Hey everyone we kevin here with cpi inflation data coming in at seven percent year over year, the highest since 1982 folks are now wondering. Is this the potential start to a recession and is a balance sheet runoff from the federal reserve going to make things worse? Consider this, since 1914, there have been 12 cycles or cyclical instances where headline inflation has risen above 5 right now being one of them of the prior 11 times. Eight of them coincided with the onset of recession. That means 72 of the time we had inflation above 5 in a cyclical period.

A recession followed folks. This video is brought to you by masterworks, with more information in the description down below and more on them shortly, but we got ta talk about the potential for the federal reserve's tightening to be an issue or will tightening end up being a nothing burger. Remember folks, the federal reserve tightening is removing liquidity from the market and when the federal reserve removes liquidity from the market, we think that means there's less liquidity available for business, borrowing, investing into the stock market, investing into cryptocurrencies or other risk-based assets. And so what ends up happening? Potentially those valuations come down, especially since we already know that valuations are pretty richly elevated right now, especially by you know, comparing to standards of history, and we look at price to earnings ratios now compared to the past and we're at relative highs, which means we could Endure some kind of stock market shock.

In fact, that's kind of what we've been seeing for the last six weeks has been a lot of negativity in the market and a lot of convictionless rallies, but folks bill dudley in bloomberg's opinion. Section today put together a very detailed piece on why he actually believes the federal reserve's tightening might actually be a big old and nothing burger. He suggests that while there are going to be similarities between 2017 and now, there are a lot of differences and we've got to consider those when we wonder, will the market crash because of the federal reserve's tightening. So let's go down this analysis.

First, our economic outlook today is actually much stronger than economic outlook was in 2017.. We also have substantially larger holdings at the federal reserve, which means every little bit of running off. Of the balance sheet is a smaller percentage of the overall portfolio that they're holding and the bonds. They have are shorter and average maturity, which means the feds kind of got to get rid of those anyway.

But let's compare a little bit more to 2017 and then see what kind of conclusions we can draw here, because right now, a lot of people are worried about that vacuum: cleaner of the federal reserve sucking up excess money right during the last economic expansion. The transition, through the stages of monetary policy, normalization aka, trying to go to some level of normal where rates are stable and the fed's, not printing money or taking money out of the system. During the last expansion, this process was very, very slow. The federal reserve began increasing rates somewhere at the end of 2016 and they didn't really start tapering until three years after they finished printing money.

This time around, we expect asset purchases to stop in march and a potential unwinding of the balance sheet as soon as july. At least that's what goldman sachs expects jp morgan has a similar expectation. That means we might only be waiting two to three months before, starting to unwind the fed's balance sheet right now compared to the three years. We waited the last time around.

On top of that, the last time we had quantitative tightening, we ended up having turmoil in the stock market. Remember the end of 2018 or even the beginning of 2018 stock market was not very happy when the federal reserve was sucking up money from out of the market. They started sucking up money from out of the market, the beginning of 2018 and that continued throughout the tooth uh throughout 2018, which led to a very brutal stock market in 2018, and a lot of folks think that 2020 could end up. Looking like 2018, where we go into the year with a seven to eight percent selloff and we end the year with another 21 sell-off.

Well folks, let's understand the repo market, because this folks might actually end up making quantitative tightening a complete, nothing burger. So first things. First, a message from our sponsor masterworks, the 60 40 portfolio of stocks and bonds was first invented in the early 1950s and the idea was revolutionary at the time. Well, folks, that was 60 to now 70 years ago, and i don't think anyone is still holding 40 of their portfolio in bonds.

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Around check out the link in the description with masterworks to learn more now, the federal reserve has such a large balance sheet that what the federal reserve is going to expect to do is sell bonds to the market, treasury bonds and mortgage-backed securities, who buys these well Sovereign funds, uh sovereign institutions who need to park their money into relatively safe debt from other countries, we'll buy our bonds. People often wonder like who's, paying who's, buying a bond to get a 1.5 yield. Well, if you compare to the rest of the world, if an institutional investor in canada wanted to invest in a relatively risk-free bond, they're, probably getting negative yields in europe they're getting negative yields in japan. They've got a lot of risk.

Investing in bonds in china, or even inflationary regions like south america, specifically brazil, experiencing over 10 inflation or look at the turkish lira, which has lost a third of its value relatively quickly over the last few months. There are a lot of risks investing in other assets, and so the united states bond market team seems to be relatively desirable for folks to go shopping for relatively safe debt in uh to park their money in so that way, they're, not you losing money. It's almost like they're parking money to break even, but where is this money going to come from? Well, the reverse repo market can give us a little bit of an idea. So if we go ahead and jump on over to google right now - and we do a quick search for the reverse reaper market, we'll type in st louis fed reverse reaper market.

This represents the amount of deposits from banks and institutions at the federal reserve, and this oftentimes signifies excess cash that banks have above and beyond money, market funds and other requirements. Take a look at this folks. This is the federal reserve's reverse repo operation. It has exploded in the amount of money that is accepted on an overnight basis and the federal reserve uh or i'm sorry bloomberg, put together this particular piece which gives us a little bit of insight into maybe what we might be up against.

So take a look at this on the left side, you see the first gray line and this indicates the start to reducing bond purchases or eliminating bond purchases rather and finally, starting to run off the balance sheet. You'll notice at the top it says, rrp facility. That's the reverse repo facility and, as we expect to increase the fed funds rate and start reducing the federal reserve's balance sheet, we might actually start running off the reverse repo facility first, and this actually means that we probably won't be dipping into bank reserves until all The way through august of 2023, which is when we'll actually start seeing, tightening because remember this folks, we're not really tightening if we're just taking money away that nobody needs right now, anyway, this money at the reverse repo facility could be money. That's just sitting there that banks don't need and they're not even lending out when you have tightening it's when you actually start removing money from our institutions and our banks and that's what's so interesting is if we build this sort of foundation here, let's say, and we Built this bottom portion up over here with uh minimum money that banks need so we'll just right here, that's the minimum amount of money the banks need.

This is the extra money that banks have right here. So this is the extra well. We could go over here and fill in the top section here and call this over here more than extra more than extra, so this is the minimum they need to operate. This is really the extra stuff that they can lend out to businesses, and this is just the level of ridiculousness.

Well, the reverse repo market right now has 1.527 trillion dollars in it. The federal reserve is expecting to probably like run off up to about 90 billion dollars per month of assets. 1.527 divided by 90, works out to about a 17-month cycle before we completely burn this entire extra section over here. So before this extra section is just erased.

Like this it's going to be about 17 months, then you actually get into the tightening phase where you start coming in here, and you start shaving off the top over here. So, in other words, because of how long it's going to take for the federal reserve to actually tighten and how they're, probably only going to tighten to the tune of about 90 billion dollars per month, they're not actually or effectively going to tighten until august of 2023, Which means right now, markets are potentially in this element of peak fear, because, oh no, the tightening is coming. Oh no rates are going to go up, but wait a minute. We've got so much freaking money that the markets right now might actually be overpricing.

The level of fear and drama that is going to come in the future. In fact, i drew this chart that i think gives us a really really good uh explanation, visually of of how the market seems to be acting. Let's say this red line right here. Let's say this represents fear in the markets and let's say this - and this is already realized fear, so we've seen fear go up recently right.

Let's then come over here and say this dotted line right here represents fear to come. So, in other words, fear that hasn't happened yet, but the market's belief that more fear is coming. It would appear to me that the market thinks we're going to be at peak fear sometime when we have rate hikes start and a runoff of the federal reserve's money. In other words, uh may comes around the federal reserve, says we're raising rates and we're taking money out of the system.

It seems like right now. The stock market is pricing in the worst case scenario that when those rates go up and when the federal reserve starts sucking up money, the market's gon na be really pissed and the market's gon na sell off. But the market is pricing that in now, and so when, as usual when the market prices things in early. In my opinion, it's a sign that we're probably actually going to have a decline in fear marked by this orange line, that we might still have fear to go in this market, but that this fear might rotate down substantially.

And ironically, we might end up being at a point where we're in substantially lower fear or a lower fear environment come march to may than what the market is pricing in right now because of the fear of these rate, hikes and runoffs, peaking, uh or creating peak Fear in march through may now no guarantees - that's just the theory, but when we combine this theory with the argument that wait a minute we're when we actually begin the runoff we're not really tightening for another 17 freaking months, that's crazy that we're not actually going to Be tightening for another 17 months, which means again we're not actually taking money out of the system for that long, and this makes sense now, because if we look at what the fed says, they say they want to foster a very expansionary policy for the next decade. To make sure that they can get individuals to max employment. Participation talked about this yesterday that the federal reserve just needs to clean up the mess of inflation, raise rates to deal with inflation, but don't run off the balance sheet so heavily or raise rates so extremely that we now push our economy into recession. That would be the worst case scenario, because it would go counter to what the federal reserve is trying to do, which is get more people in the workforce.

More businesses growing, more labor force participation and max employment, which includes having equal employment amongst all different races, which, right now there are substantial disparities in. In fact, black unemployment is as high as it was back in the 1950s, which is kind of insane. If you think about what our world was like 70 years ago, compared today, but anyway, uh this, this fed runoff in my opinion, is potentially very very bullish and it's being overblown by markets right now. We even even had loretta mester just this morning say they don't want to bring markets down with a balance sheet reduction.

They don't want to royal markets. They want to give markets the confidence that the federal reserve is going to respond to inflation, which they've been slow to respond to and whatever bond runoff we end up end up actually, having would be at such a level that we don't end up shocking the market. That's what we're being told right now might not believe this might still be an opportunity to hedge and be careful. In fact, the market is relatively mixed right now on a typical convictionless sort of rally that we had this morning, but i will say not having that tightening really take effect until august big thing again watch this chart right here.

The reverse repos chart you're going to watch this repo chart go down substantially over the next year and a half and when this chart goes to zero, maybe that's when we actually start experiencing tightening. But until then it's actually a lot of liquidity in the system and it doesn't look like it's going anywhere all right folks. Thank you so much for watching this video. Hopefully this was helpful if it was consider sharing the video and we'll see in the next one.

Thanks again, bye.