A Late or Early Cycle Environment

By Raymond T Bridges CPA, Bridges Capital LLC

In today's ever-changing financial landscape, crafting a resilient investment thesis is crucial for investors seeking to weather the storms of market volatility while consistently growing their wealth. This is where the expertise of investment professionals and actively managed Exchange-Traded Funds (ETFs) can provide invaluable support. The goal isn't necessarily to outperform a 100% equity portfolio in every market condition; rather, it's about achieving consistent returns and safeguarding capital, especially when generating a steady income from one's investments. One key factor in this endeavor is understanding where we stand in the economic cycle.

In a perfectly free market, economic indicators would be the primary tools for gauging our position in the business cycle. However, our financial system is designed to allow some control over money supply and interest rates by those in power, both on the monetary and fiscal fronts. In the monetary sphere, the Federal Reserve takes center stage, influencing economic change through policy actions. On the fiscal side, Congress and the President play pivotal roles in shaping the nation's economic trajectory. To accurately identify our place in the economic cycle, one must recognize that both monetary and fiscal policies have significant impacts on money supply and interest rates.

Beginning with the Federal Reserve, its mandate revolves around achieving maximum employment and stable prices, which often exhibit an inverse relationship. Since late 2021, with inflation proving less transient than initially anticipated, the Fed has shifted its focus toward maintaining stable prices. Despite historically low unemployment figures, the Fed has embarked on one of its most aggressive interest rate hiking cycles in history. While this cycle nears its end, the full effects of these rate increases have yet to materialize in the real economy. Additionally, the Fed manages a balance sheet that currently holds approximately $8.14 trillion worth of assets, including bonds, loans, and securities. Expanding the balance sheet by purchasing assets results in increased money supply, while the reverse occurs during quantitative tightening when assets are sold or allowed to mature.

Over the past year and a half, the Fed has reduced its balance sheet by roughly $900 billion. This monetary policy shift began to impact the economy in March, when a potential credit crisis emerged due to numerous banks holding liabilities exceeding their assets. The Fed intervened with an emergency program that swiftly expanded its balance sheet by approximately $300 billion in less than a month, stabilizing the situation but also delaying the turning point in the economic cycle. Since then, the Fed has continued its quantitative tightening, with no clear indication of when it will cease. Observing fiscal dynamics can provide insight into the potential end of quantitative tightening.

Federal government spending now exceeds $6.4 trillion annually, while total tax revenue amounts to over $4.4 trillion. This results in an annual deficit of roughly $2 trillion, which is financed by issuing debt into the market. While deficit spending creates money, the issuance of treasuries into the market temporarily withdraws liquidity from the financial system. However, commercial banks have an offset mechanism through the reverse repo market, where they can park excess reserves at the Federal Reserve and earn interest. Prior to the COVID-19 pandemic response, the reverse repo market remained relatively stagnant around $500 million, with occasional spikes to a few hundred billion dollars. However, since the pandemic response, the reverse repo market ballooned to over $2.56 trillion in late 2022. It currently stands at $1.53 trillion and is depleting rapidly as commercial banks utilize these reserves to finance treasury purchases and support the federal deficit.

Taking all these factors into account, it's clear that the Federal Reserve is approaching the end of its interest rate hiking cycle but is still engaged in quantitative tightening. Meanwhile, the federal government's annual deficit of $2 trillion is currently being financed by the reverse repo market, which is depleting at a rate of approximately $200 billion per month over the past three months. At this pace, the reverse repo market could be exhausted within seven months, coinciding with the conclusion of the Federal Reserve's emergency bank program, the Bank Term Funding Program. With the Fed's commitment to maintaining higher interest rates for an extended period and a looming liquidity shortage, it's prudent to consider that we may be in the late stages of the economic cycle. While financial markets could maintain some strength as we approach this liquidity cliff, early 2024 may present formidable challenges.

As an investor navigating this environment, it's wise to seek out an active manager who comprehends the current economic dynamics and prioritizes capital preservation while seizing opportunities as we transition from late to early cycle conditions. Keep in mind that active ETFs can offer tax efficiency with capital gain treatment, making them an attractive option for managing your investments during these uncertain times.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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