A Letter or A Plea?

ARK Invest’s Cathie Wood has opposed the Federal Reverse since at least the time the U.S. central bank first hiked rates above zero. Just three weeks after the Fed’s first interest rate hike, with more promised, Wood warned the Fed was making a mistake. On April 2nd, Wood jumped on a market signal from the inversion of the yield curve to underline the point.

The inversion barely last 2 days. The yield curve quickly “reverted” for the next 3 months and threw wrenches into the prognostications of a Wall Street looking for a recession to stop the Fed in its tracks. The yield curve inverted again in early July and has yet to look back. Yet, the Fed has become increasingly hawkish even in the face of this traditional signal of a recession. The Fed’s resolution was epitomized by a curt speech at Jackson Hole where Chair Jay Powell stood resolute on the Fed’s inflation fighting mantra.

Source: Board of Governors of the Federal Reserve System (US), Market Yield on U.S. Treasury Securities at 10-Year Constant Maturity, Quoted on an Investment Basis [DGS10], retrieved from FRED, Federal Reserve Bank of St. Louis; October 10, 2022.

So it is no surprise that Wood recently opened a new salvo in her campaign against the Fed’s monetary policy by writing an “open letter to the Fed” to extend her latest criticism in her videocast “In the Know.” In this letter, Wood warns that the Fed is overly focused on lagging indicators from inflation and employment and cannot see the “deflationary bust” that awaits the other side of its aggressive monetary tightening. In many ways, a deflationary bust has already occurred in financial markets. For example, Wood’s flagship fund The ARK Innovation ETF (ARKK) is just a “day’s trade” away from returning to its pandemic lows. Those sudden March, 2020 lows came on the heels of an economic and market crash that was full-force deflation until monetary and fiscal stimulus saved the day.

ARK Innovation ETF (ARKK) long ago lost all its pandemic era gains and how looks set to return to its pandemic crash levels. (Source: TradingView.com)

A Deflation Is Already Here

In other words, the deflation that Wood fears has already unfolded in certain financial markets. That pain is felt by anyone invested in the stock market. That pain runs even deeper for those speculating in the companies uncomfortably jostling around in the collection of ARK funds. However, Wood’s letter does not point to prices in her funds. Instead, the letter relies on a series of economic readings showing peak prices and subsequent declines for gold, silver, lumber, iron ore, DRAM, shipping, copper, corn, oil, and container board. The letter points out the ballooning inventories at major U.S. retailers and elements of employment data that show the first signs of a hot labor market finally beginning to cool.

All this complaining across Wall Street and all these data of course beg the question: why is the Fed ignoring it all? However, I think this question is misplaced. For example, Mary Daly, head of the San Francisco Fed, insisted that the Fed is forward looking. She even scolded the market is wrong in expecting rate cuts in 2023. The Fed has hundreds of economists on staff, including the ones who help to curate the charts from the St Louis Fed that I used to show the yield inversion. They know everything and more than the economists who get all the attention in the media. So I think it is a stretch to conclude that the Fed has no idea what is going on.

Why the Fed Won’t Read Cathie Wood’s Letter: Speculating on the Fed’s (Unstated) Strategy

Instead, I look to the larger, strategic context. The Fed kept rates too low for too long: the mania in the housing market and stratospheric valuations of profitless companies (again, see the ARK Funds) are sufficient evidence that the Fed should have started the journey toward normalization earlier. Moreover, the Fed has a massive $9 trillion dollar balance sheet that represents a considerable share of the $20 trillion U.S. economy. My guess is the Fed is not hearing the whispers of the famous inflation fighter, former Fed Chair Paul Volcker. Instead, the Fed recognizes the layers of distortions it helped to create in the economy, and it desperately wants to hit the reset button. From the purview of neutral to slightly restrictive policy, it can THEN observe the impact and assess whether the economy can sustain the resulting damage. I also guess that the Fed fully recognizes that the very minute markets sniff a peak in monetary tightening, speculative forces will roar away. Just watch what happens to the ARK Funds in that moment. Indeed, when Wood expected the Fed to cry uncle in July, she anticipated a vindicating resurgence in the ARK Funds.

In this environment where financial markets have become accustomed to easy money and have little experience dealing with inflationary pressures, the Fed is forced to err on the side of being aggressively hawkish as long as it dares possible. The Fed needs to make sure that when the time comes to pause and observe, little to no inflationary embers are left smoldering, ready to reignite with the giddy anticipation of easy money days to come again. As long as employment remains robust and resilient, the Fed can maintain political support for its actions even as support from market participants plummets. The rush to get to neutral or past neutral is likely exactly because the employment window cannot remain open to the Fed for an extended period. The Fed’s actions suggest a strategy for finishing hikes by the time the labor market’s weakness is obvious through an uptrend in the unemployment rate. The Fed has shown itself unmoved by losses in financial markets. So, pundits can throw all the macroeconomic tomatoes they want, the Fed is in over-correction mode for now.

Clinging to the ARK

When the bottom fell out of the ARK Funds, I updated my technical assessment and trading strategy on each of the major funds. I continue to think that the technicals are much more important than the fundamentals here. While the inverse correlation between interest rates and ARK performance is fundamental (surely much to Wood’s chagrin), the technicals of trend-following are sufficient for making trades. At some point, rates WILL peak. I contend the technicals (of trading on extremes) will actually become even more important then. Who knows what will be left standing in the ARK funds by that point…

Be careful out there!

More By This Author:

Fed's Daly: The Market Is Wrong About A Hump In 2023 Fed Rates
Softening Inflation Expectations Are The Beginning Not The End Of The Fed’s Hawkish Posturing
The Reserve Bank Of Australia Looks Ahead To Peak Inflation