has been inflation, rising energy prices and so on. You talked about the structure of inflation, that it had four drivers: energy, the supply chain, housing and wages. And you concluded that it’s likely to remain — inflation — is likely to remain somewhere between 3 and 5% for at least the medium term. Has anything improved on the inflation front that you can see now changes your sense of where that terminal fed funds rate might be?
Right. So broadly speaking, nothing has really changed in the last two months. On the micro level, as mentioned previously, the big change is gasoline prices coming down, but everything else is awash, meaning if there’s a small improvement in rental prices, that’s being offset by higher wages.
So regarding the concept of inflation being sticky for longer, those metrics are still staying at a very high level and when I think about that and how it impacts the terminal rate, which is where we think the Fed will end the interest rate hiking cycle or where the 10-year yield will be at that time. The biggest issue that I see with market agents is that they focus on the words peak inflation or the rate of change of inflation and most people can appreciate that because traditional markets, especially something trading oriented, always moves off of a peak or a trough or the rate of change something.
However, when it comes to inflation, that’s an exception to the rule. Let me give you a real-life example or a human example of that Andrew. If you weighed 200 pounds and you gained 8 1/2% of your body mass this year, you now weigh 217 pounds. That means your body mass, has increased. Now, if you were a market process agent and you said to yourself, “OK, great, we stopped gaining weight at 217 pounds.” That’s a bullish scenario, right? Or that’s less inflationary and that is true. You may have peaked out at 217 and the rate of change going from 200 to 217 has certainly slowed to almost 0. But just because you stopped gaining weight, or the pace slowed at which you’re gaining the weight, you still weigh 217 pounds, and your body mass is not shedding anything and that means over the next several years, that additional body mass will continue to weigh on your health, and that’s where we’re at now.
So yes, inflation may have peaked at a very high level, that rate of change may have slowed but the risk in the market is that people perceive that to lead into a pivot or quote, unquote “change in policy stance by the Federal Reserve.” Or that they think that’s an immediate adjustment back down to the 200-pound body weight. That’s just not how it works when it comes to inflation. So as a result, the terminal rate … while it’s up at a high level somewhere between call it 3.8 and 4% in the markets pricing or discounting mechanism, it’s likely that it could stay up there for quite some time if the Fed remains in their tight policy stance or keeps it up there. And the idea is, is that the longer they keep the rate at a higher level, or they pause after their last hike then organically if you weighed 217 pounds it’ll psychologically get entrenched into the system and we can then gradually bring it down organically back towards that 200 pounds.
That’s kind of how I see it and that’s where it’s set up. And I think after the most recent Jackson Hole Symposium, where Chairman Powell of the Federal Reserve said that we might be at a higher level for longer, the stock market started to appreciate that notion that it’s not always just about a peak in the rate of inflation peak and inflation rate or the rate of change. It’s about getting it out of the system and ensuring it’s not entrenched.
You and I normally get into a discussion about the shape of the yield curve, but this time let’s talk about how bond markets typically behave during a tightening cycle. You recently published some startling data surrounding what the journey of interest rates looks like from the moment the FOMC begins tightening policy. Just to explain to the audience Neil, what that journey looks like.
So just a quick definition so we make sure the audience understands the different terminology, there are always various terms or ways people use to describe interest rates. One is the nominal interest rate, one is the real interest rate, and one is the break-even rate.
So very simply, the nominal interest rate is the difference between the real interest rate and the break-even rate. And the break-even rate, Andrew, is the difference in the yield between inflation-protected and nominal debt. And so, the way you measure how things change during an interest rate cycle is to look at what real interest rates are doing and what break evens are doing. And at any given moment, they can go both higher, one can go higher, one can move sideways, one can go lower, one can move sideways, or both of them can move lower. And that’s how you move across the interest rate hiking cycle in this case.
So, the further out you go, and you shift regimes towards ultimately the Fed tightening and what that translates into at this moment for example, is that the real interest rate is now rising at a rapid pace and the break-even rate is now falling in a rapid pace. And the degree of the blunt force of the Fed’s hand engineering tighter financial conditions and lowering the inflation expectations in theory should have some significant market impacts for that regime and those range anything in the currency market to a universally stronger dollar which we’re seeing across the board. And the equity market, on the margin, it’s bearish for risk assets. For commodities, it’s bearish. We’ve seen crude oil come down dramatically, right? Credit spreads should widen, but maybe the total return when you bake in the yield to what you own might offset that, but in general, they tend to widen. And volatility is broadly higher as we’re seeing predominantly in fixed income currencies and in commodities at the moment.
And we’re moving down that path and so every several months as they tighten policy further from something moderately restrictive to something aggressively restrictive, those directions of real yields and break-evens tend to start to move in different ways and they weigh or benefit certain asset classes and right now we’re in a regime where this is what we call the breaking point. So sometime over the next several months, the Fed’s strong blunt force instrument of raising interest rates should lead to real yields rising to a point that is extremely restrictive from a financial conditions index. And then their goal, which has been the goal really since March is to engineer the inflation rate down or the inflation expectations down and they’re winning at that battle right now.
Why do bond investors start pricing in rate cuts when the Fed’s still tightening? That’s a question that kind of gripped me when I was trading interest rates 20 years ago and how the curve moves shape before the action is over, explain that now.
It’s a fair question, one that can be looked at two ways. One is intellectually or how we would describe it subjectively or qualitatively and then the second door or version would be something quantitatively and I’ll just touch on both.
In my opinion, something that’s subjective would be, we’re given forecasts and we’re given forward guidance by the Fed. I might interpret a Fed speech a certain way. I might watch the economic data closely a certain way. And then ultimately financial conditions tighten until something breaks, and when it breaks, historically, the Fed tends to pivot in a reasonably short period of time. Those are just what I would view as the pedestrian reasons why the bond market begins to price in interest rate cuts this far in advance. The more what I would call “the professional portfolio approach” to the answer which is more quantitative goes something like this Andrew. It has a lot to do with thinking of big data, machine learning, knowing all the statistics. So, if I wake up today and I know that the current Fed funds rate is at 2½ % and then I told you that the Federal Reserve’s neutral rate or that equilibrium level that I referenced earlier in this discussion is around 2.4%. So, for all intents and purposes, using a blunt instrument, we’re at the Fed’s targeted neutral rate that they put out in their quarterly projections.
Now knowing that information, we can also add in a bunch of other things that we could extract if I had a machine that extracted big data pretty quickly. It will tell you that the average amount of the Fed hikes interest rates above the neutral rate is 1.21%. The extreme amount of Fed hikes historically over every cycle has gone up by 172 basis points above that. We know that based on what’s priced into the yield curve that the last interest rate hike is expected in December of this year and you can keep going down this rabbit hole and saying, “OK, well the quickest that the Fed ever cut an interest rate is 1.4 months” or “The average that they cut after the last hike is 6 1/2 months” or “The longest that they took after the last interest rate hike is 14.7 months.” And then finally you can add in one more input that just says something like this “What’s the speed at which they cut the interest rate?” In fact, historically, they cut that interest rate 2.4 times faster than the speed at which they hiked the interest rate. In this case that would be pretty magnificent given how fast we raised rates but historically the hiking cycles are over a one-to-two-year period, not a six-month period.
So, my point is, is that anybody with a machine, anybody that can extract these statistics, know all of these various variables based on quantitative probabilistic outcomes and historical precedent. And so, if you’re given that set of data in advance and I told you, what bet would you like to make? If the terminal rate that we referenced earlier was at 4% by December, would you rather bet at a casino that the interest rate is going to go to 6% first or 2% next. And when you look at how the market is positioned or the pricing of that probabilistic outcome, the market looks something like this … it’s a 7% chance they would go to 6% and there’s a 28% chance that they would go down to 2% next. So, you’ve got 4 to 1 odds that they’re going to lower the interest rate and so when somebody sees that they just say “OK. I’m going to go bet on that.” And they know the sequencing and it’s been done like this every time. It’s never different this time. And so, the professional portfolio construction is to embrace those probabilistic outcomes and those historical precedents. And because we know all of this information now which is unique to the fixed income market, you cannot get this level of transparency in other asset classes because you can recreate these scenarios via the yield curve and looking at the vast array of instruments it’s easy to say to yourself, “OK. I know when the cuts happen. I know when they start, how long they go, and how much they cut by. Let’s now go make bets along those probabilistic outcomes. “Those are the two different reasons one subjective, one quantitative.
Very good. Let’s just now compare two markets, bonds and stocks. The VIX measure of volatility is back at around the 10-year average and that’s even after we’ve kind of — Stocks have fallen following the Jackson Hole comments whereas the MOVE, the bond market version of the same index, is still relatively high. Can you shed some light on that for us now?
Sure. So real quick Andrew, I think it’s always important like I did earlier, just quick definition of both so the audience understands it, right. The VIX index is as everybody knows is a financial benchmark that’s designed to be an up-to-the-minute market estimate of expected volatility in the S&P 500. A lot of times Andrew, qualitatively, people associate fear with the VIX index, despite the fact that it’s mechanically calculated by using options quotations, right?
And then in the fixed income market, they have equivalent one of this called the MOVE Index, which is just a weighted index across the yield curve of that same implied volatility on short-term treasury options. So, a very similar mechanical regulated approach. A big question this year has been why has the two not moved in tandem. Meaning, why is the MOVE index very high and why is the VIX more contained to its normal averages? And there are lots of reasons for him, and I’ll just give you several of them so you’re getting an idea.
So just interestingly enough, now that you just asked that question. I was just pulling something up while we speak and it’s interesting. The MOVE index has now in the last week broken the streak in terms of a record period above its 200-day moving average. The last time it was this many days above it was back in 2008. The Fed has kept the market reasonably guessing whether they’re going to go from 50 basis points next or 75 basis points of a hike next or drop all the way back down to 25. And then when you think about how many Federal Reserve meetings there are between now and the end of 2023, let’s say there’s 11 meetings and you have all these different variations. I could go 25, 50 or 75 or maybe I even cut a rate. So, as you can see, when you build out that matrix, there’s hundreds of permeations of what could happen next. So, the MOVE index is realizing the volatility of what the Federal Reserve is doing, and it’s justified to stab at those levels.
On the flip side, there’s a lot of reasons of why the VIX is lower, and really what drives the VIX. So, in the big picture, historically the VIX is driven by earnings from the S&P, which then drive the S&P price up and down. In this case, earnings, despite all these headwinds that we’ve been talking about for the last six months, have actually held in reasonably well. The second quarter earnings were not as bad as anybody expected, and the outlooks were actually incrementally okay. And so that’s the first one.
The second thing is, is that the information that the equity market knows regarding the bond market, it already knows it. It knows that the next 150 basis points, or hundred [basis points] of interest rate hikes are coming between now and December, so it’s not new information. Earlier in the year that was new information. We didn’t know if we’re going to go from zero to 1%, zero to 2%, or zero to 3%. It’s no longer guessing, it knows it’s at 4%, so that’s the second reason.
The third one is, is that you know not to get into too many details, but certainly there are lots of different places or services that monitor positioning being underweight indices or benchmarks, long positioning, short positioning, prime brokerage margin balances, all those things that we see in financial media every day. And the reality is, is that the stock market is significantly underweight in its benchmark. So as a result, there’s no one that’s really reaching for protection on the stock market because exposure levels are already down, meaning if I had $1.00 and I usually buy protection, that would drive up the VIX, I don’t have to do that anymore if my exposure is now at $0.40 or $0.50 of the market. I’m willing to wear the downside because I’m not going to make any money on anything from here. I’d rather own it than sell more of it.
And then there are a few other things. So just in general, when the VIX is at 25 is vastly different than when it’s at 15. In order to stay at that level, the way the mechanics work, you have to move two plus percent a day in the stock market just to break even on that in volatility, that’s a lot. So as time goes on and we get more accustomed to the Federal Reserve interest rate hiking cycle … the market doesn’t move up or down by 2% anymore like it did in the springtime. And so that’s another reason.
And then there’s some several other minor ones that we could go into, but you get the idea. The profile is different and just because there’s volatility and other asset classes, it doesn’t necessarily need to bleed into the VIX on a linear basis. Ultimately, those fundamentals of what drive the VIX end up taking over after the initial burst higher.
Would you say, Neil, that we’re beyond the point of an inter-meeting move on rates from the Fed?
I would personally say that there’s always a chance that we wake up in mid-September and the inflation data, either the CPI economic release in mid-September, or the University of Michigan long term inflation expectations have some dramatic upside surprise that could lead to the bond market pricing in something on an intra-meeting basis. But I would just say that that’s somewhere between –I’m making it simple — I think it’s like September 12th or September 15th area. The meeting is on September 21st. The idea that they would need to react five days prior to that seems pretty aggressive to me. A more realistic scenario would be is that if the market was pricing in 75 [basis points]for September following those types of surprises, there would be some semblance in the pricing that took the probability higher saying that “hey, there’s a chance that they go to 100, they go by one full percentage point instead of just three-quarters of a percent.” That’s probably a more realistic scenario.
Also secondary, Andrew, it’s important again to recognize the juncture where we’re at, which is late cycle versus early cycle. In an early cycle when it’s just moderately aggressive, there’s a lot of scope for them to surprise on the upside, which is what they did in June in reaction to the inflation data metrics that came out. The idea that they would do that this aggressively when they’re above a neutral rate, that takes a little bit of the argument down. So, I struggle seeing that but sure there might be a non-negligible opportunity that that occurs.
Neil Azous, founder and CIO of Revenue Capital Management with us here at IBKRpodcast.com. Thank you very much for joining me today, Neil.
Andrew, thank you again for having me. I appreciate it, have a great day.
And you and to the rest of the audience. For all of your trading education needs, don’t forget to check us out at tradersacademy.online.
Thanks, everybody. Thanks, Neil. Bye for now.
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