There’s No Such Thing as Free

For those of you who would prefer to listen:

This was a tough week for the Bulls. There’s no other way to slice it. The Bull-Bear tug-of-war continues. The Bear definitely took the higher ground. Bear Markets are a necessary part of the cycle. They’re never fun.

Inflation is still a big problem. Any hopes that peaking prices were behind us and the Fed is getting ready to pause its tightening campaign, were completely dashed. The Consumer Price Index (CPI) came in at 8.3% in August. That’s a year-over-year number. Importantly, it has fallen for 2 straight months. It’s just not falling as fast as expected. Inflation may have peaked at 9.1% in June. Unfortunately, it’s staying stubbornly high. Energy was down another 5%, extending last month’s 4.6% decline. Gasoline was down 10%, marking 95 straight daily declines. Everything else is up. Food prices were up 0.8% in just a month. That’s really high. But it’s down from July’s 1.1% increase. Food prices have spiked 11.4% since last Summer. That’s the biggest annual increase since 1979.

Core CPI, which excludes food and energy, and is the Fed’s preferred inflation gauge, rose 6.3%, missing estimates for 6.1%. It’s going in the wrong direction. This was the highest since March. It was 5.9% in July. The cost of shelter, which includes rents, increased 0.7% month over month. That is the highest jump since 1991. Rents and wages show little signs of slowing. This all means the Federal Reserve will keep a strong grip on interest rates as it tightens in order to whip inflation.

The Market has now priced in a Fed Funds rate of over 4% by year’s end and a higher terminal rate of 4.5% by next Spring. The Market just got there faster. That created the turbulence. Tight money is choking off growth. That destroys demand which runs the risk of sending the US Economy into recession. The Fed’s goal is to brake the Economy, not break the Economy. The Market is suggesting they are going to do both.

Neither the Bond Market, nor the Stock Market was ready for this inflation report. It expected much cooler price increases. The Bond Market repriced things immediately with spiking yields taking down price to catch up to what’s expected to be a more aggressive Fed. The 4-day stock rally was wiped out in just 1 day. That was Tuesday. The selling continued the rest of the week. The Dow and S&P are back to levels in July. The June lows are still a ways away. We think those lows hold for the year. But a test cannot be ruled out; Especially if the Fed stays full throttle.

This Fed has painfully proven it is poor at forecasting. Their theoretical approach has not resulted in accuracy in reality. Transitory was their preferred term to describe inflation. They referenced transitory a lot. The term became a joke in certain circles, even ending up on Top 10 lists. Inflation has been anything but transitory. The Fed was forced to switch gears to combat the runaway price increases. Housing was a target. 30-Year fixed mortgages cleared 6%, the highest levels since 2014. It has more than doubled this year. 6% mortgages by a lot less house. Fed Chair Powell said that economic pain will be felt. It’s definitely happening. 

The yield curve is still an important tell. It’s been inverted most of the year. That’s historically a sign of trouble ahead, though the timing is seldom immediate. The 2-Year Treasury yield has been higher than the 10 and 30, which is completely backward. The spread between the 2-Year and 30-Year Treasury yield reached 40 basis points (0.4%) this week. That is the most inverted it’s been in over 20 years. It’s not normal. The situation is far from normal. We know it. The Fed knows it. The Market definitely knows it. The Market still thinks the Fed is going to flinch and have to start cutting rates next year with the Economy in recession. That’s looking more and more likely. Carville had it right: The Bond Market can intimidate anybody.

The United States is the largest economy on the planet. It’s the undisputed global engine. It matters big time. The economic situation overseas is quite precarious, with an even worse inflation situation and recession in some regions already. Inflation is 9% in Europe. The Dollar sits at highs not seen in 2 decades. The Euro currency is back to par against the Dollar, where it debuted in 1999. The British Pound just hit lows not seen since 1985. A worldwide recession is increasingly likely. FedEx said that this week. There’s some serious stress in the system. The US is clearly the best of the rest. The Federal Reserve right now has the weight of the world on its shoulders. Its actions impact all things financial.

The Fed is still in the beginning stages of unwinding its biggest experiment ever. In response to the Covid Crash in 2020, the Federal Reserve took interest rates to zero and started aggressively buying bonds. It’s a term called Quantitative Easing (QE). They said they would do whatever it took to prevent a crisis. They did. Money became effectively free. Cheap money encouraged investment. It also allowed for reckless behavior. Bubbles were formed. They kept it coming for 2 years. Bubbles have since burst. The check finally came in 2022. We investors and taxpayers are now paying the price. There’s no such thing as free.

The Federal Reserve now owns about a third of all Treasuries and mortgage-backed securities in circulation. Think about that for a second. Two years of QE doubled the central bank’s balance sheet to $9 Trillion. That is equivalent to roughly 40% of the United States GDP. This record level of liquidity injected into the financial system helped fuel raging rallies in stocks, bonds, crypto and housing, among other assets. In other words, the Fed triggered asset bubbles, pretty much everywhere.

Over the Summer, the central bank started to shrink its portfolio by letting up to $30 Billion of Treasuries and $17.5 Billion of mortgage-backed securities roll off its balance sheet. They let them mature without reinvesting the proceeds. The tightening doubled in size this week. $95 Billion will be the new monthly runoff. Liquidity is being drained. The money supply is shrinking. Money keeps getting less cheap by the day. 

A Rail strike was avoided. You might have heard. As if our Economy needed another problem. The potential economic damage in the form of further supply chain chaos and another source of inflation pressure would have been significant. The last-minute deal prevents halted shipments of key goods and commodities from coast-to-coast. About 40% of American long-haul trade is transported by rail. A strike would have idled roughly 7,000 trains. That would cost the US Economy an estimated $2 Billion per day. Retailers and Consumers are already planning for the Holidays. The US Economy averted a train wreck, at least for now. 

Back to the Market: The Market is now assigning a 78% probability of a 3/4-point hike next week. What’s new, in response to this elevated inflation report, the Market is now pricing in a 22% probability of a full 1% hike. A half-point hike is no longer on the table. The Fed has not done a 1% interest rate increase since the Volcker days when he even did a 2% hike in the early 80s to combat the double-digit inflation. The other high-profile concern right now is earnings. Estimates are likely still too high. The Street has not cut earnings forecasts much. That will change. The Market has a way of forcing people’s hands. The recent decline has factored in the inevitable earnings contraction ahead. The question is simply how much earnings will slow. The answer lies ahead. We will only know when we know. 

The Market is a discounting mechanism. It anticipates future events and prices them in. The Market is all about expectations. It’s not whether things are good or bad. It’s whether they’re better or worse. In these stages of the cycle, volatility builds. Things get confusing. It’s essential to maintain discipline with a defensive mindset. There are some contrarian positives at play, as investors already reflect the negativity. Sentiment is still sour, near all-time lows. The BofA Global Fund Manager Survey showed the highest cash levels since 2001 and record-low allocation to equities. This is indeed rare territory. With those types of numbers, you’d think there isn’t much left to sell. But selling certainly continued this week. Bear Markets are all about survival. 

Escalator up, elevator down; That’s the Market way. The Stock Market completely erased the 4-day rally in just 1 session. The sell-off sent it back to where it was a week ago. The percentage of S&P 500 stocks above their 50-day moving averages has fallen from 72% to 32% this week, suggesting Tuesday’s decline was associated with short-term breakdowns. This measure topped at 93% at the August highs. It bottomed at 2% at the June low. Elevators operate at a higher speed and different angle than escalators.

On top of all of this, Friday was a quadruple witching day. In Market speak that means the simultaneous expiration of market index futures, stock futures, market index options and stock options. This always leads to higher volume and increased volatility. It adds to the turbulence already in place. 

Hang in there. The key is in the calm. Bear Markets are a natural part of the cycle. Corrections are designed to do just that; Correct the excesses. The Fed’s meeting next week, and Earnings Season in October are major catalysts ahead and a lot of bad stuff has already been priced in. They will be Market moving. It’s important to remember that things become less bad before good. It’s all about expectations. Right now they’re pretty low. But the new price of money will keep things in check. Free money led to some serious euphoria. Now we’re paying the price. It’s the theme for 2022.

I tell my girls this all the time: There’s no such thing as free. There is no such thing as free. Someone is paying. I’m not sure they listen. I know eventually they will.

Have a nice weekend. I understand rain may be on the way to the Bay. That is worth celebrating. We’ll be back, dark and early on Monday.


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