A lot can happen in eight minutes. You can boil an egg. You can read eight pages of a novel. You can brew a coffee. You can wait for the sun’s light to reach you. Apparently, you can also wipe $78 billion out of existence.
Last Friday, in his annual address at Jackson Hole, Fed Chairman Jay Powell reverted to hawkish form and suggested that the Fed will keep raising rates until inflation’s back is broken. This comes into sharp contrast with the Fed’s remark just one month ago that “the rate is close to neutral”, which traders took as a sign that rate hikes were drawing to a close and rallied. The reversal in equity markets was spectacular. In eight short minutes, most stocks turned negative, and the S&P 500 experienced one of its worst days in two years.
None of this comes as a surprise. We are in a bear market and volatility is to be expected. Inflation is so high and markets have learned to over-dissect every world the Fed says, that inconsistencies and policy uncertainty are also to be expected.
It may sound strange after Friday’s stock market carnage, but traders and investors need to forget what they heard in Jackson Hole. Instead, they need to focus on one leading indicator: Fed Assets (Bloomberg – FARBAST Index). Next month, the Fed is raising its Quantitative Tightening cap from $45b to $95b. Will it siphon money from markets at a fast pace? Its true intentions will be shown in that field, not in policy speeches.
The game is one of balance. Markets must be ready for rate hikes, but they should not be panicking.
We are honestly less worried about equity volatility and more worried about the long-term implications of the Fed’s approach. Sharply raising interest rates might not work as fast or efficiently as they may believe. It’s playbook, was written at an era when the world’s foremost economy was a lot more closed. Trade as a percentage of GDP was 35% in the early eighties. Now, even after a dramatic fall during the trade wars and the pandemic, it is over 52%. A more open economy means that reducing local demand will have a smaller impact on inflation. So, demand would have to be reduced significantly, before it has an impact on the things that bring inflation up, namely energy. People would have to stop ordering goods, for example, so trucks won’t have to move to deliver them and factory lines can go slower, consuming less energy. For demand to drop, people will need to see their income curtailed and credit availability slashed. Given that consumers have not been prone to spending excesses in the past years (anyone remember ‘secular stagnation’?), there simply isn’t that much fat to burn.
Meanwhile, the Dollar is getting so strong, that the US trade deficit is widening substantially. Meanwhile, Emerging Markets, a lot of which have Dollar-denominated debt, are suffering. We are already seeing significant dislocations in Asian bond markets.
What we are worried more about, however, is that the Fed’s main aim, to maintain its credibility as an inflation-fighting machine, and therefore its vaunted independence, may not be achieved by engineering a recession. We come into this new crisis, not after an era of plenty, but after an era of consumer deleveraging and re-regulated banks.
When prices eventually stop rising, the recession could go deep and inflation could quickly turn into deflation. Politicians will be calling ‘policy error’ and blaming everything on central banks. It isn’t difficult to see how we get there. For fourteen years, central banks were unchecked in printing money in a closed system, that helped financial markets, but led to misallocations in the real economy and a sharp rise in income inequality. Add a recession, and the stated belief that people should be prevented from going to their bosses for a raise, and it’s not hard to see the bull’s eye painted on the back of central banks. Central banks may look to markets and banks for help, but what they will find is a pack of starving and disorientated Pavlov’s dogs looking back at them. Abandoning years of accurate policy guidance may do that to investors.
UK PM hopeful Lis Truss has already said it wants to revisit the Bank of England’s mandate. We wouldn’t be too surprised if this becomes a trend, and central bank independence is questioned.
Make no mistake. We are transitioning into a new paradigm. It’s not very quick, or smooth and people are not always willing to abandon their beliefs. But it is happening. Instead of trying to figure out what energy and tech stocks will do in the next few months, investors need to focus over the longer term, and the fundamentals that drive companies.