The Fed’s Next Move: Unpacking Economic Projections with Rareview Capital

Join Andrew Wilkinson and Neil Azous, CIO of Rareview Capital, as they dissect the latest economic shifts ahead of the FOMC meeting. From anticipated interest rate cuts to global market reactions, they explore key insights on inflation, unemployment, and market dynamics. Tune in for expert analysis and actionable strategies for investors navigating today’s complex financial landscape.

Summary – IBKR Podcasts Ep. 192

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Andrew Wilkinson 

Welcome to this week’s economic podcast from Interactive Brokers. My name is Andrew Wilkinson and I am joined as ever ahead of the FOMC meeting by CIO and founder at Rareview Capital, Neil Azouz. 

Welcome Neil, how are you? 

Neil Azous 

I’m good. Thank you for having me, Andrew. Always great to be here with you. 

Andrew Wilkinson 

We’re recording this a couple of days in advance of the September 17-18 meeting and it’s widely anticipated that the Fed will begin the long-anticipated series of interest rate reductions. Neil, can you frame for us why the pendulum has moved to where it is and what’s the market telling us now? 

Neil Azous 

Sure, Andrew. All right, I’ll just touch on the three major components of the meeting and what the market’s saying. So first, the interest rate, second, the summary of economic projections also known as the SEP or the SEP, and then finally one, one brief comment QT. So regarding the interest rate, Andrew, the market’s pricing in I believe 10 interest rate cuts. 

of a quarter % each at each meeting between now and the fall of 2025. So said differently the market’s pricing in around two and a half % of cuts from that current Fed effective rate of 5.33 down to around 2.9% over the next year or so. And now Andrew, I guess to answer your question, how do you think about that path in a prison? 

And to me, it’s about the pace of cuts driven by the degree of weakness in employment. Whereas the absolute level of where the Federal Reserve will end that cutting cycle is more predicated on inflation. So currently, Andrew, the market’s saying that the risk of the Fed cutting a small amount is significantly less than cutting a large amount due to the uptick in unemployment and the downtick in inflation. 

So here at Rareview Capital, we don’t really deal in absolute forecasts, but we are very mindful that the risk factor is heavily skewed towards a higher unemployment rate. Let me just give you an example of what I mean by that. So I think soup to nuts after the recent 0. 9 % gain in the unemployment rate. 

The historical hit rate on that metric continuing higher is 100% over the last 75 years. So it’s hard to argue against something that has a 100% efficacy rate.  

So why does that matter for the path of rates over the next year or so? Because historically the Fed cuts the interest rate around 2.4x faster than they hike it. Secondly, they have actually never cut slower than they hiked it. which is usually due to being in response of a financial accident that they created.  

And then finally, you just have to be mindful that in the recent hiking cycle, they did increase interest rates by .75% four times in a row. 

And so who’s to say that they couldn’t do the opposite of that? 

So Andrew the market’s pricing the Fed to get back to its neutral rate or the level that the economy is running too hot or cold by December 2025 or fifteen months from now. While that seems fast, it’s pretty much in line with past cycles. 

And just to be blunt or frank about it, that’s just how the process works. It’s not really rocket science. So just moving on, Andrew, to the second major component of the meeting. They call it the Summary of Economic Projections or the SEP. As a reminder those projections are updated quarterly. 

So the last update we got was in June. And back then, the Fed raised its inflation forecast by just 0.2 % for this year and 0.1 % next year. And that was a mechanical shift to reduce the median amount of cuts expected this year, down from 75 to 25 basis points. 

And then a total through next year to 125 basis points of cut from 150. Since that time, inflation has trended lower, and unemployment has trended higher. This time around, the Fed’s going to backtrack to where they were last spring. Indicating a minimum of probably 75 basis points of cuts for the remainder of this year and somewhere between 75 basis points of cuts in 2025. 

Another way to say that, Andrew, is they’re just going to mark to market their forecast closer to what the market is pricing and that should be no surprise because in a hiking cycle the Fed forces the market’s hand, And in the cutting cycle, the market forces the Fed’s hand. And that’s what’s happening here. 

And then just one brief comment, Andrew, to conclude on quantitative tightening. As a reminder, the pace of the balance sheet reduction was downshifted at that May FOMC meeting just a few months ago. So we wouldn’t be surprised if the Fed reduced QT further at next week’s meeting. For no other reason that there’s been enough time since their last down shift. 

And if so, on the margin, we just look at that as being incrementally negative for the U. S. dollar, incrementally positive for U. S. treasuries, and I suppose it’s good for U. S. bank stocks as less liquidity is drained from the system. That’s the backdrop for the Federal Reserve meeting, Andrew. 

Andrew Wilkinson 

Very good. Neil, we’ll come back to curve disinversion into fixed income in a moment, but while you’re here I want to get your take on very recent events.  

What do you make of things like the yen carry trade unwind that so ungraciously slapped the Japanese stock market? And by development, the rest of the world’s stock markets? 

Neil Azous 

My view, Andrew, is to look at the forest for the trees and not get fixated on one tree, such as the yen carry trade. For example, it’s not just the yen carry trade unwind. There was an index versus single stock dispersion trade unwind globally. The VIX, as you remember, rose from around 15 to 65 in a record speed. 

The NASDAQ versus the Russell 2000 saw a double-digit performance rotation. And then, of course, the two major ones most recently, the U. S. Treasury yield curve turned positive after being inverted. for listening. And finally, I think a really important one for portfolio construction, the stock bond correlation flip back to negative on a rolling basis for the first time in a couple of years. 

I think the key point overall, Andrew, is that risk events tend to cluster. And when they have these five to seven standard deviation moves, like we’ve seen over the last six weeks in key market relationships, it signals that the forest has spoken, not one tree like the Japanese yen, And the forest is basically saying that the Fed is too tight. 

They’re behind the curve and they need to cut interest rates. That’s my take on it. 

Andrew Wilkinson 

Very good. Let’s get back to the curve disinversion you just referenced a moment ago. It’s about time, isn’t it? What do you make of that? This is, for the audience,  we typically talk about the 2s 10s yield curve. It’s been negative for such a long time, two, three years now. And it finally poked its head back into a normal, positive shape curve. do you think, Neil? 

Neil Azous 

Yeah, that’s right. So I’ll go with what you just said. I’ll reference the two year, 10 year U.S. treasury yield curve is the most generic representation. And the first thing I know, is the degree of the starting point that you just highlighted. The yield curve was the most inverted ever during this recent interest rate hiking cycles. 

That’s noteworthy in itself.  

The second noteworthy observation is that it was the longest yield curve version in his inversion in history. I think it’s lasted exactly around 800 days and it inverted on July 1^st, 2022, so that’s a pretty dang long time to remain in that setting. 

Therefore, I guess my starting point is I’m pretty open minded about what could come next, how fast whatever comes next could come, and at what magnitude. And here’s what I mean by that.  

It’s not really when the yield curve inverts like it did 2 plus years ago that a recession follows. 

It’s when it disinverts that a recession is forthcoming. It’s just a question of when, how deep, if you really believe in the yield curve being a key indicator.  

So for example, Andrew, I think if you look back at 15 or so yield disinversions, going back to the 1960s or maybe 1962 specifically, the median time to a recession after the yield curve disinverts is around seven months. 

So we have some time. And to be fair, since we have 15 of these examples or disinversions, there are several instances where the economy was already in a recession when it disinverted, or it took as little as four months, or really as long as almost four years. I think it was like 47 months if I remember correctly. 

There’s a wide sampling, but my view is that you should be on alert for a recession in the intermediate term if you respect this indicator. And that you should be mindful that the major macro relationships can be affected or impacted by that such as growth versus value or equal versus market cap weighted or large versus small cap relationships like that. 

You need to pay attention to for structural changes 

Andrew Wilkinson 

So given that the Federal Reserve is about to make the first cut in years, from perspective of a bond buyer, are you missing performance if you buy now? 

Neil Azous

That’s a pretty fair question Andrew because bond yields, I believe, have come down anywhere between 1.2 and 1.4 %, depending on the maturity over the summer.  

So a lot of performance has already been generated. This is how we think about that question here at Rareview Capital or how we construct portfolios thinking about that. 

So we just break the event into three phases or the interest rate cutting cycle into three phases and the % of that U. S. Treasury yield change during each phase, Andrew, is very different. 

In the first phase, which is, from the last hike, so July 25th, 2023, to the first cut being next week. 

About 30% of the excess return in U. S. Treasuries, over the entire interest rate cycle, happens between that last hike and the first cut. We just had that. Theoretically, if you remained in cash or cash like instruments, you missed the first 30% of the move or that entire phase one. 

But don’t be deterred. Looking forward, you have the second phase, which is next week or the first cut, down to the neutral rate, right? That equilibrium rate of the economy not too hot or too cold. And in this instance, or this phase, you get like a small portion of the return, around 9% or so. 

That’s predominantly the coupon and a little bit of excess return, but it’s incremental at best. You’re sitting around earning your carry.  

And then finally in that third phase is the neutral rate to the last cut. This is where most of the return happens around 60, 61%, is after the Fed cuts rates down to the neutral policy rate. 

It’s not a great thing that you missed the first phase and now you’re in this phase two where you’re clipping your coupon, getting an incremental excess return for the unknown period, but you want to own intermediate term paper, Andrew. Call it somewhere between three and 10 years of maturity and collect that coupon now and be set up or ready for very high excess returns potentially in phase three as the Fed cuts down to the neutral rate or goes below it. 

Andrew Wilkinson 

So let’s turn our attention to the stock market now, Neil. What do you think might be the most underappreciated feature of the stock market today? 

Neil Azous 

Yeah, that’s easy Andrew. I label it “crash up risk”.  

While everyone’s always sensitive to market corrections or a potential crash, I truly believe they underappreciate how fast the markets are recovering, after garden variety sell offs such what happened in early august and what is happening currently Let me just give you two examples recently that, to me, are eye popping, Andrew. 

Get this, on average the NASDAQ 100 takes about 32 days to rally 10% after being technically in correction territory. In early August, it took 8 days, which was the fastest 10% recovery ever given those parameters.  

And then secondly, I think everybody with astonishment watched how fast the VIX spiked from the mid-teens all the way up to 65 in record fashion, right? 

And this is another insane stat. Historically, once the VIX goes above 35, it takes around 170 days or call it six months to fall back below its median, which is around 17, 17.5. This time, Andrew, it only took seven days.  

So I believe, Andrew, this “crash up risk” is a direct result of the amount of call option overwrite or buffered ETF strategies that have launched in the marketplace in the last 18 months. 

It’s pretty saturated. And there are tens of billions of dollars of short stock hedges, now 5, 10, 15 % above the market, that once the index blows through those barriers, buying begets buying, and it happens in a vacuum so fast. 

And what this really means, Andrew, bringing it back down to earth, is that for investors, time in the market is more important than timing the market. 

Meaning investors can’t afford to gain that exercise and miss those top ten updates of the year, right? Or their total return is diminished by roughly half. And then for traders, I’m just going to be brutally frank because I’ve traded with the best of them. Good luck, Andrew, handicapping that type of violent whipsaw price action in a short period without twisting yourself into a pretzel. 

Andrew Wilkinson 

Neil, in the last couple of days, we’ve had the first debate between Vice President Harris and former President Trump.  

Where are the pressure points on stocks, bonds, from the election, if any, from your perspective? 

Neil Azous 

I knew you were going to ask about the election, Andrew. I know you couldn’t resist. And so I’m going to keep these comments specific to the markets. No personal opinions here. For me, it’s as an investor or portfolio constructor, it’s too early to know for sure who’s going to be the next president, what their policies would be, and to what extent either would undo current policy programs, based on the makeup of the House and the Senate.  

Also, I would very much note the starting point for either candidate is very different than where it was in 2020 or 2016 regarding the deficit, the annual budget and the level of where the stock market is and where interest rates are starting in this cutting cycle. 

So I think, Andrew, another way to think about it is focus on one big thing. And for me, that big thing is to watch fiscal policy, which to me is now the dominant structural driver.  

So If people aren’t familiar with this, the U. S. is running a deficit, I think around six to 7% of GDP. That figure has only been exceeded in three previous occasions. 

One was during the pandemic when we unleashed massive amounts of stimulus. Two, back in ‘08 and ‘09 during the global financial crisis.  

And then way before I was born in World War II. So personally, I want to know if government spending will be higher than that, call it 5% of GDP. We’ll stay at that 6 or 7 % deficit level, like it was the last several years. 

If so, that keeps the spending engine running. And if you think about that big picture, Andrew, it really doesn’t matter who wins the presidency. The deficit horse left the barn. It ain’t ever coming back. And that’s how I think about it. Otherwise, Andrew, I guess if you had to narrow it down on a candidate-by-candidate basis, I think if former President Trump wins, I’m pretty interested to see how his tax cuts get extended given this new deficit profile. 

Remember, as a reminder, they’re supposed to sunset in 2025 and so forth. And if not, what does that sunsetting of those tax cuts means if he was to win and then roll back part of the Inflation Reduction Act through executive order or even legislation? That collision of not extending the tax cuts and ruling back the IRA. 

That collision is austerity period.  

And then on the flip side, the pedestrian conversation is if Vice President Harris wins from an economic standpoint, and it really depends on the makeup of the Congress, but if the Democrats are in control and she can increase the corporate tax cut to whatever that number is, call it 28%, I guess we have to take off about 5% of S& P earnings from models. 

Other than that, Andrew, I’m going to leave the politics to the gurus. 

Andrew Wilkinson 

Let’s switch back to the FOMC meeting. How does an investor position for the first interest rate cut, Neil? 

Neil Azous 

So I like risk assets that are tied to lower real interest rates first to super long duration and then finally supposed to benefit lower financing costs.  

The three investments that come to mind and ones we’ve been putting to work here at Rareview Capital in our portfolios is goldminers, number two biotech and number three mortgage rates. I call it, Andrew, my high beta carry basket. 

I think that’s the clearest cut version of how to get started. I’m less certain in the short term, given the degree how much interest rates have already fallen. 

The fact that we have phases in that, regarding that asset class, and then in currencies, the responses to the first cut are a bit more ambiguous and so I don’t want to put a lot of high conviction bets around that. 

I think equities are good And I think you should stick with lower real interest rate ideas super long duration expressions and lower financing cost investments 

Andrew Wilkinson 

So finally, let’s turn to Berkshire Hathaway. They’ve seemingly got a large stockpile of cash these days, or they’ve been selling and the notable name in the news has been Bank of America. They’ve been selling down the positions. What’s your takeaway from that strategy? 

Neil Azous

That’s an interesting question. You’re throwing me for a loop there, Andrew!  

The pedestrian view is that they’re building cash reserves like they always have ahead of an anticipated recession to go shopping at discounted prices, as he would say, like a kid in a candy store, right? 

Or maybe, Andrew, they just had too much concentration risk in specific companies, right? They just need to bring that down so there’s more diversification of their size. And it’s probably most likely on an ex-post basis that will end up being the case when people study this period in a decade. 

That said, Andrew, since you asked me that question, I do have an off the beaten path view or what I would like to call Neil’s market conjecture so let me think about that for a minute. 

So Mr. Buffett owns, I think about 37 or 38% of Berkshire shares and they’re probably worth, I don’t know, $140 billion, 150 billion somewhere in that neighborhood now based on today’s prices. And I think they’ve stockpiled around $250 billion, and I know they like to have about $100 billion on hand at any given time. 

And if you just think about this progression, so he’s 94 years old. Unfortunately, he just lost his longtime partner, Charlie Munger. Here’s my question. What if Berkshire just buys back Warren Buffett shares in one large $140 billion transaction, so the stock can’t be diluted after he’s gone? 

Now, before anybody says anything that can’t happen, I would just like to remind people that Mr. Buffett has a phone call most likely, probably more than anybody else as a non-official, into this person called the U. S. Treasury Secretary.  

And I’m sure they can find a solution to the estate planning and tax ramifications that the IRS can live with. 

So I’ll leave it there, Andrew, but that’s my conjecture. 

Andrew Wilkinson 

Brilliant. My guest today has been Neil Azous, CIO and Founder at Rareview Capital. Many thanks Neil for joining me. 

Neil Azous 

Thank you as always for having me on, Andrew, and best of luck. 

Andrew Wilkinson 

It’s always a pleasure and don’t forget to subscribe wherever you download your podcasts from. Thanks Neil. 

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