There’s a current macroeconomic debate among notable investors about whether the U.S. is headed for a debt cliff facilitated by the Federal Reserve’s hubris, a discussion especially relevant right now with tech stocks being bid up aggressively on the hope that significant rate cuts are ahead. There are some trades for investors looking to avoid a possible asset bubble and other potholes that could be ahead. But first some background. Many have been critical of the Federal Reserve since its creation at the end of 1913. Our nation’s worst recessions (most notably the Great Depression) and its worst periods of inflation have occurred since. Murray Rothbard who wrote, ” The Case Against the Fed,” described the Fed’s money creation as “legalized counterfeiting”. Nobel laureate Milton Friedman, among others blamed the Fed for causing the Great Depression with restrictive policy, a view supported by Ben Bernanke who has written prolifically on the topic and then took quite the opposite tack of the Depression-era Fed once he was chairman himself during the Great Financial Crisis with aggressive money creation via “quantitative easing” and rate cuts. This move subsequently became the central bank’s No. 1 go-to in their crisis playbook as demonstrated by Bernanke’s successor Janet Yellen, more inexplicably given the economic challenges were modest by comparison. Naturally her successor Jerome Powell, thus emboldened, and with a far bigger crisis on his hands during the Covid shutdown printed with impunity. The ‘Fed put’ The money printing by the Fed has been so profound that most investors are now familiar with the term “Fed Put,” meaning that investors in risk assets aren’t taking much risk at all. This theory posits that whenever a sign of economic weakness comes along risking whatever bubble starts to deflate, the Fed will ride to the rescue with printed money and reinflate it, whether a stock at 100 times earnings, or a 10-year Treasury bond yielding less than 2%. It would be natural for investors to wonder whether the government, propped up by mountains of debt, financed by money printing by the central bank is sustainable, and unsurprisingly many commentators have grown hoarse explaining that it isn’t. Not all the critics are carnival barkers mind you advocating gold bars and bunkers. Billionaire Howard Marks, founder of Oaktree, and the late, great Charlie Munger of Berkshire Hathaway frequently expressed critical views on the easy money policies of the Federal Reserve Bank and the significant dangers these policies pose to the US economy. Howard Marks, in his memo “Sea Change,” pointed out that these easy money policies, characterized by declining and ultra-low interest rates, have significantly influenced the economy, making it artificially easy to run businesses, leverage investments, and avoid defaults and bankruptcies. The view of both of these notable investors is that distorted monetary policy encouraged risk-taking, unwise investments, inflated asset prices, and diminishing the attractiveness of low-risk assets, driving investors towards higher-risk investments like stocks, real estate, and private equity, creating asset bubbles. Charlie Munger, quoted by Marks, summarized the situation with the phrase, “Easy money corrupts, and really easy money corrupts absolutely.” What’s interesting of course in all of this is that knowing policymakers are putting their thumb — or perhaps their foot — on the scales of the economy and grossly distorting it might encourage investors to withdraw from the markets, but that is the wrong response. If policymakers are printing money, it is an asset whose value is being consistently diluted. Steve Eisman of Neuberger Berman, notable for correctly identifying the credit crisis and betting quite profitably on it ahead of time, when asked about a looming debt cliff on CNBC’s Fast Money recently dismissed them near-term, pointing out that investment Chicken Littles have been squawking about it for 40 years, and that if they’ve been wrong about it for that long perhaps they should have some humility. I’m paraphrasing, but you get the idea. How to trade it: Avoid asset bubbles So where does that leave a confused self-directed investor stuck between the investment greats who condemn the damaging hubris of central banks and profligate politicians and the dismissal of those concerns by an investor who successfully timed one of the biggest bear markets in a century? What’s interesting is that those who describe asset bubbles and those who dismiss a debt cliff may both be correct. As investors, how do we proceed if we assume that they are? Step one is to avoid the possible asset bubbles. In the stock market, by definition, those are most likely to be the names that have seen the most outsized and rapid price appreciation. By simply moving from a cap-weighted portfolio to an equal-weighted portfolio one can significantly reduce the exposure to the big winners, relatively. If you’re looking at the S & P 500 one could buy long-dated calls in the S & P 500 equal weight ETF (RSP) as a substitute for owning the SPDR S & P 500 Trust (SPY) for example. The trade: Bought RSP Jan. ’25 $160 call for $10 Another possibility? Value stocks, which have, until recently, been quite out of favor relative to growth. Here too one might consider calls on an ETF such as the Vanguard Value ETF (VTV) as a substitute for the Technology Select Sector SPDR Fund (XLK) . The trade: Bought VTV Aug. $150 call for $6.70 Playing low rates Interest rates rose quite notably last year, the U.S. 10-year hit nearly 5% before falling back to 4%. The standard 30-year fixed mortgage rate rose even further, a function of both the rising risk-free rate and the rising spread. As many well know, investing in mortgages historically carries a very low risk of default — many are guaranteed and are of course collateralized by the real estate. Buying bonds has interest rate risk. When interest rates rise, bond prices fall. So residential mortgage-backed bonds will fall if rates rise, all else equal. They carry another risk in some circumstances, namely pre-payment risk. The lender collecting 6% might feel good about their yield if the rate on similar debt falls to 4% for example, but an opportunistic borrower may elect to refinance. This risk to the lender is known as “repayment risk”. On the other hand, holders of a portfolio of mortgages will see the duration of their portfolio grow as interest rates rise because, in a rising rate environment, prepayments will drop – folks are less likely to refinance at higher rates, and what we’re seeing is that folks are also less likely to move. They’re “locked in” by a low mortgage rate. More recently rates have started to fall again, and demand for housing and prices have been remarkably resilient. Moreover, the spread between mortgage rates and Treasuries is unusually high. This creates an interesting dynamic. Risk-free rates stay static or even rise mildly, but if the spread narrows mortgage rates could fall, a tailwind for a mortgage portfolio. If prepayments increase, because many of the existing mortgages are at lower rates, the mortgages are “below par”, so any prepayment would result in a decent short-term return. Buy a bond for $88 and have it prepaid at $100 earlier than expected or earning 6%-7% in the meantime isn’t a bad deal. Note though that RMBS and MBS more generally are NOT the same thing. Residential mortgages have a very different risk profile than MBS backed by office buildings for example, so choose accordingly. The iShares MBS ETF (MBB) is an ETF that invests in mortgages backed by government agencies, although I encourage investors to kick around in the bond market as there are much better opportunities than there have been in years. The trade: Bought MBB June $93 call for $2.60 Reasonable yields, low probability of default, and trading significantly below par have an opportunity for capital appreciation if the Fed senses trouble and chooses its favorite play once again: lowering rates. DISCLOSURES: (None) THE ABOVE CONTENT IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY . THIS CONTENT IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSITUTE FINANCIAL, INVESTMENT, TAX OR LEGAL ADVICE OR A RECOMMENDATION TO BUY ANY SECURITY OR OTHER FINANCIAL ASSET. THE CONTENT IS GENERAL IN NATURE AND DOES NOT REFLECT ANY INDIVIDUAL’S UNIQUE PERSONAL CIRCUMSTANCES. THE ABOVE CONTENT MIGHT NOT BE SUITABLE FOR YOUR PARTICULAR CIRCUMSTANCES. BEFORE MAKING ANY FINANCIAL DECISIONS, YOU SHOULD STRONGLY CONSIDER SEEKING ADVICE FROM YOUR OWN FINANCIAL OR INVESTMENT ADVISOR. Click here for the full disclaimer.
