Hey There Income Hunters,

 

Another week, more volatility.

 

• • • Treasury is issuing $110 billion of bonds ($50 billion in 3-year on Tuesday, $37 billion in 10-year on Wednesday and $23-billion in 30-year on Thursday)
    • The CPI report comes out on Thursday (7.3% expected)
    • University of Michigan consumer sentiment and 5-year inflation projections will be released

 

The most important issue ahead of us is this …

 

Does the Fed start quantitative tightening in March?

 

I think so because QT is preferable to raising rates.

 

You see, QT is much more significant for market liquidity than raising rates because liquidity is being directly drained from the banking system

 

It also makes the banks, and financial sector in general,  a great bearish play as we head into March.

 

Today, I’ll dissect the financials and reveal back-tested data on how they perform during Stage 3 (Stagflation) and Stage 4 (deflation) market environments.

 

(Get familiar with my four stages of inflation here.)

 

Trading Stages 3&4 During QT

 

When you look at the four stages of inflation, you can see that stages 1 and 2 are similar and 3 and 4 are similar.

 

The difference between the two sets is that in stages 1 and 2 growth is accelerating, while in stages 3 and 4 growth is decelerating. 

 

So, as we head into an environment that is meant to slow growth (Fed tightening), it helps to know that the US will be in the latter stages until the Fed eases the tightening.

 

Here’s why that is so helpful …

 

In stage 3 or 4 when the Fed is doing QT, the banks and financial sector in general, perform very poorly. 

 

There are a couple of reasons for that …

 

Treasury Bond Curve Impact on Banks

 

The Fed’s QT policy will accelerate the rising of short-term bond rates versus long-term rates. 

 

This change in the slope of the curve will dramatically impact bank profit margins.

 

Think about it this way:

 

Banks’ main profit comes from using deposits that have been free reserves for banks with rates at zero. Then they make 30-year fixed rate mortgage loans at long-end rates.

 

So, right now they pay depositors zero and lend to homeowners at 4% – that’s a 400% return. 

 

However, if short rates rise to 2% and long rates stay where they are, the profit margins drop 50% on loans. 

 

Take a look at how the SPDR S&P Regional Banking ETF (Ticker: KRE) did the last time the curve flattened aggressively.  

 

 

The 2-yr/10yr curve will easily flatten to 0, or even negative, if the Fed follows through what is currently priced in for the months ahead. 

 

KRE would decline 20-25% under those conditions. That would occur whether the market is in Stage 3 or 4, and under the current Fed mandate, the central bank must crush growth to get inflation down. 

 

Now let’s take a look at the SPDR Select Sector Financial ETF (Ticker: XLF) against the Fed QT executed in 2018.

 

QT is even tougher on banks than the flattening in the curve because it drains them of liquidity.

 

It also removes all the trading profits during QE when they make a killing buying bonds from the Treasury and selling them to the Fed. 

 

 

Key Back-Test Numbers

 

I researched back-tested  results for Stage 3 stagflation and Stage 4 deflation …

 

Based on expected returns for the financial sector stocks during each stage when the Fed is executing quantitative tightening:

 

• • • Stage 3 Stagflation: Financial (XLF) stocks back tested to a -25% return
    • Stage 4 Deflation: Financial stocks back tested to a -35% return

 

Bring It Home

 

Hopefully these results show you how valuable breaking the market into inflation stages is. It offers an objective process to utilize that can work in any market environment.

 

When the market is pricing in such extreme Fed policy moves, you can increase your position size to your max and take advantage of excellent low risk/high reward opportunities.

 

There is no way the Fed will tighten 5-plus times in 2022, and this week may present a very good opportunity to buy bonds and sell banks.

 

Live and Trade with Passion My Friend,

 

Griff