Jay Powell is selling but the bond market isn’t buying

Fed Chairman Jerome Powell declared that the Fed’s commitment to taming inflation is “unconditional”:

June 23 (Reuters) – The Federal Reserve’s commitment to reining in 40-year-high inflation is “unconditional,” Powell told lawmakers on Thursday, even as he acknowledged that sharply higher interest rates may push up unemployment.

“We really need to restore price stability … because without that we’re not going to be able to have a sustained period of maximum employment where the benefits are spread very widely,” the Fed Chairman told the U.S. House of Representatives Financial Services Committee.

Under questioning by members of the House panel on Thursday, Powell said there was a risk the Fed’s actions could lead to a rise in unemployment. “We don’t have precision tools,” he said, “so there is a risk that unemployment would move up, from what is historically a low level though. A labor market with 4.1% or 4.3% unemployment is still a very strong labor market.”

He also dismissed cutting interest rates if unemployment were to rise while inflation remained high. “We can’t fail on this: we really have to get inflation down to 2%,” he said.

The Fed chief was also asked about the central bank’s balance sheet, which was built up to around $9 trillion during the pandemic in an effort to ease financial conditions and is now being pared. The Fed aims to get it “roughly in the range of $2.5 or $3 trillion smaller than it is now,” Powell said.

But the bond market isn’t buying it. Treasury yields from 2-year to 30-year are compressed in a narrow band above 3%, indicating a flat yield curve. Expectations are that the Fed can’t go much higher than 3.0% to 3.5%.

Treasury Yield Curve

The dot plot from the last FOMC meeting similarly projects a 3.4% fed funds rate by the end of 2022, 3.8% by 2023, and lower at 3.4% by the end of 2024.

FOMC Dot Plot

You cannot cure inflation with a Fed funds rate (FFR) of 3.5%.

CPI is growing at 8.6% YoY, while the FFR target maximum is 1.75%. Another 1.75% just won’t cut it. You have to hike rates above inflation. Positive real interest rates are the best antidote for inflation but the economy, in its current precarious state, could not withstand this.

Fed Funds Rate & CPI

Taming inflation in the 1980s

Paul Volcker killed inflation by hiking the fed funds rate to 20% in 1980, but we live in a different world.

In 1980, federal debt to GDP was less than 50% of GDP. Today it’s 118%.

Federal Debt/GDP

The Federal deficit was 2.5% of GDP. Now it’s 12%.

Federal Deficit/GDP

Private debt (excluding the financial sector) was 1.35 times GDP in 1980. Now it’s more than double.

Private Non-Financial Debt/GDP

Powell can’t hike rates like Volcker. If he tried, he would collapse the economy and the US Treasury would be forced to default on its debt. Collapse of the global reserve asset is about as close as you can get to financial Armageddon.

Pricking the bubble

Instead, the Fed plans to use QT to deflate the asset bubbles in stocks and housing, in the hope that a reverse wealth effect — as households feel poorer — will slow consumer spending and reduce inflation.

So far, the S&P 500 has dropped by 25% and the housing market is likely to follow. The 30-year mortgage rate has climbed to 5.81%, more than double the rate in August last year.

30-Year Fixed Mortgage Rate

Housing starts and permits are both declining.

Housing Starts & Permits

Powell talks of a $2.5 to $3.0 trillion reduction in the Fed’s balance sheet. That would increase the supply of Treasuries and MBS in financial markets by an equivalent amount which would be sucked out of the stock market, causing a fall in prices.

The two largest foreign investors in US Treasuries — Japan and China — have also both become net sellers to support their currencies against the rising Dollar. That will further increase the supply of Treasuries, causing an outflow from stocks.

Since 2009, stock market capitalization increased by $47.4 trillion, from $16.9T to $64.3T at the end of Q1. At the same time, the Fed’s balance sheet increased by $7.9 trillion, from $0.9T to $8.8T. Market cap increased by $6T for every $1T increase in the Fed’s balance sheet (QE). The multiplier effect is 6 times (47.4/7.9).

Stock Market Capitalization & Fed Total Assets

If the Fed were to shrink its balance sheet by $2.5 trillion and net foreign sales  of Treasuries amount to another $0.5 trillion, we could expect a similar multiplier effect to cause an $18 trillion fall in market capitalization ($3Tx6). Market cap would fall to $50T or 26.5% from its $68T peak in Q4 of 2021.

That’s just the start.

“Inflation is always and everywhere a monetary phenomenon”

Nobel prize-winner Milton Friedman argued that long-term increases or decreases in the general price level were caused by changes in the supply of money and not by shortages or surpluses of oil, commodities or labor.

The chart below shows the supply of money (M2) as a percentage of GDP. The economy thrived with M2 below 50% throughout the Dotcom boom of the late 1990s but has since grown bloated with liquidity as the Fed tried to revive the economy from the massive supply shock of China’s admission to the World Trade Organization in 2002 — the introduction of hundreds of millions of workers earning roughly 1/30th of Western-level wages.

Money Supply (M2)/GDP

The massive supply shock helped to contain prices over the next two decades, perpetuating the myth of the Great Moderation — that the Fed had finally tamed inflation. Fed hubris led them to pursue easier monetary policy with little fear of  inflationary consequences.

All illusions eventually come to an end, however, and the 2020 pandemic caused the Fed to purchase trillions of Dollars of securities to support massive government stimulus payments. The MMT experiment failed disastrously, causing a $5 trillion spike in M2 without an accompanying rise in GDP. M2 spiked up from an already bloated 70% of GDP to more than 90%, before GDP recovered slightly to reduce it to the current 89%.

Trade tensions with China, coupled with supply chain disruptions from the 2020 pandemic and a sharp rise in natural gas prices — as industry switched from coal to reduce CO2 emissions — triggered price increases. These were aggravated by Russia’s invasion of Ukraine and resulting sanctions, leading to oil shortages.

Normally, high prices are the cure for high prices. Consumers cut back purchases in response to high prices and demand falls to the point that it matches available supply. Prices then stabilize.

But consumers are sitting on a mountain of cash, as illustrated in the above M2 chart. They continued spending despite higher prices and demand didn’t fall. Investors who have access to cheap debt also, quite rationally, borrow to buy appreciating real assets. Unfortunately cheap leverage is seldom channeled into productive investment and instead fuels expanding asset bubbles in homes and equities.

The Fed is forced to intervene, employing demand destruction, through rate hikes and QT deflate asset bubbles, to reduce consumer spending.

An unwelcome side-effect of demand destruction is that it also destroys jobs. Unemployment rises and eventually the Fed is forced to relent.

Conclusion

Fed Chairman Jerome Powell says that the Fed’s commitment to reining in inflation is “unconditional” but the bond market is pricing in rate hikes peaking between 3.0% and 3.5%, way below the current rate of inflation. The economy is unlikely to be able to withstand more because of precarious levels of debt to GDP and a massive fiscal deficit.

Instead, the Fed plans to shrink their balance sheet by $2.3 to $3 trillion. QT is expected to deflate asset bubbles in stocks and housing and achieve a reverse wealth effect. Households are likely to curb spending as their net worth falls and they feel poorer.

Unfortunately, demand destruction from rate hikes and QT will also cause unemployment, inevitably leading to a recession. The Fed seems to think that the economy is resilient because unemployment is low and job openings outnumber unemployed workers by almost 2 to 1.

Job Openings & Unemployment (U3)

But elevated debt levels and rapidly rising credit spreads could precipitate a sharp deleveraging, with crumbling asset prices, rising layoffs and credit defaults.

High Yield Spreads

The Fed may also manage to lower prices through demand destruction but inflation is likely to rear its head again when they start easing. Surging inflation is likely to repeat until the Fed addresses the underlying issue: an excessive supply of money.

Milton Friedman was a scholar of the Great Depression of the 1930s which he attributed to mistakes by the Fed:

“The Fed was largely responsible for converting what might have been a garden-variety recession, although perhaps a fairly severe one, into a major catastrophe. Instead of using its powers to offset the depression, it presided over a decline in the quantity of money by one-third from 1929 to 1933 … Far from the depression being a failure of the free-enterprise system, it was a tragic failure of government.”

Ben Bernanke, another scholar of the Great Depression, acknowledged this during his tenure as Fed Chairman:

“Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton (Friedman) and Anna (Schwarz): Regarding the Great Depression, you’re right. We did it. We’re very sorry. But thanks to you, we won’t do it again.”

Instead the Fed made the opposite mistake. By almost doubling the quantity of money (M2) relative to GDP (output) they have created an entirely different kind of monster.

Money Supply (M2)/GDP

Slaying the beast of inflation is likely to prove just as difficult as ending the deflationary spiral of the 1930s.

Larry Summers: Fed needs same disinflation as under Volcker

Larry Summers highlights a paper from the NBER regarding measurement of CPI since the 1980s. Changes in how cost of housing is measured have lowered core CPI relative to the methodology used prior to the early 1980s (blue line below). Applying the current methodology (red line) retrospectively suggests that comparable core CPI is closer to the Volcker era.

Larry Summers

Summers continues:

“New paper shows past and present CPI inflation are more similar than official data suggests. When correcting for change in how housing inflation is measured, we find a return to target core inflation will require the same disinflation as achieved under Volcker.”

Funding both sides of the war | Thomas L Friedman

Our continued addiction to fossil fuels is bolstering Vladimir Putin’s petrodictatorship and creating a situation where we in the West are — yes, say it with me now — funding both sides of the war. We fund our military aid to Ukraine with our tax dollars and some of America’s allies fund Putin’s military with purchases of his oil and gas exports.

~ Thomas L Friedman, NY Times, May 17, 2022

It’s a bear market

The S&P 500 broke primary support at 4170 to confirm a bear market. A Trend Index peak at zero warns of strong selling pressure.

S&P 500

The Nasdaq 100 similarly broke support at 13K, confirming the bear market.

Nasdaq 100

Dow Jones Industrial Average, already in a primary down-trend, confirmed the bear market with a break below 32.5K.

Dow Jones Industrial Average

The Transportation Average lags slightly, testing primary support at 14.5K. Follow-through below 14K would be the final nail in the coffin.

Dow Jones Transportation Average

A plunging Freightwaves National Truckload Index warns that we should not have long to wait.

Freightwaves Truckload Index

Conclusion

All major US stock market indices now warn of a bear market. Weak retracement, to test new resistance levels, should not be confused with a buy-the-dip opportunity.

S&P 500

Stocks: Winter is coming

GDP grew by a solid 10.64% for the 12 months ended March ’22 but that is in nominal terms.

GDP

GDP for the quarter slowed to 1.58%, while real GDP fell to -0.36%. Not only is growth slowing but inflation is taking a bigger bite.

GDP & Real GDP

The implicit price deflator climbed to 1.94% for the quarter — almost 8.0% when annualized.

GDP Implicit Price Deflator

Growth is expected to decline further as long-term interest rates rise.

10-Year Treasury Yield & Moody's Baa Corporate Bond Yield

Conventional monetary policy would be for the Fed to hike the funds rate (gray below) above CPI (red). But, with CPI at 8.56% for the 12 months to March and FFR at 0.20%, the Fed may be tempted to try unconventional methods to ease inflationary pressures.

Fed Funds Rate & CPI

That includes shrinking its $9 trillion balance sheet (QT).

During the pandemic, the Fed purchased almost $5 trillion of securities. The resulting shortage of Treasuries and mortgage-backed securities (MBS) caused long-terms yields to fall and a migration of investors to equities in search of yield.

The Fed is expected to commence QT in May at the rate of $95 billion per month — $60 billion in Treasuries and $35 billion in MBS — after a phase-in over the first three months. Long-term Treasury yields are likely to rise even faster, accompanied by a reverse flow from equities into bonds.

S&P 500 & Fed Total Assets

S&P 500 breach of support at 4200, signaling a bear market, would anticipate this.

Conclusion

Fed rate hikes combined with QT are expected to drive long-term interest rates higher and cause an outflow from equities into bonds.

A bear market (Winter) is coming.

Job openings warn of higher inflation

Job openings came in at a seasonally-adjusted 11.27 million for February, compared to unemployment of 6.27 million. A shortfall of 5 million workers.

Job Openings & Unemployment

Conclusion

An excess of 5 million job openings, above the unemployment level, is expected to maintain upward pressure on wage rates as employers compete for scarce workers. Inflationary pressure is likely to continue.

S&P 500 rallies as Fed tightens

Stocks rallied, with the S&P 500 recovering above thew former primary support level at 4300. Follow-through above 4400 would be a short-term bull signal.

S&P 500

Markets were lifted by reports of progress on a Russia-Ukraine peace agreement — although that is unlikely to affect sanctions on Russia this year — while the Fed went ahead with “the most publicized quarter point rate hike in world history” according to Julian Brigden at MI2 Partners.

FOMC

The Federal Reserve on Wednesday approved its first interest rate increase in more than three years, an incremental salvo to address spiraling inflation without torpedoing economic growth. After keeping its benchmark interest rate anchored near zero since the beginning of the Covid pandemic, the policymaking Federal Open Market Committee (FOMC) said it will raise rates by a quarter percentage point, or 25 basis points….. Fed officials indicated the rate increases will come with slower economic growth this year. Along with the rate hikes, the committee also penciled in increases at each of the six remaining meetings this year, pointing to a consensus funds rate of 1.9% by year’s end. (CNBC)

Rate hikes are likely to continue at every meeting until the economy slows or the Fed breaks something — which is quite likely. To say the plumbing of the global financial system is complicated would be an understatement and we are already seeing reports of yield curves misbehaving (a negative yield curve warns of recession).

Federal Reserve policymakers have made “excellent progress” on their plan for reducing the central bank’s nearly $9 trillion balance sheet, and could finalize details at their next policy meeting in May, Fed Chair Jerome Powell said on Wednesday. Overall, he said, the plan will look “familiar” to when the Fed last reduced bond holdings between 2017 and 2019, “but it will be faster than the last time, and of course it’s much sooner in the cycle than last time.” (Reuters)

The last time the Fed tried to shrink its balance sheet, between 2017 and 2019, it caused repo rates (SOFR) to explode in September 2019. The Fed was panicked into lending in the repo market and restarting QE, ending their QT experiment.

SOFR

QT

Equities are unlikely to be fazed by initial rate hikes but markets are highly sensitive to liquidity. A decline in the Fed’s balance sheet would be mirrored by a fall in M2 money supply.

M2 Money Supply/GDP & Fed Total Assets/GDP

And a similar decline in stocks.

S&P 500 & Fed Total Assets

Ukraine & Russia

Unfortunately, Ukrainian and French officials poured cold water on prospects of an early ceasefire.

Annmarie Horden

Neil Ellis

Samuel Ramani

Conclusion

Financial markets were correct not be alarmed by the prospect of Fed rate hikes. The real interest rate remains deeply negative. But commencement of quantitative tightening (QT) in May is likely to drain liquidity, causing stocks to decline.

Relief over prospects of a Russia-Ukraine ceasefire and/or any reductions in sanctions is premature.

The bear market is likely to continue.