Last Week Last week was a bit of a schizophrenic one for rates and equities as narratives crisscrossed one another. The beginning of the week was dominated by talk of recession and corporate margin co...
Watching yesterday’s post on the Federal Open Market Committee (FOMC) press conference with Fed Chairman Jay Powell, I feel that we saw a chairman chastened by a resounding early loss in battle to his greatest enemy (inflation) but full of steely resolve to reverse the tide and win the war. Chairman Powell opened his remarks by saying,
“Inflation is much too high, and we understand the hardship it is causing, and we are moving expeditiously to bring it back down. We have the tools we need and the resolve to bring back price stability to American families and businesses.”
The Chairman, in his usual straightforward and thoughtful manner, stated that the restoration of price stability, “is why we (The Fed) are here.”
I took from those opening remarks that, just as the Fed promised and delivered “whatever it took” to prop up and increase aggregate demand and employment during the 2007-2009 Financial Crisis and the 2020 Covid crisis, now they were going to take that approach to restoring price stability. However, this time the Fed would be taking away as opposed to giving to.
About a half-hour before the press conference, the FOMC had announced a 50-basis point hike to the Fed Funds rate (a band of 75 to 100 basis points) and the beginning of their balance sheet reduction starting June 1, a $47.5 billion runoff cap per month for three months, and then a $95 billion monthly cap thereafter.
Between these policy announcements and Chairman Powell’s stern opening remarks, both equity and bond markets shuddered. And then, Chairman Powell responded to the question of whether policy rate hikes of more than 50 basis points (say 75 basis points) were possible. The Chairman responded that the committee was not considering 75 basis point hikes at this time, and that there would probably be 50 basis point hikes at the next couple of meetings.
To this, the front end of the yield curve dropped 15 basis points in yield and stocks surged higher in relief. I believe, however, that the reaction to Chairman Powell’s comment was more of a “traders got to trade” moment. To be prudent, we really have to look past Chairman Powell’s comment on 75 basis points and circle back to the clear message that the Fed will do whatever it takes to restore price stability and the ever-pragmatic Powell will go to whatever rate level he needs to go to should current policy not be adequate.
The Chairman, as well as most Federal Reserve Board Governors and Federal Reserve Bank Presidents, have sounded extremely alarmed over the last couple of months by a labor market that “is extremely tight."
What concerns me is the alarm at The Fed is relatively new. The shock and dismay over the “extremely tight” labor market is an opinion he and other committee members seem to have come to recently.
In the press conference, Chairman Powell did point to the March readings of inflation and employment cost measures as the wake-up moment for the committee. Therefore, who is to say the committee really believes 100 basis points over the next two meetings and then down to 25 basis point hikes will be enough.
Clearly, based on the opinions of some Federal Reserve Presidents like St Louis Fed President James Bullard, larger rate hikes are needed. Earlier in the year when Bullard was sounding the alarm, calling for 50 basis point policy rate hikes, he was looked upon as an outlier, one not necessarily in step with the consensus view of the committee. Now Bullard has proved prescient. We know from the March FOMC minutes Bullard dissented and wanted a faster pace of policy rate hikes and removal of policy accommodation. It appears that the consensus is now moving rather quickly toward President Bullard’s position.
Yesterday, the Federal Reserve announced a policy position it has never tried before. They are raising their Fed Funds policy rate sharply (be it in 50 basis points or 75 basis points) and at the same time attempting to significantly reduce the size of their balance sheet of Treasury and Agency Mortgage bonds during a time where the once voracious bid for interest rate duration is declining rapidly both at home and overseas.
The Fed has stated in public remarks they feel the balance sheet reduction is roughly equivalent to an extra 25 basis point policy rate hike with regard to effect. However, this really is a great unknown. My experience in the rates markets tells me that whatever you think the damage might be, double it.
The last couple of decades have been fun watching equities and bonds go up sharply at the same time. That is really nice when you design a 60% equity – 40% bond portfolio. The bond position is supposed to provide a nice hedge for the more volatile equity position. When the assets are long and the hedge you have purchased both go up, it is a fantastic feeling. Now however, with the removal of super-accommodative monetary policy, we have both equities and bonds falling down a steep hill holding hands. The balanced 60%-40% portfolio model is down anywhere from 10%-12% year to date and we are only in May. There is going to be an awful lot of retail selling pressure when investors see where they are with that strategy mid-year.
Moreover, we have to address the supply portion of the inflation equation. While it is true that the cost of labor is the biggest input for inflation, when we address supply-driven inflation around food, energy, and housing, those three together stack up pretty well with the cost of labor. The Fed can tighten financial conditions by doing what they are doing with the aggressive reduction of their balance sheet and raising housing finance rates substantially which could reduce soaring home purchase and rental prices (although there’s also a huge supply problem there too that would probably be exacerbated by higher financing costs) but what can they do about soaring food prices?
Think about this, from 2011 to 2013, when price last peaked, the expense of fertilizer was equal to $1 per bushel of corn. From 2017 to 2020, the expense was around $0.60 per bushel, reaching a low of $0.56 per bushel. For 2022, the current expense is expected to hit $1.40 per bushel. It is becoming, even with record-setting prices for crops such as corn, unprofitable to plant because the cost of fertilizing destroys the profit margin right off the bat.
Between the United States and Canada facing problems like the fertilizer issue and Ukrainian production crippled by war, the world is going to have a tremendous food insecurity issue. We still rely on a global supply chain with much coming from countries that are or will undergo soaring food insecurity, and that, unfortunately, is the most destabilizing crisis a society can face. This will put yet another wrench into the supply chain.
Well, that was depressing! Unfortunately, I believe that the Fed will not be able to slay inflation without throwing the economy into a major recession. I am also not sure they can even deliver price stability then due to the serious global supply pressures that only seem to be growing. Based on all this, stagflation is coming, and I am looking at exchange-traded funds that are long interest rate options, commodity giants like Royal Dutch Shell, and Glencore, and a lot of cash to ride out the storm.
Investing involves certain risks, including possible loss of principal. You should understand and carefully consider a strategy’s objectives, risks, fees, expenses and other information before investing. The views expressed in this commentary are subject to change and are not intended to be a recommendation or investment advice. Such views do not take into account the individual financial circumstances or objectives of any investor that receives them. All indices are unmanaged and are not available for direct investment. Indices do not incur costs including the payment of transaction costs, fees and other expenses. This information should not be considered a solicitation or an offer to provide any service in any jurisdiction where it would be unlawful to do so under the laws of that jurisdiction. Past performance is no guarantee of future results.
Securities offered through SWBC Investment Services, LLC, a registered broker/dealer. Member FINRA & SIPC. Advisory services offered through SWBC Investment Company, a Registered Investment Advisor, registered as such with the US Securities & Exchange Commission. SWBC Investment Services, LLC is under separate ownership from any other named entity. SWBC Investment Services, LLC a division of SWBC, is a nationwide partnership of advisor.
John Tuohy is CEO of SWBC Investment Services, LLC, a Broker/Dealer and SWBC Investment Company, an SEC Registered Investment Advisor (RIA). In his role, John is responsible for identifying, developing, and executing the division's strategic plan and all business development, sales, and marketing activities.