CNBC financial host Jim Cramer in a bubble

Breaking the Hype Machine: The Fed Versus Financial Talking Heads

By:Ilya Spivak

Rising rates are likely to pop the financial influencer bubble.

  • Low interest rates fuel bubbles in financial assets, as well as their cheerleaders.
  • Fed rate hikes might cool speculation and thin the herd of finance influencers.
  • The U.S. dollar may capitalize on liquidity as spooked investors cash out.

Billionaire investor and behemoth hedge fund founder Ray Dalio has surgically dissected the archetypical credit crash in his book Principles for Navigating Big Debt Crises, published in 2018.

Dalio vividly describes how initially well-founded economic expansion drives up the price of assets, enabling them to serve as collateral to buy still more with borrowed money. Over time, this self-reinforcing process fuels price gains beyond underlying value. What follows is familiar enough: Wile E. Coyote suddenly discovers he has run off solid ground, momentum gives way to gravity, and there’s a crash.

The anatomy of an asset bubble

Dalio flags the telltale signs of a building bubble: low interest rates encourage debt growth that exceeds increases in income, a flood of new market participants enter the fray hoping not to miss out as assets rise, and a lots of financial innovations sprout up to satisfy their rabid risk appetite.

This should sound familiar.

Care to invest in illiquid, unregulated-by-design digital tokens that yield nothing but gain in price because some day they might displace fiat currencies—all because they are backed by even less than the creditworthiness of governments? We’ll call it “crypto” and throw in a founding myth about a mysterious inventor for some cool factor.

The hype machine on overdrive

As with warrants, investment trusts, junk bonds, South Sea Company shares and Dutch tulips, a vast ecosystem of vocal boosters grew around the fantastical creations of the zero-interest-rate world after the 2008 financial crisis.

Between January and August 2022 finance influencers on YouTube published more than five times as many videos and gained nearly double the number of subscribers as those talking about something else, according to a report from the Emplify customer experience platform. The results on Instagram were similar: Finance influencers gained more followers and published over double the number of posts of other influencer groups.

Enter the Federal Reserve

Back to Dalio: He finds financial bubbles typically burst when central banks decide to raise interest rates and cut off the cheap credit essential for runaway speculation to continue. This can be a response to the bubble itself and the inflation it has stoked, or some external factors. Supply/demand mismatches amplified by a flood of fiscal and monetary stimulus in the wake of a global pandemic, for example.

fed funds rate vs s&p 500, btc performance 2022
Data Source: Bloomberg

Faced with price growth exceeding its 2% target by more than four times, the U.S. Federal Reserve hiked interest rates by a blistering 4.25 points in 2022. The benchmark S&P 500 stock index fell over 14% while the price of Bitcoin—the largest cryptocurrency—shed more than 57%.

The boosters are still many, as the Emplify data readily shows. Perhaps it is too soon to throw in the towel. Many current market-watchers have been conditioned to “buy the dip” after the four-fold increase in stocks since the last big drop – a drawdown of 38.5% in 2008. However, sticky prices and the structurally higher interest rates that they demand argue for something different this time.

Labor market gaps to keep inflation, interest rates aloft

The Fed found some initial success with its inflation fight. Price growth cooled after peaking at 9% in June 2022 as rising borrowing costs put the brakes on economic activity. Nevertheless, it remains uncomfortably high. Getting to the Fed’s target 2% will probably demand still higher rates. Staying there will likely mean a structurally higher floor on lending rates than in the past decade.

US Labor Supply/Demand Balance vs Inflation
Data Source: Bloomberg

In large part, this is because of an imbalance in the labor market. The number of people employed plus the available vacancies – together a proxy for overall demand – has far outstripped the total labor force – the available supply. That has pressured wages higher as employers compete for scarce talent. The rapid retirement of the Baby Boomer generation means that this shortage is unlikely to be offset quickly. That points to a lasting period of stronger inflationary pressure, and thereby higher rates.

Popping the bubble in finance influencers

This is likely to thin the influencer herd somewhat, as the buzzy assets and strategies that many of them promoted fade from the spotlight. The heady narratives dependent on the rock-bottom interest rate world after the 2008-09 financial crisis – whether explicitly or implicitly, realized or not – will stop making sense as costlier capital pushes investors toward a narrower universe of safer assets and bigger cash reserves.

Meanwhile, the U.S. dollar stands to capitalize. After the Fed’s leading rate hike blitz in 2022, the currency has built up a large yield advantage against most of its G10 peers. Put simply, just holding USD-denominated assets earns more interest than doing the same with those priced in Euro or Yen. In the next act, the Greenback’s unrivaled liquidity will make it the cash-out venue of choice for spooked investors as markets turn defensive.

Ilya Spivak, tastylive head of global macro, has 15 years of experience in trading strategy, and he specializes in identifying thematic moves in currencies, commodities, interest rates and equities. He hosts Macro Money and co-hosts Overtime, Monday-Thursday. @Ilyaspivak 

For live daily programming, market news and commentary, visit tastylive or the YouTube channels tastylive (for options traders), and tastyliveTrending for stocks, futures, forex & macro.

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