Different manifestations of money are better understood than others. The paper bills in our wallets and the digits sitting in our checking and savings accounts at the bank are easily understood. Since the Financial Crisis, investors and market participants have had to familiarize themselves with other forms of money, like reserves parked at the central bank. Unfortunately, just about any analysis of the financial system, monetary policy, and interest rate cycles only deals with the aforementioned forms of money. The problem is that it is a woefully incomplete landscape.

As documented on this page before, the birth of the repo market changed the complexion of financial markets. The ability to get cash for Treasuries, without selling them, gave bonds “moneyness.” No, you couldn’t use them for everyday transactions like paying the electric bill, but their money-like nature gave them plenty of utility, like pledging them to purchase other financial assets. And the scale of the U.S. Treasury market is unlike any other market in the world. Over $500 billion in cash treasuries (ex-futures) are traded every day. The repo market sees over $3 trillion in volume daily. From one perspective, the famed S&P 500 ETF (SPY) does $50 billion in volume each day. Treasuries play an enormous role in global finance, not just due to the U.S.’ stature as an economic power, but because they extend the concept of “moneyness” into a wider spectrum.

For much of the last year significant attention has been paid to the odds of a recession with the preeminent catalyst being the historic pace of increases in the Fed Funds rate (Figure 1). The performance of the risk assets in 2022 made it seem like confirmation was playing out in real time before our eyes. But, with the benefit of hindsight, 2022 was more about popping excesses (SPACs, crypto, meme stocks, etc) than a foreshadow of an imminent economic decline. 

Figure 1: Forecasting a Recession Was a Popular Call, Source: WSJ

Monetary policy’s reach can only go so far, regardless of whether the tool used is the Fed Funds rate or the size and composition of the central bank’s balance sheet. For too long, interest cycles have been the sole paradigm through which analysts forecast recession. In an era where “moneyness” is composed on a spectrum, this approach is shortsighted and in desperate need of reform. And as the Covid response showed, monetary policy is a revolver compared to the Treasury’s bazooka.

Figure 2: Government Spending Has Not Been Tightening, Source: Prometheus Research

While monetary policy may be tightening, the fiscal tap has remained loose. In fact, outside the extraordinary efforts in the wake of Covid, government spending has been more supportive in recent months than at any point post the GFC. The benefits are twofold. First, stimulative fiscal policy grows the economy directly, supports incomes, and buoys aggregate demand. Second, in a period of monetary tightening, the added Treasuries (the government doesn’t run a surplus after all), help lubricate the financial system and credit markets. Fiscal stimulus has also wiped out any impact quantitative tightening (QT) could have (Figure 3), granted any such impact would be wildly overrated. In our estimation, the fiscal stance is the single, most important overlooked variable in assessing why the economy has remained resilient this far in a rapid tightening cycle.

Figure 3: Fiscal Spending Has Sterilized the Fed’s Balance Sheet Machinations, Source: Damped Spring

Further, it is quite easy to argue that, thus far, these interest rate increases, while affecting certain parts of the economy, are overall not restrictive enough. In fact, they’ve barely begun to bite. Figure 4 shows interest payments as a proportion of corporate sales. Even after moving rates from 0% to 5% the burden of interest expenses is historically low. The figure hasn’t even troughed thus far, let alone started to indicate that rate increases are crimping business activity. In fact, when taking into account interest income on cash and money funds, net interest payments in the first quarter of 2023 decreased. With interest rates this high some are seeing a net benefit to rate hikes.

Figure 4: Interest Payments Aren’t Biting

Either rates need to move higher or stay high longer in order for the effect of the current rate hikes to take root. For the latter, the longer the fiscal tap remains open the longer resilience can remain (though not forever). Much like homeowners refinanced and termed their mortgages out further, businesses and corporations did the same when rates were low. This has lengthened the lag effect of the rate hikes to date or presses the need for even more hikes.

For the former, even though one more rate hike is projected this year, investors still expect more than 4 cuts next year. Investors may say they’re bullish but they certainly are not acting like it. Until the 2024 cuts are priced away and/or more hikes are priced in, then positioning can still propel this market in the medium term. The fear of missing out is a powerful force.

Figure 5: Bullishness Sentiment Does Not Mean Bullish Positioning