Financial Markets Remain Abnormal | Andy Constan on Flat Yield Curve, Expensive Stock Market, and MicroStrategy
Monetary Matters with Jack Farley
Deep Dive
Why do you think financial markets remain abnormal?
Financial markets remain abnormal because they do not offer adequate risk-adjusted returns, which supports the economy above trend without sustainable reasons. This is evident in the flat yield curve, where short-term rates are tight while long-term rates remain stimulative, and in equity multiples being high at 22 for the S&P 500, which is above the normal range of 16 to 19.
Why are short-term interest rates not effectively controlling the economy?
Short-term interest rates are not effectively controlling the economy because a significant portion of the US economy, particularly housing and small businesses, is insulated by fixed-rate mortgages and low sensitivity to short-term rates. Most of the economy's growth is supported by low long-term rates and high consumption.
Why did the September cut by the Fed result in higher long-term rates?
The September cut by the Fed resulted in higher long-term rates because it signaled to the market that the Fed was not as hawkish as needed, leading to a loss of credibility and an expansion of term premiums. This means that long-term rates rose due to increased uncertainty about future monetary policy.
Why do you think the Fed should pause in December?
The Fed should pause in December because the economy is showing signs of strength and inflation is still above target. A pause would help maintain hawkishness and avoid easing financial conditions, which could lead to a hotter economy and stickier inflation.
Why is MicroStrategy trading at a premium to its assets?
MicroStrategy is trading at a premium to its assets because it is issuing stock and convertible bonds at high implied volatilities, which are very valuable. This premium creates a reflexive loop where MicroStrategy's actions to buy Bitcoin drive up the stock price, and the high implied volatility makes the convertible bonds attractive to arbitrageurs. However, this premium is likely unsustainable and could lead to a significant correction.
Why do you think the bond market and equity markets are currently easy despite high short-term rates?
The bond market and equity markets are currently easy despite high short-term rates because long-term interest rates remain low and stimulative, and equity multiples are high, offering inadequate returns for the risk. Additionally, the market is flush with liquidity, and banks are willing and able to lend, which supports economic growth.
Why do you think the Fed's current policy is myopic?
The Fed's current policy is myopic because it focuses on backward-looking measures of inflation and real Fed funds, which do not accurately reflect the current economic conditions. The Fed should consider forward-looking inflation expectations and the broader financial market conditions to make more effective decisions.
Why do you think the economy will continue to experience this near-normal roundabout cycle?
The economy will continue to experience this near-normal roundabout cycle because financial conditions are too easy, supported by low long-term rates and high equity multiples. This cycle repeats as the Fed appears dovish, data heats up, and then the Fed becomes hawkish, causing a correction in financial conditions. It will only break if the Fed commits to a more restrictive policy or the bond market forces a correction.
Why do you think MSTR convertible bonds are attractive to institutional investors?
MSTR convertible bonds are attractive to institutional investors because they can be delta-hedged and sold for high implied volatilities, providing a way to gain exposure to Bitcoin through an arbitrage strategy. However, this premium is likely unsustainable and could lead to significant losses if the market corrects.
Why do you think inflation is still a bigger risk than recession?
Inflation is still a bigger risk than recession because the financial markets are overly supportive of the economy, creating fragility and unsustainability. The Fed needs to withdraw this support consciously to avoid a disruptive hard landing, which could result in higher inflation if not managed properly.
- Financial markets are abnormal, impacting the real economy.
- Real economy is near normal but supported due to cheap money.
- Short-term rates are not the primary driver of the economy.
- Yield curve is flat, not positively sloped as is normal.
- Equities are expensive, credit is cheap, and financial conditions are easy except for short-term rates.
Shownotes Transcript