The Fed Trap

We are in an era of fiscal dominance.  You wouldn't know it by how much market observers are obsessed about the Fed.  Lots of talk about the next Fed chair, with Kevin Hassett being the big favorite, but Trump trying to act like he hasn't decided and mentioned Kevin Warsh as the other possibility on Friday.  The excitement over the latest FOMC meeting, where investors were expecting a hawkish cut, but it didn't turn out to be as hawkish as they expected.  It wasn't jumbo shrimp this time.  

People are still following the monetary policy playbook from the 1970s to the 2010s.  This is a different era of monetary policy.  Back then, private debt was the dominant driver of the economy.  Bank lending was the primary source of liquidity.  Now bank lending has taken a back seat to the federal government, which is now the driver.  

What we saw on Wednesday, Thursday, and Friday after the FOMC meeting will be repeated many times over the next couple of years.  You get a rally on optimism that the Fed is riding to the rescue, being dovish, and then a letdown when reality takes over.  Fiscal dominance means fiscal policy drives economic growth, not monetary policy.  The US public debt to GDP ratio is around 120%.  Back as recently as 2007, it was around 60%.  So the debt to GDP ratio has doubled in less than 20 years.  That is what happens when government spending gets out of control, when taxes are cut, instead of being raised.  Politicians don't care about deficits, because the public doesn't care.  The public loves those stimmy checks, tax cuts, child tax credits, Obamacare subsidies, Social Security and Medicare, and government pork for this and that.  Of course, the public doesn't like inflation, but they can't put two and two together.  They want the stimmies but don't want the inflation.  

When government debt dominates the bond market, lower short term rates actually can be a reduction in stimulus, as government interest payments go down, lowering the amount of interest income going out to the public.  Sure, some private borrowers tied to short end rates will have lower interest expense, but that is more than offset by private borrowers who borrow long term, which is less tied to short term interest rates and more tied to long term inflation and fiscal policy.  Loose fiscal policy keeps long end yields elevated.  That's why even after the Fed has cut rates from 5.25% to 3.50% over the past 15 months, 30 year yields have gone much higher.  At 120% of public debt to GDP, public borrowing is more important than private borrowing.  Lower interest rates reduce the fiscal deficit.  A reduction in the fiscal deficit slow downs the economy.  That's why these rallies based on the Fed being dovish will be faded as the economy weakens, despite lower and lower Fed funds rates.  

The other important events beside the FOMC was the ORCL and AVGO earnings reports.  They both sold off big after their earnings announcements, on fears of a slowdown in AI capex.  We are slowly going from AI capex being loved no matter what, to AI capex being a boondoggle money pit.  Clearly ORCL has been put in the penalty box, and the market is skeptical about all the investment that its making in AI data centers.  META is heading towards that penalty box, but not quite in just yet.  Just the fact that the market is now punishing debt financed AI capex means these hyperscalers will be more reluctant to just keep growing their capex with regards for future returns.  That ends up hurting NVDA, AVGO, and the hardware/chip companies more than the AI spenders.  

On investor positioning, without COT data, we need to rely more on prime broker data.  GS Prime broker data shows hedge funds slowly increasing their net long equity positions, now up to February levels, before the tariff panic.  

So we have hedge funds with high net equity exposure, and as we know, retail is heavily weighted towards stocks as well, being the biggest net buyers of equities, more than hedge funds and institutions.  Looking at the cumulative equity ETFs inflows for the past few years, the rate at which investors are piling in is increasing, now at a rate that is 4 times greater than in 2022.  That is what happens when investors chase performance, and get complacent.  When investors are heavily long, complacent, and valuations are high, the marekt is vulnerable to a sharp correction at anytime.  

You are starting to see that complacency show up in the options market, with the ISEE index of calls to puts opened back towards high levels.  It looks like a dovish Powell was enough to get investors very optimistic again, even as the Nasdaq lags the SPX, usually a bad sign for the market.

 

We are beginning to see signs that this rally off the November 21 low is running out of gas, with the sudden selling on Friday coming out of nowhere, with AI related stocks lagging badly, and investors going into defensive sectors.  Last week, consumper staples and health care were at the top weekly performers, with info tech at the bottom by a mile.  That's not a market that I want to be long, even if we are near year end with positive seasonal forces coming up in about a week.  

 

I think we are setting up for a good shorting opportunity at year end, with the Nasdaq lagging, with the most important segment of the market, AI, trading the weakest.  Add to that the heavy long positioning in both retail and hedge funds, and you have an environment ripe for a correction.  We should be getting the Supreme Court decision on tariffs any day now, and that could be a short term positive catalyst for stocks when Trump tariffs are deemed illegal, but it is somewhat expected (76% odds on Kalshi).  Not bearish for the next 2 weeks due to the likely delay of profit taking into January for capital gains tax purposes.  But that sets up for a weak January.  A Santa Claus rally after December triple witching opex would set up a good entry point for shorts going into January.