Foreword
This is a quick note, which tends to be just off the cuff thoughts/ideas that look at current market situations, and to try to encourage some discussions.
As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.
If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.
Jumping ship
I have read from numerous sources over the past 2-3 weeks that large institutions (e.g: hedge funds) have been steadily selling out of their long positions. Today, Bloomberg joined in the party with this article: Nasdaq 100’s Worst Day Since March Sparked by Inflation Fears.
As noted in the prior quick note, this seems to be all related to how the market is gaming out expected higher inflation in the near future. My understanding is that the thought process goes along the lines of:
- Supply chain disruptions during Covid-19 resulted in reduced capacity.
- Fiscal policies are essentially massive transfer payments, which are affecting some workers’ need and/or willingness to go to work.
- A lot of lower paying and/or less desirable jobs are having trouble filling vacancies.
- All these results in reduced supply of goods.
- At the same time, reopening of the US markets is causing a spike in demand.
- The fact that consumers have been mostly huddled up at home for the past few months, and thus not spending money, means that they also now have more disposable income (on top of the transfer payments).
- All these result in increased demand of goods.
- Demand up, supply down, classic economics predicts increase in prices, i.e: inflation.
- The Fed is, nominally, supposed to react to increasing inflation via raising rates.
- At the same time, because the economy is improving, there is increased probability of a reduction in QE, which is, de jure, a form of monetary support for an economy in trouble.
- Since a large part of the stock market’s unrelenting rise over the past ~decade is based on both QE and lower-rates-forever, there are some who predict lower stock prices, at least in the near/medium term.
At the same time, there are technical issues at play — lower interest rates mean that the cost of carry (alternatively the “price” of money) is lower, and this generally encourages risk taking.
However, since the real economy is generally in the dumps (for many sectors/industries, in most of 2020), there is less incentive to invest in actual productive capacity, and so this excess risk taking tends to manifest in financial markets.
If interest rates does increase substantially, the cost of carry goes up, and these hot money flows may quickly dissipate.
Note that as of right now, this is mostly just conjecture. Interest rates have moved up slightly from the pits of 2020, but are still, objectively, pretty low compared to even the past 2-4 years.
Note also that at least for a large part of 2020, institutional players have severely underestimated the market’s resilience, especially in the face of retail traders who were willing to buy the dip, and thus dramatically outperformed the professionals. Will this be 2020 redux?
Janky Thoughts 