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Three Things I Think I Think – It’s Breaking

Here are some things I think I am thinking about.

1. T-Bills at 4% are a screaming deal. Back in another life when I ran my hedge fund I was unknowingly taking advantage of the overnight equity premium phenomenon. That is, I was never exposed to daytime moves. So I was invested in an event driven equity position overnight and had no directional daytime exposure. The goal was to get pure event exposure. The strategy was magical until correlations went to 1 during the financial crisis, but the thing that I will never forget from that period was how I always held loads of cash just clipping a nice little coupon. I always had at least 50% of the portfolio in cash because the event driven moves were generally huge asymmetric position sizes so you didn’t need or want a lot of size. But back then overnight rates were 3-5% so you could just hang out in cash and earn a decent nominal yield. Well, those days are back.

This is absolutely not financial advice, but if you have cash sitting around it’s worth looking at T-Bills today. You can get a 6 month T-Bill at 3.9%. That’s phenomenal. Most of your money market or high yield options will cost you 0.1% in expense ratio and get about half of what T-Bills are earning. You can usually buy T-Bills for no commission and no cost at a discount broker like Schwab. It can be a little intimidating buying the bonds and building it out over different durations, but if you want to look into building your own custom money market fund at 4% please reach out to me and I can help you out. 1

2. Mortgage rates are going to 7%. Mortgage rates are about to jump over the 7% mark. Which is crazy because, when rates were at 5% early this year I outlined why I had become bearish on housing. At 7% the math is totally broken.

This is fairly straight forward. Disposable incomes have risen about 15% since 2019. House prices went up by 50%. And mortgage rates went from 2.75% to 7%. So your median American homeowner needed about $60,000 for a down payment on a $300,000 house and had an affordable $1400 monthly mortgage. But then prices exploded to $450,000 and now that same buyer needs $90,000 down and $3,000 a month at 7% rates. Median household income is $70,000 a year. How in the world is the median American going to spend $36,000 a year on their mortgage? And that assumes they have $90,000 sitting around. I know housing has become more valuable because of COVID and work from home, but if you’re now spending 50% of your annual income on housing then that means people will need to cut way back on other stuff.

Anyhow, I am sorry to keep sounding so bearish with every note I write this year, but the math here is broken. This housing market has to freeze with this combo of rates and prices. And I am increasingly concerned that the Federal Reserve is sitting around looking at rear view mirror price indicators like wages and unemployment while numerous real-time price indicators start to crater. I predicted in May of 2020 that they’d be late raising rates when inflation surprised them on the upside. And now I am fully convinced that they’re going to be wrong on the other side as well. Now they’ve tightened way too much and the global economy is screeching to a halt while dollar monetary policy remains restrictive.

I wouldn’t be surprised if something breaks in the financial system and they have to do an emergency rate CUT at some point in the next 6-12 months. How embarrassing would that be? I think history will look back at this period of rate management as some of the most haphazard and reckless shifting of rates. I am usually sympathetic to the Fed because I know their job is impossible and the inflation environment makes it even more impossible, but I don’t know how anyone can look at what’s going on and think that 7% mortgage rates don’t create enormous outsized negative risks. Then again, I don’t know if they care. They seem to be willing to break lots of stuff just to guarantee we don’t get a repeat of the 1970s.

3. Getting pounded. The Pound Sterling has fallen over 25% in the last 18 months. It’s a remarkable move for one of the world’s largest currencies. At one point in the last few days it was down over 10%. People are joking that the UK is now trading like an emerging market economy. But it’s really just a horrible confluence of events. You’ve got the Russian oil problem on the East. You’ve got a super restrictive Federal Reserve on the West. And then you’ve got a budget mess in your own backyard. All of this creates an inflation problem that FX and bond markets don’t like very much. And it’s hard to see it changing any time soon.

None of this is good. And the even bigger worry there is that the UK has a much messier mortgage situation because, unlike the USA, most UK mortgages are short-term adjustable rate mortgages. So there are a mountain of resets coming down the pipe. Combine that with soaring energy prices and the slowdown in the US economy suddenly starts to look pretty good.

I don’t know about all this. It’s been exhausting being bearish this year. I’d almost forgotten what it was like. But the worst part is that the Fed has communicated that they won’t back off until they’ve either caused a recession or seen meaningful increases in unemployment. Which is wild. It’s like they said the quiet part out loud. I mean, their DUAL mandate is to maintain price stability and full employment and now they’re openly admitting that they want to maintain price stability by abandoning full employment.

Anyhow, that’s enough bearishness from me. I hope things get better soon, but I am having a hard time seeing how that’s possible with such a restrictive policy stance….

1 – Disclosure – I personally own large positions in T-Bills and so does my firm.