The long-awaited recession and the result of the 2022 bear market resumption that many had hoped for has failed to materialize so far in 2023. In fact, most assets have already found bid, with the NASDAQ hitting a 52-week high on July 12.
How did this happen, and will the rally continue?
Michael Burry of the famous Big Short stated in January that the US could be in a recession by the end of 2023, with a lower CPI and a Fed cutting rates (note that today’s CPI print was much lower than expected, further fueling the recent rally This). This will cause another inflationary spike in his outlook.
Recent independent macro and crypto analyst Lyn Alden explores the topic in a newsletter published this month.
In his report, Alden examines the current inflationary environment by comparing it to two similar but different periods: the 1940s and 1970s. From this, he concluded that the US economy would likely enter a stagnation phase or enter a mild recession while experiencing persistent inflation rates. This could mean that the market continues to trend up until a recession officially hits.
My July 2023 newsletter is out:https://t.co/gTH0nUyrU8
The topic focuses on fiscal dominance, and how much debt and deficits can cushion the impact of higher interest rates as a policy tool. pic.twitter.com/qmuzInyYjK
—Lyn Alden (@LynAldenContact) July 2, 2023
The Fed’s inflation battle continues
The key differences between the two periods involved fast bank lending and large, monetized fiscal deficits, which Alden said were underlying factors driving inflation. The former occurred in the 1970s when baby boomers started buying homes, while the latter occurred during World War II as a result of funding the war effort.
The 2020s are more like the 1940s than the 1970s, but the Fed is running the playbook of 1970s monetary policy. This can turn out to be very counterproductive. As Alden explains:
“So when the Federal Reserve raised interest rates, federal interest costs rose, and the federal deficit widened ironically at a time when deficits are a major cause of inflation. This is risky similar to trying to put out a kitchen grease fire with water, which makes intuitive sense but doesn’t work as expected.
In other words, current inflation is primarily driven by the creation of new federal debt, or what some call government money printing.
Raising interest rates to calm inflation could work, but it is meant for inflation rooted in the expansion of credit tied to bank loans. While higher rates tame that inflation by making borrowing more expensive and thereby reducing private sector loan creation, they exacerbate fiscal deficits by increasing the amount of interest that must be paid on that debt. The federal debt today is over 100% of GDP, compared to just 30% in the 1970s.
Federal government interest payment spending vs. Federal Funds Effective Rate. Source: Lyn Alden
While the Federal Reserve has cooled parts of the economy by raising interest rates by 500 basis points in less than a year, the underlying causes of the current inflationary environment remain unresolved. And with a much higher debt-to-GDP ratio than the US did 50 years ago, the situation is only deteriorating at a faster pace. But markets remain resilient, including tech and crypto equities, even though the correlation between the two has broken.
In this way, the Fed may be using tools that are inappropriate for the situation, but this is not stopping the market, at least for now.
Big Tech defied recession forecasts and pushed equities
Despite the Fed’s battle with inflation and market participants’ expectations of an inevitable recession, the first half of 2023 was quite bullish for equities, with rallies continuing into July. While bonds have been selling again, boosting yields to highs near 2022, risk assets such as technology stocks are surging.
It’s important to note that this rally was primarily led by just 7 stocks, including names like Nvidia, Apple, Amazon, and Google. This equity is a disproportionate weight of the NASDAQ:
Just seven stocks make up 55% of the NASDAQ 100 and 27% of the S&P 500
Distribution has become so lopsided that the NASDAQ will rebalance to reduce the weight of these megacaps.
— Markets & Mayhem (@Mayhem4Markets) July 13, 2023
Related: Bitcoin mining stocks outperform BTC in 2023, but on-chain data shows stall potential
Bonds fall, crypto and technology
The rally in tech has been largely due to the AI-driven hype and some large-cap stocks have also attracted attention from easing bond market liquidity.
Alden chronicles how it started late last year:
“But then things started to change in early Q4 2022. The US Treasury started dumping liquidity back into the market and offsetting the Fed’s quantitative tightening, and the dollar index fell. The S&P 500 bottomed out and is starting to stabilize. Liquidity in the sovereign bond market began to subside. Liquidity-driven assets like bitcoin are making a comeback.”
The July 11 report from Pantera Capital made a similar observation, noting that real interest rates also tell a very different story when compared to the 1970s.
“Traditional markets may be struggling – and blockchain may be a safe haven,” in part because “the Fed needs to continue raising interest rates,” given that real rates remain at -0.35%, according to the report. They also conclude from this that “There is still a lot of risk in bonds.”
They went on to note that while most other asset classes are interest rate sensitive, crypto is not. Bitcoin’s correlation to equity over 2022 was driven by the collapse of “over-exploited centralized entities.” Today, that correlation has reached near-zero levels:
Bitcoin correlation with S&P 500. Source: Pantera Capital
Among the main conclusions here perhaps is that risk assets appear to have an underbid for now. However, this trend could easily reverse by the end of the year.
Dan Morehead of Pantera Capital said it well when stating that:
“Having traded 35 years of market cycles, I have learned that markets can be down for so long. There’s only so much pain for investors to take… It’s been a full year since TerraLUNA/SBF/etc. Enough time. We can unite now.”Bitcoin price trends and YoY returns. Source: Pantera Capital
With the halving right around the corner and the prospect of a spot bitcoin ETF on the horizon, the catalyst for crypto seems poised for a breakout in almost any situation.
This article does not contain investment advice or recommendations. Every investment and trading step involves risk, and readers should do their own research when making decisions.