Key fiscal & monetary policy decisions coming up

Paid subscriber analysis

Two major policy decisions are upon us this week:

• Fiscal policy decision - will the Treasury increase its long-term bond issuance to finance the huge budget deficit? And how do we price in 2024 electoral implications into this decision?

• Monetary policy decision - the Fed will keep rates at 5.5%, for sure (>97% prob), but it will also signal what is to be expected in the next few meetings. How many cuts do we get this year?

The first decision carries a huge impact on bond supply, thus affecting its prices, and consequentially equities. The second carries a huge impact on all asset prices.

Also next week: GOOGL & MSFT earnings on Tuesday, AMZN, AAPL, and META on Thursday. Quite the busy week, isn’t it?

Before we present the different potential outcomes and how we intend to position, let’s just quickly unpack what happened the last two times we had these two events coinciding.

1. On July 31st 2023: FOMC was the week before (July 26th), Treasury announced the policy decision on Monday, marking the beginning of a three-month-long sell-off. July 31st was the market high for the year thus far.
   
   Why did the sell-off happen?

   Because the Treasury significantly increased the supply of long term bonds. More supply of bonds => lower bond prices, and higher yields. The 10Y yield went from 3.9% to almost 5% in those 3 months. What about equities? The SPX went from almost 4,600 down to 4,100 in the same time period (see chart below).
   
   Why did equities move down? As yields go up, bonds are more attractive, as you want to park your excess cash into a zero-risk asset bearing 4% or higher (all the auctioned bonds do end up getting purchased, a lot of it by retail investors actually). This encourages investors to sell their stocks and park more money into Treasuries. What do people typically sell? Their biggest gainers. Investors take profits from their tech stocks and use some of that to buy bonds. That’s why this Treasury decision typically pushes both bonds and stocks down. We explained this mechanism in more detail here.
   

2. On November 1st 2023: Treasury announced the decision on Monday, but the composition of bond purchases came out on Wednesday morning, while FOMC delivered its very anticipated pause in hikes by the end of day. Markets rallied powerfully after that, making 15% gains in the next two months. October 27th was the market low of the past three months.

   
   Why did the rally happen?

   Because the Treasury did the opposite; they decided to use more short-term bonds (bills, <1 year maturity) to cover the budget deficit, and announced a much lower than expected issuance of long-term bonds (coupons, 5Y, 10Y, 20Y maturity). It was a catalyst that pushed the 10Y yield from 4.9% down to 3.9% (reversing the entire previous 3-month move), while pushing the SPX from 4200 to 4780 in two months (see chart below).
   
   It was the same logic, but in reverse. Lower supply of long term bonds => price goes up, yields go down. Bonds relatively less attractive than equities, so investors start buying equities back - buying the dip! Furthermore, the Fed’s decision to pause rates as inflation was getting better sent a strong signal to buy equities. A strong rally was the natural consequence. The last time this happened, we’ve covered the full impact and the implications, positioning aggressively long. This was our conclusion on Nov 2nd:

   Yesterday we covered all our shorts, got back into TLT, and doubled our SPX exposure. The macro book is therefore long right now. It is a tactical move that we will sustain over the next two to three months.

Originally from 3Fourteen Research, HT: Bob Elliott.

Now that we are aware of the two potential scenarios, let’s examine what might happen this time, and how we intend to position for it.