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Kashyap's Macro Outlook - December 2023

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Kashyap's Macro Outlook - December 2023
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“Economic history is a never-ending series of episodes based on falsehoods and lies, not truths. It represents the path to big money. The object is to recognize the trend whose premise is false, ride that trend and step off before it is discredited.”

– George Soros

This quote from Soros is never far from my mind. It is why I’m always searching for the market narrative and trying to make sense of it.

In this article:

  • I explain where the liquidity came from to fuel the Mag 7 and crypto bubbles

  • Why "Overnight Reverse Repurchase Agreements" - an obscure Fed balance sheet item - is worth your attention

  • Why the Fed is going to cut rates and resume QE shortly

  • Why the next recession will be stagflationary and not deflationary

  • My expectation for asset prices

The article is lengthy. It is relevant. I hope I've also made it an interesting read.

The Current Narrative

Crowded long positioning, extreme FOMO, wildly bullish sentiment – this is where we stand today.

What’s the narrative driving this? Expectation of the Fed cutting rates and resuming QE.

Sometimes, the consensus is right. This is one of those times.

The last rate hike was in July. Historically, the Fed tends to cut rates 8 months after the end of the tightening cycle. The market pricing in rate cuts by March/April next year is in line with this historic precedent.

History is merely a guide. There’s a compelling reason the Fed will have to cut rates very soon, perhaps as early as this month.

The Fed and Treasury Coordination

As past Fed chairmen have established, the Fed is a private institution that is independent within the government but not of it. The current Treasury Secretary was the previous Chair of the FOMC. The Treasury and the Fed have been working closely all year, as evidenced by the coordinated response to the failure of Silicon Valley Bank. It may not seem that way, with Powell talking of wanting financial conditions to tighten even as the Treasury did the opposite and issued a gargantuan amount of debt.

This is the magician’s trick. Getting you to look in one direction while the real move is happening elsewhere.

I’m going to ask for a little patience here while I craft this story.

Three Sources of Stealth QE

We all know that the national debt only goes up. The debt currently stands at $33.88 trillion, up from $31.35 trillion at the beginning of the year.

Who buys this debt? Every individual with a Treasury Direct account, foreign central banks, institutional investors, sovereign wealth funds, pension funds, insurance companies, etc. Until recently, the Federal Reserve was a major buyer. US treasuries are the most widely distributed global asset after physical US dollar bills.

The biggest buyer of US treasuries this year has been the banks.

At the end of last year, overnight reverse repurchase agreements, or RRPs for short, stood at $2.55 trillion. At the beginning of June, RRPs stood at $2.25 trillion. The balance is now down to $768.5 billion.

Note the drop in RRPs coinciding with the rise in total public debt outstanding from June onwards.

This is the stealth QE which investors have largely ignored. This has more than offset the Fed’s $95 billion a month in Quantitative Tightening (QT) since June.

There is a second ongoing stealth QE, and that’s the decline in the value of the dollar. The dollar is down 10% since it peaked in September last year.

Brent Johnson’s Dollar Milkshake Theory provides a good explanation for this. But the salient point is that a rising dollar induces balance sheet stress on every country’s institutions and government, forcing them to de-leverage. In a debt based monetary system, deleveraging is deflationary while an increase in debt is inflationary. A falling dollar halts the deflationary impulse, allowing global (non-US) central banks to ease.

The Fed has also been easing global liquidity (the third stealth QE) by providing swap lines to foreign central banks. Think of it as off-balance sheet QE. Or leprechaun gold – only good for a short duration but solves global central banks’ liquidity problems at their time of maximum need. And always readily available so long as the foreign countries stay in the good graces of Uncle Sam.

If you have been wondering why there is a bubble in AI and crypto during a Fed tightening cycle, this is the answer. The actual tightening cycle ended long ago. Last year was a triple tightening, with the dollar rising, the banks increasing reserves and curtailing lending, even as the Fed was hiking rates and doing QT.

Like the magician, the Fed kept us focused on its own balance sheet and the Fed Funds rate, lulling us into thinking financial conditions were tight. The media coverage of deposit outflows from banks made us think banks were tightening liquidity even further. All the while, the banks were plowing their excess reserves into buying Treasury bills, loosening financial conditions, and creating liquidity to fuel the current bubble.

With almost no one the wiser.

If this doesn’t make sense yet, bear with me a bit longer.

Unpacking RRPs and Bank Reserves

What are these RRPs and why are they so important to this story?

When the Fed embarked on a massive money printing program in response to Covid ("we print it digitally") they bought treasuries from the open market.

The newly printed money made its way into the hands of the sellers of treasuries, the treasuries found their way into the Fed’s balance sheet on the asset side (counterbalanced by an increase in deposit liabilities).

Think of a back alley drug deal. The dealer hands over a package, the buyer hands over a roll of cash, and they both walk away. A simple swap of cash for drugs.

The Fed’s money printing is only slightly more complicated. The banks act as an intermediary in the transaction, receiving digital dollars from the Fed on behalf of the seller. The money shows up in the seller’s checking account.

Accounting wise, bank deposits go up.

Banks are subjected to capital requirements, meaning they need to hold a certain percentage of deposits as reserves but are free to lend out the rest. That lending can take the form of a business loan to the local diner, a student loan so Timmy can get they/them degree in religion and gender studies, a no money down used car loan, or financing a Wall Street junk bond issue.

Or in the case of Silicon Valley Bank, lend money to Venture Capitalists so they can mark up share prices of start-ups with no prayer of hope for ever making money. Then turn around and accept those shares as collateral and give out loans to start-up employees. It was the first prototype of a Silicon Valley perpetual motion machine.

But I digress.

Banks typically hold more reserves than they are required to by law. These ‘excess reserves’ are parked at the Fed in the form of reverse repos. At the time of writing, the Fed pays 5.3% interest on those reserves.

The banking system creates money by giving out loans and creating bank deposits. As long as bank reserves are parked at the Fed, they aren’t making their way into the real economy and causing inflation (in econspeak, they are considered to be sterilized). The trouble starts (if you hate inflation, that is) when these reserves make their way into the economy. Which is exactly what happened.

As soon as the debt ceiling crisis passed in June, Treasury Secretary Yellen embarked on a treasury issuance binge. The Fed’s rate hikes had forced bond yields up across the curve, and further treasury issuance would have sent rates up even further, wreaking havoc on bank balance sheets. The Treasury needed to issue bonds and raise funds for the government to spend, but it had to do so in a way that another Silicon Valley Bank type failure could be avoided.

The Switcheroo in Treasury Debt Issuance

The Treasury did so by issuing short-term bills that would take the place of RRPs.

Recall the magician’s trick.

The Fed would pretend to act tough on inflation and promise higher for longer. While the Treasury would drain the RRPs and release the excess reserves into the economy.

By paying a higher interest rate than the Fed, the Treasury was able to drain the RRPs and avoid putting pressure on long-term bond yields. The Democrats got to spend. The money supply went up, fueling the tech and crypto bubbles. The bears (mea culpa) were fooled into thinking financial conditions were tight.

The Fed officials played the game well, especially with their last hand where they fooled everyone with the SEP projection of an additional rate hike. Methinks the December SEP (dot plot) is going to surprise everyone.

The Doom Loop Risk

But now, the jig is up.

Interest payments on the national debt are approaching $1 trillion a year, or >35% of tax receipts. The government is borrowing money just to pay the interest on previously borrowed money.

The RRPs were drawn down by $420 billion in October and $250 billion last month. The current $768.5 billion will last anywhere from 2-3 months. Less, if the banks start to lock-in duration (buy bonds with longer maturities) ahead of rate cuts.

Banks are in no shape to add to their bond portfolios unless the Fed gives the all-clear that rate hikes are done and rate cuts are coming soon.

In fact, every holder of long duration treasuries is in the same boat. In early November, the Treasury tried to auction $24 billion in 30-year bonds. The dealers ended up bagholding nearly a quarter of the issuance.

This is how the doom loop begins.

The Treasury can’t lower funding costs by issuing longer term debt because there are no buyers.

The Treasury can’t issue short-term debt at 5.56% and roll over every month either, not without interest expense eventually surpassing 100% of tax receipts.

Something has to give. Once the RRPs are fully drawn, it all comes onto the Fed balance sheet.

Goodbye, privilège exorbitant?

Unless the Fed cuts rates significantly and signals more rate cuts to come.

The record high short interest in treasury futures gets covered. Fixed income investors get long duration again. Bank balance sheets start to mend, restarting the lending cycle, halting the pain in commercial real estate, and reflating asset values.

Stocks, gold, crypto, yields, even copper… all assets have sensed this already.

I won’t say this often… but the CTAs were right.

The alternative to this logical sequence of events is the doom loop, which is highly unlikely given how tightly knit the Fed and Treasury are.

The doom loop is also unlikely for another reason. It is not in the Fed’s self-interest to trigger it. The Fed holds $4.85 trillion in US treasuries on its balance sheet, down from a peak of $5.77 trillion last year. These assets are recognized on the books at face value, not marked-to-market.

The Fed has crystallized losses with each sale of treasuries and MBS as part of its $95 billion a month QT program. Rather than lower its capital to reflect the losses, the Fed creates a ‘deferred asset’ to reflect these losses.

Eventually, the Fed needs to generate income from its securities holdings to offset these losses. But more importantly, they have to stop the QT program just to stem the losses.

The issuer of the reserve currency of the world becoming insolvent will have geopolitical implications. Goodbye, privilège exorbitant. Goodbye, control over SWIFT. Clip the wings of OFAC. No more jurisdictional overreach by the DoJ.

The world will de-dollarise faster than the Colombian cartels taking market share from a fallen drug lord.

Of course, that can never be allowed to happen.

Cumulatively, the weight of the evidence points to rate cuts and outright QE coming soon. The US cannot afford to spiral down the doom loop.

Potential Economic Impacts

Will we get a recession or a soft landing?

No way to tell. But there's no avoiding one or the other outcome. All Fed rate hike cycles end up lowering aggregate demand. Given that this has been the fastest rate hike campaign in the Fed's history, my vote is for recession.

But it'll not be a repeat of the GFC. The Fed will be printing money while consumers are still reeling from high inflation.

We are entering a stagflationary environment similar to the 1970s. Inflation comes in waves. Wave 1 has ebbed, leaving prices 30-40% higher than pre-covid levels. Wave 2 is coming, bringing misery for the working class even as investors profit from rising asset prices.

The most likely outcome is a series of rolling asset bubbles, as the freshly printed money chases one narrative followed by another. The moves will be exacerbated by trend followers and algos pumping liquidity into flavor of the day sectors and asset classes.

Volatility is coming back. It will be a macro trader's dream.

Tech does not do well in inflationary environments, but we'll see. Technology has transformed the world since the '70s, so the historic precedent may not apply.

Like many bears, I had been fooled earlier this year into thinking a banking crisis would cause deflation. I thought the Bank Term Funding Program (the "not-QE" QE) would provide only a temporary boost, which would be offset once the debt ceiling crisis ended and the Treasury started refilling their TGA balances at the Fed. I watched in disbelief as the AI bubble took off even as the Treasury was supposedly draining liquidity from the market. Last week, everything went up, breaking historical correlations.

With my current framework, it all makes sense. The rate hikes and QT were irrelevant. It was all a magician's trick.

And soon, the money printer is about to go brrr. As Ray Dalio is fond of saying, "cash is trash".

For consulting engagements and contract research, email me at

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