The stock and bond markets have both been hammered this year as the SPX plunged 17% (the NAZ much worse) and the entire Treasury yield curve shifted up.
So far, the Federal Reserve has only raised the fed funds rate by 0.5%. They sure got a bang for their buck! They have announced another 0.5% raise in each of June and July. Plus, they have announced that they will begin selling longer-term Treasuries and mortgage bonds beginning June 1. The mortgage rate jumped in response.
But they haven’t actually done these moves yet. And they said that they are planning to reach for a “neutral” fed funds rate which won’t stimulate the economy. That implies that the fed funds rate needs to be at least as high as the inflation rate because a negative real rate pays speculators to borrow money. The Fed also said that they will do whatever it takes to bring inflation down to their desired range of 2% even if it means that unemployment will rise.
The Personal Consumption Expenditures Price Index, which is the Fed’s preferred inflation measure, is currently 6.3%. Personal Consumption Expenditures Price Index, Excluding Food and Energy (which the Fed likes because food and energy prices are volatile) is 4.9%. The inflation rate dropped 0.3% from March to April which caused some people to jump for joy. YIPPEE!! ( /sarcasm – this is hardly impressive.)
The Fed didn’t mention the asset markets because maintaining high asset prices is not part of the Fed’s mandate. They know perfectly well that asset prices will fall as a result of their actions to drain liquidity (Quantitative Tightening), just as asset prices rose as a result of their actions to increase liquidity (Quantitative Easing).
Last week was a pretty good week in the markets. Both stock and bond prices rose a little. Investors rejoiced. One our own METARs took the opportunity to gleefully stick out his tongue at John Hussman, a famous bear.
The rise looked like noise to me. It doesn’t look like a trend change…yet. But lots of people are looking for a bottom.
Mommy, are we there yet?
It’s clear that the Fed wants to bring down inflation as painlessly as possible. They want a soft landing, not a recession. Will inflation recede by itself? What are the signs?
Consumer price inflation is caused by too many dollars in consumer pockets chasing too few goods and services. Fiscal stimulus that was sent to consumers in 2020 and 2021 was partially spent but a lot went into savings. (And a lot went into the stock market.) M1 is the money supply of cash and readily-spent checking accounts.
M1 peaked and declined a touch last month. Real Disposable Personal Income: Per Capita is about what it was at the end of 2019 after peaking in 2020 and 2021 due to fiscal stimulus. The personal savings rate declined to 4.4% as people spent from their savings accounts. Personal savings is now lower than 4Q2019. This shows that demand has peaked. It’s unlikely that consumers will suddenly get a large, unusual infusion of cash. Wages are up but so are prices and profits, so labor’s share of economic income is flat. These factors tend to dampen inflation.
The supply side is constrained. Retailers: Inventories to Sales Ratio is far below normal. And energy prices (oil and natgas) which feed into many products, transport and cooling in summer are still rising fast. These are highly inflationary.
A determined Fed trend change has the potential to cause a recession and/ or a financial panic. The decline in stock market values has been orderly, not a panic, as shown by a moderate VIX and low Financial Stress and moderately elevated yield spread. Air is being let out of a classic bubble. The bubble was caused by emergency liquidity which is now being withdrawn. The deflation of the bubble was predictable. It will not reinflate. The stock market will return to normal if the Fed returns to neutral.
If the Fed actually does stick to its guns and reach a neutral rate the stock and bond markets will continue to decline. Trillions of dollars of value will evaporate from these markets. (Including the bond assets held by the Fed itself.)
Last week, the Fear & Greed Index was in Extreme Fear, but not abject terror. The trade was risk-on as stocks and junk bonds rose faster than the 10YT. The USD weakened, causing gold to strengthen a touch. The “mungofitch ratio” of copper to gold was stable.
The “mungofich 99-day rule” triggered as the SPX has not seen a new high in over 99 trading days. This has historically presaged a more serious fall in the stock market.
The percent of SP100 stocks above their 200 day moving average was over 35% after falling from 75% at the start of 2022. This is weak but still moderate and not a panic level.
How should we look at these moderately poor but not terrible indicators? VIX, Financial Stress, Fear & Greed Index, junk bond spreads, stock market internals? Is this a glass half-full (the markets have stabilized and will rise from here)? Or is it a glass half-empty (the markets have a long way to fall, whether or not they panic along the way)?
Jeff and intercst would say it doesn’t matter. The only days that matter are when you buy and when you sell stocks. Bear markets in between have no impact…unless you bought high at a level that won’t be seen again for a long time, maybe not until after you need to sell.
Will the markets destabilize next week when the Fed carries through on its stated plans because interest rates will rise? Or will it stabilize because the traders will be reassured that the Fed’s word can be trusted and has already been baked in? I think the latter is more likely. But the markets will be very sensitive to economic signals.
The METAR for next week is partly sunny, perhaps with a few intermittent showers. But this is not a trend change. As the Fed continues to tighten, asset prices will continue to fall the way that autumn naturally cools into winter. If we are lucky, we will avoid stagflation, but it’s too soon to tell.