This week, the Fed’s decision on interest rates is weighing heavily on the stock market and investors’ minds.
But wondering whether rates will be higher… lower… or remain the same is the wrong question to be asking.
Instead, we should look at what this will mean for long-term inflation… and a possible recession.
In today’s video update, Chief Analyst Adam Galas shares the full picture. He’ll show where we really stand and what actions are needed to meet the Fed’s inflation goals.
And best of all, he’ll share details on the recession hedge we include as part of our Fortress Portfolio.
Click below to watch the video or scroll down to read the transcript.
Happy SWAN (sleep well at night) investing,
Brad Thomas Editor, Fortress Portfolio
Transcript
Welcome, Fortress Portfolio members to a special edition of this week's video update.
On Wednesday [this video was filmed on Tuesday] the Fed is going to decide what to do with interest rates and put out revised economic forecasts.
And of course, Jerome Powell will give his press conference.
If you’ve been watching TV or listening to financial radio, you’ve heard a lot of people discussing whether or not the Fed's going to hike to 5.5% or just sit at 5.25%.
And some people have talked about how, “Oh September doesn't matter. It's all about November.”
And other people have said, “The real question is – how long is the Federal Reserve going to sit tight on rates where they are right now?”
These are all interesting questions… Well, at least if you're a financial nerd like me.
But the question above is the wrong question to ask.
There is a more important question to ask.
Now, as you can see here in the chart below… the more important question to be asking is – are rates high enough to beat inflation?
(Source: Taylor Rule Fed Funds Prescription Heatmap for 2023: Q3 from Atlanta Fed)
Now, the Fed, of course, has lots of models.
It has 400 Ph.D. economists working for it. And they have dozens of different kinds of models.
But the various different models based on the data – and the Fed keeps saying it's data dependent – say that between 5.5% and about 8% is where interest rates should be right now based on the economic data.
But, the thing to really focus on (and that has me personally worried) is that based on the model for 2% inflation, the Fed should be between 7% and 8% right now.
But, of course, we're at 5.25%, so that's quite a far distance away.
So does that mean that we're all screwed and the Fed is doomed us all?
After all it's going to take (at the current rate) about two or three years for the Fed to actually get to where its models say it has to go – back to 2% inflation.
Well, no… there is some good news because as you can see below, the San Francisco Fed estimates that if you factor in quantitative tightening (that reverse money printing that the Fed is doing) as well as the regional banking crisis (which is still going on but at a low boil), we are actually at about 7% interest rates right now.
So that means the Fed isn't about 2.5% behind the curve, but just 1 to 3 more rate hikes behind the curve.
Now, that's assuming (according to its own economist models), that it wants to get to 2% inflation.
Some economists say that they're skeptical that the Fed actually means what they say. The Fed keeps saying 2%, 2%, 2%, but in fact… they're not willing to do what it takes to get us there.
As you can see below, the bond market agrees that it is time to be skeptical of the Fed, and that they are lying to us.
We're not going back to 2%. We're basically going to sit tight at 5.25% all the way to July before the Fed starts cutting rates. And then it’s going to cut three times next year.
Now, what does that actually mean?
Well, first of all, this information here is pretty much what all the professionals on Wall Street use (the hedge fund managers and people on Bloomberg).
(Source: CME Fed Probabilities from CME Group)
Whenever you see people talking about what's priced in and what the Fed is going to do – this CME model based on bond futures – is what they're talking about.
What this is basically telling us is that the bond market right now says there is a 100% chance of recession by July, and a 97% chance of a recession before then next year.
Now, that is certainly good news for the economy and Main Street, not necessarily for Wall Street. Remember, one of the big reasons that the market has been flying so high for so long is because of its absolute conviction that the Fed is about to start cutting – and start cutting aggressively.
So you might be wondering, what does this actually mean for your Fortress Portfolio?
A great question.
Well, let's take a look at a very important chart.
This chart will tell us the inflation breakeven rate.
So based on the bond market and where bond yields are today, what does the bond market – the smart money on Wall Street – think that long term inflation is going to be?
Well, as you can see below, it has a range of between 2.3% and 2.6%.
(Source: Inflation Breakeven Chart from Ycharts)
And for the very long term – 30 years, which is the duration for the PIMCO bond ETF that we're using in Fortress Portfolio – it’s 2.31%.
So here's what that actually means.
Historically, the real interest rate or the inflation adjusted interest rate is about 1.5% for long bonds. That means that if the Fed were actually going to take us back down to 2%... the 30-year Treasury should have a long term yield of about 3.5%, which would mean that PIMCO's ETF would have a fair value of about $100 per share.
Right now, it's trading at $79 and the bond market is saying that at 2.31% long term inflation, the 30-year yield should be 3.8% with a fair value of $93.50.
This means that if the Fed were actually going to take us to 2% right now, this ETF would be 22% undervalued.
But, it's currently 16% undervalued based on what the bond market thinks and long term inflation.
So the Fed not going to get us to 2%, but get us relatively close, close enough for government work, as they say.
But what does this actually mean in terms of the coming recession?
Well, historically, in a recession long bond yields (such as the 30-year yield), tend to fall 2% and rally about 50% to 60%. That's why they're the best recession hedge in history.
Now, because inflation is higher, we’re not expecting a 2% decline but more of a 1% decline to get us to around 3.5%.
Now, that still means roughly a 26% rally expected from our long bonds. And for Fortress Portfolio members, 17% of your portfolio is hedged against a direct recession.
And the good news is – that’s our conservative base case.
Now, as you can see below, we have the copper to gold ratio chart, which is highly accurate at forecasting interest rates. And right now, it’s screaming recession and about 2% on the 30-year yield.
(Source: Copper Gold Ratio 10-year Yield Chart from The Daily Shot)
That would be about a 2.5% decline in yields, which would be a 65% rally.
So we're basically saying around 26% is our conservative likely estimate for a rally from this point... but it could be as much as 65%.
Now, here is the power of hedging.
As you can see below, we have a recession bear market bottom model for the S&P, depending on how much earnings decline in the coming recession of 2024.
(Source: Fortress Portfolio Valuation Tool Metrics Based on FactSet, Bloomberg, and S&P data)
And remember, the bond market says it’s a 97% probability.
Now, the base case (a 13% decline in earnings) would mean the S&P falls about 25%.
And, the model above is accurate as long as the recession happens next year. It doesn't matter what time it happens next year as long as it happens.
So we're looking at 25% to 30% likely decline in the S&P 500.
If you remember a few months back, we mentioned Morgan Stanley was warning that this was starting to look like 1948.
Back then, the stock market fell about 28%, just like this time.
Then it took off like a rocket. It basically got very close to record highs and then it rolled over and hit fresh new lows… not crazy lower lows, but still around -30%. This time we're looking at around -32%, -35% off the record highs that were set back on January 4th of 2022.
Here’s the thing, 30% to 35% peak decline is completely normal for the average recessionary bear market.
But as I always like to say, when you're living through it in the moment, it never feels average.
Remember that we came within 3% of new record highs. Stocks screaming higher. Amazon, Google, big tech, everyone loving it… partying it like it was 1999.
We came very close and now markets are rolling over, and the recession is finally taking hold.
And now we’re looking at a 25% to 30% decline from here after the party we've just had. It’s going to feel like hell to a lot of people, your friends, your neighbors… They're going to be losing their minds.
But this is where Fortress Portfolio will shine. Remember, it's not just about the bonds.
As you can see below, we also have managed futures.
And the combination of long bonds and managed futures since the 1970s, is the single best hedging combination for our current environment.
In fact, while the market's likely to fall 25% to 30%, this hedging bucket is likely to go up 25% to 30%.
Just like a mirror image...
That's why it's the best hedging combination.
If the market falls 34% and your hedges go up 34%, guess what? Your portfolio falls half as much as the market.
Now, it still might be painful, but it's a lot less painful than what your friends and neighbors are going to be experiencing. And the key is it keeps you sane and safe.
Because right now, we're sitting on a safe 7% yield in our portfolio.
And, guess what? In this recession, we might be able to get you opportunities at 8%, 9%, 10%, or even higher.
For example, during the pandemic, there were 17% very safe yields we could have gotten you… had this service existed at that time.
So there are going to be incredible opportunities, but you have to stay calm and rational.
Everyone else around you is going to be losing their mind. They will be looking for any reason to sell.
You need to stay calm, and that is what we can help you with in our monthly issues and these weekly video updates. The Fortress Portfolio is super steady and will see half the declines of the market, even in the most extreme market declines.
And while this is happening, you will be minting money on those dividends.
You’ll be laughing all the way to the bank while your neighbors are losing their minds in terror.
You'll be living in a dividend funded utopia while everyone else around you is going through a yearlong hell.
Remember, we came within 3% of new record highs. So it's kind of like the market gods were teasing us… but we've been prepared the entire time for things to bottom out, and so have our members.
That's the power of Fortress to help you earn not just that safe 7% yield in a raging bull market… but lock in the kinds of incredible yields that you can only get in a recessionary crash. We want you to sleep like a baby with the sweetest yields you can ever imagine – without having to experience the kind of stress that can ruin your day, your year, or even your life.
I want to thank you for joining us.
I hope you join us next week when we go through some more important topics that the financial media is not talking about. I’ll let you know why these topics matters to you and your Fortress Portfolio.
Until then, please send us your questions and feedback so I can respond to them in these videos and our monthly issues.
Just remember, I cannot provide personalized investment advice.
Until next week, this is Adam Gauss, wishing you and your family safe investing and a happy, healthy and relaxing weekend.
