Macro - Why it is important, and what is my (current) mental model

tl;dr

• Macro moves slowly but decisively, creating inflection points

• Don’t fight the Fed

• My 2*2 model of macro, outlining 4 possible scenarios

• Market’s expectation vs Fed’s base case implies risk-reward is skewed to the downside in the short to medium term

We don’t speak enough about macro in digital assets. It is either under-appreciated, not understood, or there is an unsubstantiated belief that digital assets are uncorrelated to macro. At Morgan Stanley, even though we were trading or managing specific assets, we always kept a keen eye on macro events.

What is macro?

Macro or Macroeconomics is the study of the impact of various factors on economies at an aggregate level - city/state/national/global. These factors include inflation, interest rates, unemployment rate, GDP, deficit, money supply, etc.

If you are interested in price action, then macro economics is a complex web of variables that ultimately guides the liquidity in the system that is chasing assets, and how the increase or decrease in such liquidity can have an impact on prices of these assets.

Macro moves slowly but decisively, and inflection points in the economy almost always coincide with major macro policy shifts. It is therefore perhaps not necessary to track macro on a daily basis, however, it is very important, for every asset class, to keep a close eye on macro to benefit from the major shifts.

For instance, the raging rally in assets post covid coincided with the Fed and other central banks announcing massive amounts of money printing (increasing liquidity -> more capital chasing same assets -> price rise). And the sharp sell off in assets at the turn of 2021/22 coincided with the Fed signalling its intentions to hike rates to curb inflation (decreasing liquidity -> less capital chasing same assets ->  price fall).

What is the Fed's role in macro?

Most global assets are denominated in USD. Most central banks hold large reserves of USD. Most of the global trade (legal and illegal) happens in USD. 

USD is the reserve currency of the world and the Fed controls the supply of this USD. Therefore, a substantial portion of the liquidity in the world is generated from the Fed.

Hence the adage, Don’t Fight the Fed. 

The Fed, and most central banks, are primarily concerned about 2 things - inflation and unemployment rate. In other words, how is their policy having an impact on the significant majority of the population who are impacted by these 2 factors (there is a lot of political coercion as well). To that end the Fed (or FOMC) sets the Fed Funds Rate which is an overnight rate at which banks lend or borrow their excess reserves. Most of the credit in the system prices itself off of the Fed Funds Rate and therefore higher this rate, more expensive the credit, and the more depositors should ideally receive for their savings at banks. Most other central banks also handle their monetary policy on the back of the Fed’s policy as it impacts their FX reserves, imports, exports, deficit, etc.

What is my current mental model?

*Not financial advice*

One can very easily get lost in the macro discussion as there are a lot of variables and interdependencies. However, my mental model revolves around 2 variables - inflation (Y axis) and unemployment (X axis) - the key variables that the Fed is focused upon.

I have also assumed 2 universal truths:

• Inflation target for the Fed is ~2% (this has always been the case)

• Unemployment rate increasing by 0.5%+ is a key recession indicator (The bureau that confirms ‘official’ recession in the US has a closed-source model that looks at “multiple factors” to qualify a recession. This is quite different to a ‘technical’ recession which is just two consecutive quarters of negative GDP growth)

Now, let’s address the 4 quadrants in the graph.

Quadrant III: Where the market is today

Wall Street’s thesis is as follows:

• A recession in Q2/Q3 (ie unemployment >4%, or 0.5%+ the rate today)

• Disinflationary or deflationary environment (ie inflation <=2%)

• Since inflation is under control but unemployment is not (due to a recession), the Fed will be compelled to cut rates, and potentially re-start QE

From the Fed Funds Futures we can see that the market is already anticipating a rate cut in Q3/Q4 2023. 

Quadrant IV: Where the Fed is today

The Fed’s thesis is as follows:

• We are due a soft landing (no real recession) and growth prospects look healthy

• Inflation looks to be coming under control (~2%)

• Therefore we don’t need to cut rates quickly [and potentially invite inflation again]

This implies that the yield curve will need to move up, making credit conditions tighter than Wall Street’s base case.

Interestingly, the US treasury yield curve is wider today than it was 1 month ago, but the stock markets don’t seem to have bothered much (as they are still in Quadrant III). 

Anyways, if the Fed’s thesis plays out, then it is not a bad outcome. The stock markets (and crypto) may have to adjust its expectations downwards due to a “higher for longer” interest rate narrative, but the overall economy will have a positive outlook.

Quadrant I: Stagflation 

This is currently a low probability event but one that I feel we are not out of the woods on:

• Labour market continues to be strong and we don’t get a real recession

• Inflation is sticky above 2% (say 3-4%) - China re-opening, continued conflicts, wage growth, etc are factors

• Fed is compelled to keep hiking as inflation is high but unemployment is low

This implies that yield curve will have to move up much more than where we are today (possibly 150-200 bps) which would be bearish for growth assets (tech, crypto).

Quadrant 2: Hard Landing

This is the lowest probability and one we appear to have avoided for now but prolonged stay in Quadrant I can quickly turn into Quadrant 2.

• Unemployment increases, bringing a recession

• Inflation is sticky above 2%

• Fed has to hike or keep rates too high to address inflation

This is the Quadrant I absolutely dread. Fed will mostly cut rates and QE to propel growth, but will almost certainly face inflation. It will create even more civil unrest and one that will take us closer to certain armageddon outcomes we don’t want to think about. Bitcoin will probably go to new all time highs but it may not be a pleasant world to live in…..

Any caveats?

Yes. My analysis of Quadrant III (where markets are today) may have a more prolonged life than what I anticipate due to a) Chinese re-opening and demand, b) Excess liquidity in the system given Fed’s QT hasn’t really got us anywhere back to pre-pandemic money supply yet.

Final Word

From a macro standpoint, risk appears skewed to the downside in the short to medium term, especially for growth assets.

This article has focused primarily on the US as the Fed controls the macro narrative. However, there are interesting developments across other major economies as well. Japan has hit multi-decade high inflation, EU continues to bail out the private energy sector and hasn’t hiked much yet, etc. 

I plan to revisit this article every quarter to refresh my mental model and share my thoughts.