Description

Apologies upfront for posting a macro idea on valueinvestorsclub. The past two years have unfortunately been a bit of a hostile environment for pure stockpickers and compounder bros that only focus on company fundamentals. In the following I present (for discussion) a recession hedge (for stock pickers) and an interest rate bet. There are many possible single name expressions of this, but they would all be derivative expressions of this POV.

March 2023 Fed Funds Futures are pricing in a ~2.75% Fed Funds rate. In other words, the Fed is expected to hike another 250bp within less than a year.

There are FOMC meetings scheduled for May, June, July, September, November, December 2022 and one can assume two further meetings in January and March 2023. Fed Funds futures are currently roughly assuming that the Fed goes +50bp in May, +25 in June, +25 in July, another +50 in September, +50 in November, then another +25 by Jan and March respectively. Cumulative changes of +250bp in under a year are historically very rare. We have to go back to 1988 and 1993 to find an example of such rapid rate hikes (cumulative hikes of +327bp in 4 quarters and +300bp in 5 quarters). Both hiking cycles post 2000 have been slower (11 quarters from ‘04 to ‘07 and 19 quarters from ‘14 to ‘19). 

Interest rates, by necessity have to be lower than in the 80s and 90s as debt/GDP levels have doubled from around 60 to 123% since then (the higher the debt/GDP level, the less capacity an economy has to pay high interest rates and the more it has to engage in financial repression by keeping interest rates low). Note that due to this dynamic, the Federal funds rate has been making successive lower highs). The last high was 2.5%. 

Both the media and fund managers seem to be turning increasingly concerned about a U.S. recession. Some indicators of this are the 2s10s inversion on March 31st, the sharp drop in the transportation sector ETF (IYT) and the outperformance of Utilities (XLU), Staples (XLP) and Healthcare (XLV). These are resilient sectors that fund managers tend to allocate to when they are afraid of an imminent recession. 

Overall I would say there are early signs of the potential for a recession to happen, but we are not at the point where we can see overwhelming evidence. Nevertheless I like the risk/reward of buying March 23 Fed Fund futures at 2.75% and being exposed to a slower than expected rate hike cycle and the possibility of recessionary odds increasing.

The above chart by Morgan Stanley shows that the Fed rarely increases rates into a deteriorating labor market (and never during a recession). In the past, the Fed hiked while the labor market was still improving in order to be able to decrease rates during a recession. This time, with the Fed beginning the hiking cycle with the unemployment rate sub 4% (arguably -80bp below NAIRU) the most likely outcome is that the Fed will, at some point in the next year, be forced to re-evaluate its ambitious hiking path and pause as the labor market worsens.

Trade Rationale

This trade gets you long:

• Increasing probability of a recession in 2023 

• A reversal in unemployment

• A fed policy mistake (either through excessive tightening or balance sheet runoff)

• A slower and more gentle hiking cycle (“soft landing”)

Implicitly, you are short:

• A further increase in inflation & inflation expectations

• The Fed prioritizing fighting inflation over its mandate of full employment

• An even faster than expected rate hike scenario (Powell Volcker)

Keep in mind that the last time the Fed did a +50bp rate hike was in 1994 and now we have three +50s priced in in one year along with four +25s. If the Fed indeed tries to execute such a steep rate hike path I would think that it’s more likely that we see a policy mistake or other exogenous event somewhere along the way that forces the Fed to reverse course than not. 

I would also note that two Fed governors (Waller, Harker) have come out after the March CPI print explicitly making the call that inflation has peaked. If inflation does peak here this leaves more room for the Fed to follow a hiking path more in line with the one that begun in 2015 (+250bp over 4 years).

If you are looking for a recession hedge, but don’t want to short cyclicals (financials, homebuilders, consumer discretionary, transportation), this may be a better expression of the trade. Every -25bp disappointment pays about $1,000 per contract. Go out a little further on the curve to, for example July or August 2023 and you could even capture a full reversion from 3% to 0% in Fed Funds futures (if we are in a recession at that time). 

Other expressions of the trade

As mentioned above, other expressions of the trade include shorting cyclical sectors. 

Another idea would be to go long the US 10-year or other high duration bonds, which tend to outperform in a recessionary environment. I prefer the Fed Funds expression as it seems like some marginal buyers of treasuries (China, Russia, the Fed) are pulling back. The long end of the curve seems to exhibit extremely high volatility (with the MOVE index doubling from 60-120 since 2021). If long end rates go high enough, the Fed may be forced to step back in as a buyer again but that’s a different bet.

One other expression of the trade that I do like is going further out the Fed Funds curve to July or August 2023 which implies a roughly 3% Fed Funds rate by then, so another +25bp above the March 2023 contract. I think by buying this contract, you may end up being short a soft-landing scenario (gives the Fed an extra six months, but you only gain +25bp), but you end up being even longer a recessionary scenario and gain the ability to capture a full reversion to 0 in Fed Funds. 

Right now, I prefer the March 2023 expression (as it can win both with a slower hiking cycle and a recessionary scenario) but if economic / unemployment data starts to worsen and recessionary size increase I might move into or add to July or August contracts.

Catalyst

CPI YoY slowing, unemployment picking up, GDP growth slowing