Introduction:
We’ve noted two related market trends over the past few months. The first is bad economic news is good for the market. That’s because the Fed is more likely to slow rate hikes into a weaker economy. Click the link for a more detailed description. The second is the market has been trading based on comments being made in public by Federal Reserve Governors.
Fed Talking in Public:
Yesterday, a Fed Governor made a feint towards talking tough on rates, but then indicated they would consider changes in inflation and economic conditions in determining the rate of future interest rate changes. The market promptly had a big up day. This is ridiculous. First, of course the Fed considers inflation and economic data in making decisions. We can’t imagine any reason why anyone would expect the Fed to make all their decisions for the year on Jan 1 and then go on vacation.
Second, the Fed Governors are a group of people who have never held jobs outside of government or academia. None of them have ever run a business. They haven’t had to make payroll. (Insert the old joke about unmarried marriage counselors here.) There’s no evidence they’re good at setting the most important price in finance; the cost of interest (which is really the cost of risk and of time). The Fed has a long-term history of blowing up asset bubbles, and then crashing the economy when it all turns bad. Even Chairman Powell has acknowledged that they were late and slow in raising rates this year.
Right now, we have the entire market manipulated by a small number of officials in a room followed by market increases and declines based on a series of occasionally cryptic public comments. This is the kind of system we’d expect from communist China or the former Soviet Union. The market is much more capable of setting the price of interest and it did so for nearly a century and a half at the birth of the United States. The market does not need a Federal Reserve and it was created to give a limited number of people outsized influence over the money supply.
Today, Chairman Powell spoke in public and was very clear that we should expect continued rate hikes. As we’ve pointed out previously, he can handle an increase in unemployment and a decline in GDP, but continued high inflation would crush his reputation. Expectations for another big 75bp increase in the fed funds rate have gone from around 50% to almost 100% in the past week.
Sentiment:
We’ve seen some comments from smart people pointing out that market sentiment is highly negative and is due to shift back. This analysis is often correct and the market does tend to swing from one mood to another. With that said, we responded on Twitter:
We have the Fed funds rate at a very low 2.5%, a Fed balance sheet of $9T, > $30T of national debt, $250T of off balance sheet liabilities, the petrodollar is breaking, Europe is a few months from a heating crisis, and we’re facing coming food shortages. Housing transactions are plummeting. And the market indexes are down less than 30% (or so). People are concerned for good reason, and while sentiment may be negative, that doesn’t mean it’s wrong.
Another way to think about this is take a look at the above comment, and note that the S&P 500 is down 16% for the year. While being short SPY and QQQ have been incredibly profitable for us this year, with all of the significantly negative news (plus negative GDP for the past 2-3 quarters depending on how you’re keeping score), a 16% decrease isn’t indicative of terrible negative sentiment.
Slower Inflation is Not the Same as Price Decreases:
Finally, we think people may be taking too much solace in evidence that inflation is slowing. Besides the fact that the CPI is hugely understated by design, except for housing where we expect a decrease in prices, in other areas of the economy, we’re seeing prices rising more slowly. But that’s after prior huge increases. In other words, nothing is getting more affordable. If prices rise 15% in year 1 and “only” 5% in year 2, people might look at that as a positive trend. The issue for most Americans is unless prices come down (and they’re not) their material lives aren’t getting better in this hypothetical example. It only means that things are getting worse more slowly. Some might point to the recent decline in fuel prices, but we’ve previously pointed out that much of that decline is due to temporary releases of reserves by the US government and the Saudis. That’s not sustainable. Eventually, (or after the midterms), reserves will need to be replenished.
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