QQQ: The Fed Could Reinflate The Tech Bubble
- The market expects the Fed's pivot - the pause in March/May and the cut in June/July.
- There are no signs of an imminent recession yet, at least based on the labor market data.
- The Fed's pivot before a recession could reinflate the tech bubble, as proxied by QQQ.
The Fed's meeting preview
The Fed is set to meet this week for one of the most consequential meetings in the recent history.
On one side, the core CPI inflation appears to have plateaued at a very high level of 5.5% after the brief disinflationary period, and even expected to accelerate next month to 5.6% according to the Cleveland Fed Inflation Now forecast.
On the other side, we are in the midst of the major banking crisis in the U.S. and Europe, which potentially threatens the global financial stability. What's more important, the banking crisis has been induced by the Fed's aggressive monetary policy tightening.
So, the Fed is facing the major policy dilemma: a) continue to focus on inflation and continue with the "ongoing" monetary policy tightening; or b) refocus on the financial stability risk and pause the monetary policy tightening or even cut the interest rates.
Obviously, the Fed's eventual direction will have the major effect on financial markets, particularly the speculative and interest rate sensitive technology stocks, as proxied via the Invesco QQQ ETF (NASDAQ:QQQ).
Current monetary policy expectations:
These are the current monetary policy expectations based on the Federal Funds futures:
- The current Federal Funds rate: 4.63% (the official range between 4.5% and 4.75%)
- The projected peak: 4.78% by May 2023 - implying that there is about 60% chance that the Fed will hike by another 25bpt either in March or in May, and then pause.
- The first expected cut: 4.48% by July 2023 - implying 100% chance of the 25bpt cut at either the June or July meeting, with about 20% change of a 50bpt cut.
- Projected terminal rate: 2.65% by February 2025 - implying gradual normalization of interest rates from mid 2023, trough 2024 until the beginning of 2025.
The market expects the Fed to refocus on the financial stability risk with the pause in the monetary policy tightening, either in March or in May after the possible additional 25bpt hike, and subsequently start to gradually decrease interest rates immediately after in June or July, all through 2024 into the first half of 2025.
It is important to note that this is not an immediate recession forecast - in case of a recession the Fed would likely aggressively cut. This appears to be more of a "soft landing" of even a "no landing" scenario.
Obviously, we are currently not in a recession, as the labor market remains very tight (as measured by the high-frequency initial claims for unemployment data, which dipped under the 200K level again last week).
Thus, the Fed is expected to make the "proverbial pivot" before the economy enters a recession.
Why the Fed has to refocus on the financial stability?
The current banking crisis is very serious, poses a major systematic risk, and it's caused by the Fed.
Specifically, the Fed has increased the short-term interest rate from the near 0% to almost 5% in 12 months. Banks are supposed to adjust the interest rate on the consumer deposits in-line with the Federal Funds rate - which means that consumers should be earning 4.5-5% interest on their bank savings accounts. However, banks did not increase the interest rate on the savings accounts. Thus, customers begun the withdraw the bank deposits and invest the savings in Treasury Bills at 4-5% yield.
Additionally, as the Fed increased the interest rate, the value of the bonds held by the banks plummeted. So, when the customers started to withdraw their deposits, the banks were forced to sell these bonds at deep losses.
So, combine the two - the consumers want the deposits back, but the banks don't have the full deposits due to the losses on bond sales. Thus, we have the liquidity shock - but not the credit crunch yet.
Consequently, the Fed cannot increase interest rates further, since this would make the problem bigger, as the short term T-Bills yields would increase and encourage even more deposit withdrawals.
In fact, the Fed should cut interest rates, which would have the double positive effect: 1) discourage the deposit withdrawals; and 2) boost the bond prices.
What about the inflation risk?
The inflation risk is likely the "yesterday's story." Banking crises are by definition deflationary. The money supply in real economy is created by the banks when they extend credit.
Banks can't profitably lend if they increase the interest rate on the customer deposits to match the Treasury Bills yield. So, the banks in this situation would be likely to stop extending credit, which would likely cause a deflationary recession.
Even worse, if the current liquidity crisis transitions into the credit crunch, which would happen with the increase in bad loans, we could be facing a deflationary depression.
Thus, the Fed can rightly refocus from the inflationary risk to the financial stability risk. More importantly, the Fed now has an incentive to avoid the recession, since the recession would increase the probability of a credit crunch.
Implications for the tech stocks
The tech stocks are particularly sensitive to interest rates, given the long duration of expected cash flows. Also, tech stocks are considered to be very speculative and thus, sensitive to change in sentiment.
Even before the current banking crisis, tech stocks have been performing well in 2023. The ETF that closely tracks the performance on Nasdaq 100, QQQ, is up over 15% YTD, overperforming the broad market index SPDR S&P 500 Trust ETF (SPY), which is up by only 2.4%.
Based on the Federal Funds futures, the Fed is expected to make the pivot, before the recession arrives. This would be bullish for the tech stocks. Nasdaq 100 - QQQ - has led the post-covid rally and reached the bubble-like valuations, before the deep correction in 2022 as the Fed hiked interest rates. The Fed's pivot could reinflate this tech bubble.
Additionally, there is the fundamental theme to support the tech stocks - and that's AI. Microsoft Corporation (MSFT), which is the most heavily weighted stock in Nasdaq 100 at almost 13% weigh, is turning into the leader in AI race. Alphabet Inc. (GOOG) and NVIDIA Corporation (NVDA) are also leaders in the AI race, and weight for 13% of QQQ together.
My recommendation for QQQ was a Sell, based on the obvious reasons that the Fed's hikes would cause a recession, which would continue to crush the overvalued tech stocks. But, at this point, I am upgrading to Neutral. After the Fed's meeting, I will re-evaluate the situation, as the Fed's focus becomes clearer.
The recession is likely coming, but the question is when, and what happens until the recession arrives. So, this is a more of a tactical near-term call.
Here is the QQQ chart. Tactically, QQQ has held the key support at 200wma, and as long as the price hold above the black line, the bottoming process is in place. Any short-term spike would take the QQQ to the red line or the 100wma. The breakout above is the bubble reinflation trigger - if supported with the Fed's pivot in absence of a recession.
This article was written by
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