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Will The Real Market Interest Rate Please Step Forward!

Episode 2

Will The Real Market Interest Rate Please Step Forward!

Posted January 10, 2022
Steve Sosnick
Interactive Brokers

Welcome back to Trader’s Insight Radio! Andrew Wilkinson, Director of Trading Education at IBKR and Steve Sosnick, Chief Strategist at IBKR discuss the upcoming year and what investors should look for.

Transcript – Traders’ Insight Radio Ep. 2: Will The Real Market Interest Rate Please Step Forward


Welcome to another podcast here at Interactive Brokers Radio I’m Andrew Wilkinson and here with me in the studio is our chief strategist, Steve Sosnick. Welcome to you, Steve. How are you?


I’m great, thanks Andrew. How about yourself?


Doing alright, thank you. So as we kick off a new year, Steve, I know that you keep a close eye on what investment houses and economists predict will happen. And it’s that time of the year when those projections are published. What are your thoughts on volatility as far as risk assets are concerned for 2022?


Well, I mean, that’s a there’s a lot to unpack. First of all, for better or worse, we do not do price targets here. It’s part of our firmwide reticence to do any recommendations, and so you won’t get an absolute price target out of me. Uhm, so that’s not unfortunate. Just the way we do it.

When I look at what other analysts are saying. Uhm, the bias is definitely toward the upside. I think a lot of the strategists had been burnt over the last couple of years by the markets reacting far better than they were leaning to, so now the average estimate continues to be sort of up about somewhere between 5 and 10% is, I think the lowest on the street is 4400 for S&P, where we’re at 46 42.

I find it difficult to believe that we will just sort of march on double digits higher when we don’t have the fiscal and monetary backdrop that we’ve been seeing over the past 19 months or so 20 months or so. Since last March, and that’s, I think, going to be a big difference, and I’m not sure that markets really fully appreciate that.

I think they’re sort of on autopilot having seen markets go higher with a relatively light volatile. I expect more.


So, but how does your thinking align with Wall Street forecasters? Are you as enthusiastic as they are?


No, I’m not because I can’t see how we enter an environment where the Fed has told us already and they have already started to reduce the amount of monetary accommodation that they’re doing, and they pretty much telegraphed that some sort of tightening cycle is about to begin. That is vastly different than what we’ve been experiencing.

As a result, I think you’ve had very ebullient if not frothy markets and the reason I see more volatility coming is there will be times where the market just, sort of hit some air pockets.

I think it’s become increasingly easy to buy the dip. I think the half lives of dips that are being bought have been shortening and as a result I think it’s not unreasonable to expect that we’re going to not necessarily not necessarily March higher in a straight line. We’re going to be backing and filling at various points.

Uhm, you know it’s rather unusual that we haven’t seen a real correction in the S&P 500 in in almost two years. You know, since March of 2020. So what’s at seven quarters? That’s a long time.

I don’t think it’s realistic to just assume that because it’s worked this way under extraordinary circumstances that it will continue to do so as the circumstances change and become less favorable.


You know, I’ve never seen a tightening cycle like this before. It was pretty well telegraphed in the fourth quarter of 2021 and the market or investors pretty much priced something in and you could almost take it from there that that’s it. It’s it’s done. And the Fed hasn’t even started acting, so it’s one of the weirdest things that I’ve ever witnessed following interest rates.

So, as you say, the stage has been set by the Federal Reserve for increasing rates, which means it’s going to take a less accommodative stance.

Can you talk about? The risks to investors of a tightening cycle.


Yeah, well first of all it’s interesting because I believe that a third of new accounts have joined the marketplace in the last, you know 21 months or so since the Fed began at cycles and stimulus began. They haven’t seen anything other than a Federal Reserve that has the accelerator pressed to the floor.

Go beyond that and you have a generation of investors who came into the markets sometime after 2009 where essentially, we’ve been in cycles, a monetary easing cycle, or at least very easy monetary policy. There’s been a couple of attempts where the Feds tried to raise rates. There have been a couple of attempts where they’ve tried to even taper the bond purchases for a while. That caused some problems.

Markets don’t like it. Markets like more money. What we’ve kind of failed to realize is, as you create more money, you’re typically creating inflation somewhere. For the last 14 years or so.

Probably that’s too many. Call it 12 years or so. We’ve created a tremendous amount of asset price inflation. We have not seen a lot of real-world inflation until this year. Part of the reason for that was globalization was sort of a deflationary factor. So Labor was getting cheaper, shipping goods was getting cheaper and sourcing was getting cheaper.

All these all these factors were mitigating real world prices, but the money that was being created created boosted asset prices, which is why you’ve had, you know, with a few exceptions, more or less, an uninterrupted bull run in a wide range of asset prices.

What happens when money starts to get tighter is the cracks in the system start to show and in general, you know I don’t think we’re going to get into like a real, you know Volcker late 70s early 80s type of monetary tightening. I think that that’s unreasonable to expect that, but it’s more of the variety of the Warren Buffett. “You don’t know swimming naked until the tide goes out.”

I think that’s the environment that we’re going to get into, and that’s why I think I see a bit it more volatility on the horizon. Because it’s more of a matter of where are things mispriced?

Where are things extended? And then how do we work around that. And that’s where you’re going to get the hiccups, the air pockets. Remember also that tightening cycles is pretty much what would put an end to the 1999 two thousand Internet bubble. A tightening cycle is more or less what put an end to the mortgage craziness of 2007, 2008.

And what happened was assets that were mispriced, that were that had some over enthusiastic prices, got repriced and to the extent that there’s leverage surrounding them, it makes it that much worse, which was the case in 2007, 2008. But even in the Internet era, the tide went out and so did a lot of the prices that had gotten way ahead of themselves.


And there are interest rates and then there are bond yields. Would you say that the bond market is sending an accurate message about the US economy at that moment?


I do not actually, and I think it’s more again a factor of the amount of money sloshing around than anything else.

We wrote about this recently. How you have two year note yields? Sort of, you know, in the 60 to 65 basis point range depending on where we are at any given moment.

On the flip side, the Fed is telling us that they’re going to do six 25 basis point hikes over the coming two year period. Well, that’s a percent and a half.

Now let’s be the way it works is, it doesn’t mean you traded a percent and a half right now, because it moves higher. If you want to think about this, ’cause this was literally the first thing I did in the financial markets was writing programs to separate out short term interest. Rates if you think about it as what’s the three month rate now? What’s the three month rate in three months? What’s the three month rate in six months, et cetera. Et cetera. And you pile them all together.


The decompounding the yield curve right?


Yeah, so effectively we would be talking about the average, you know it. It’s not exactly arithmetic, but let’s just say we would talk about the average of where interest rates would be over the two year period and so you still come up with something greater than .6. You know, as I look at where the dots are. You’re probably leaning more toward a rate that should be, you know, 3/4 or even a full percent something of that nature. And you know, or if markets were really panicky, they would be closer to 1 1/2.

But what’s going on now is we have so much money sloshing around. I didn’t look at today’s numbers, but yesterday’s number. Was a was a record high at reverse repo at the at the New York Fed and that broke the record from the day before.

We were up about 1.7 trillion dollars, with a T, On overnight repos. And the point of the overnight repos is that’s the way for the Fed to sort of sop up excess reserves and a way for the Fed to essentially prevent interest rates from going negative.

And what that’s doing is basically there’s $1.7 trillion showing up at the Fed every day. They pay 5 basis points annualized. So effectively nothing, and this money has nothing better to do than to show up in the Fed looking for these five basis points.

Until you start to work through that, and by the way, it’s probably likely to go up into the end of the year. Because these numbers tend to reverse repo activity tends to peak at the quarter end and especially year end as banks try to mitigate their books a bit. So the Fed being the home of last resort for this kind of money.

So you’ll see spikes in there. It wouldn’t surprise me in the least if we saw this continue to go up to almost 2 trillion. Until you start to work through that, the money is going to look for a home and two year notes are going to be one of those homes.

And it’s distorting the whole yield curve. I think it’ll be interesting as the Fed stops buying bonds at the back because that’s distorting the yield curve too. Knowing that there’s a buyer still, they’re still buying $90 billion a month. You know soon to be 60, soon to be 30. But that’s a lot of bonds, and these are big distortive effects.

So, even as the Fed is telling us that they’re reducing accommodation, they’re still being quite accommodative. We still have 0 interest rates, and we still have a Fed that’s buying billions in bonds every month. Until you work through that the yield curve is going to be distorted, the message of the bond market is going to be distorted. As a result equities which tend to look to the bond market for cues are also going to be a bit distorted. I know that sounds like a horribly vicious cycle, but that’s kind of what we’re looking at.


Will the real market interest rate, please step forward. So high tide people are already nervous about inflation getting into the economy, which is why the Feds going to become less accommodative. So, we traditionally hear at times like this about gold being the best hedge.

But now there are many other cryptocurrencies to consider alongside gold. Is there in that sense, a best hedge against inflation? Or is it neither crypto nor gold?


I think it’s neither unfortunately. Gold is funny and we’ve written about this previously. There are times where gold acts like an inflation hedge. There are other times where gold acts like the anti-dollar.

You can think of it as a store of value, and as the dollar appreciates it, you know the price of gold deteriorates and vice versa. Crypto – now if you want to talk about completely decorrelating assets, from a U.S. dollar holder point of view I don’t think so. I think they are both tied in with what’s going on in the US dollar. I asked the following thought question like: Would crypto be where it is right now? Would NFTs be what they are right now if we weren’t looking at negative real interest rates or even you know 0 interest rates.

If there was a risk free rate of return that paid you something, I pretty much would assure you that a lot of the most speculative asset, most speculative assets would have appreciated a lot less than they did That’s something to be working through. I don’t think crypto is a great hedge for anything that trades in dollars because it’s too volatile.

You know the average daily volatility is about 4% a day in Bitcoin and higher and a lot of others cryptos. Uhm, what are you hedging that is that volatile?

Nothing other than other cryptos, you know, things that you’d trade one versus the other. It’s not a hedge for anything real world when you’re talking about something with such high volatility.

Now, If I lived in Turkey and I own gold or I own cryptocurrency I’d be I’d be breathing a lot easier this week than I would have been.

Now obviously what happened in the in the Lira on Monday was staggering. You know, Monday, the 20th of December was unbelievable. The deterioration and then the turn around on a dime that wiped out two weeks of losses. So, the Lira rapidly strengthened.

But bottom line would be, if you live in a country that has to borrow or that does borrow in a currency other than its own, that has debts to pay in U.S. dollars or euros, or something like that then… yes, gold crypto, whatever, is probably a pretty good hedge because you’ve got an asset that trades in dollars elsewhere.

In terms of if you’re a US or another developed market investor, I don’t think Gold is a great hedge. I don’t think crypto is a hedge of anything.

I think it’s a more nuanced strategy. I think you want to find stocks in companies that have earnings power that can grow earnings in inflationary times that can pass on those costs to customers. Then you start to look at other real assets, but there’s no one real asset, whether it’s real estate or whether it’s other commodities that you know that is an end all be all against inflation.


So let’s sort of cat amongst the pigeons to finish with. Do you do you have an out of consensus call for 2022 Steve?


I think I’m out of the consensus and not being in not being wildly bullish. I think that’s my one situation. I think the other real added consensus thing, or at least or at least big hiccup or volatility creating event is the 2022 elections in November are going to be interesting.

I’m going to refrain from a political viewpoint. First of all, I’m not paid to do that, and secondly, I think we’re too far out to have a lot of clarity.

I think that’s an event that can be a real volatility inducer as we get closer to it and as we see the potential for changing control in Congress. Or if a lot or some of the 2020 shenanigans start to return in 2022.

I think that’s something to really keep an eye on, and that’s what we call a known unknown. We all know that something is going. We all know that there’s an election in November of 2022, how it turns out is anybody’s guess right now.


I can’t remember the last down year for equities, Steve, can you?


While it’s been awhile, I you know. I don’t know that I’m outright terribly bearish.

But the problem is it’s where you end the year. But I think my call would be at some point this year we’re down on the year. And whether or not we close there or not, we’ll see what happens.


That’s it for this episode from Interactive Brokers Radio you can get Steve Sosnick regular market commentary sent directly to your inbox at TradersInsight.News. And don’t forget to subscribe to our channel wherever you sign up for your podcasts. And don’t forget to check out that market commentary. Steve, thanks for joining me today.


Thank you Andrew. Pleasure as always.


All right, we’ll speak to you on the other side.

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