Better three hours too soon than a minute too late.
-William Shakespeare
This month I want to talk about what the heck the Federal Reserve is doing or not doing, why it may not matter and of course tie in Quantum Physics and Haruspex; (You’ll find out.) Since my last newsletter came out the markets, which had almost fully recovered from the early year swoon, suddenly decided to drop back down again almost to those low levels hit in early March. But with this level of volatility, 2-3% daily moves, it could see new nerve-inducing lows or have completely recovered these recent sell-offs by the time you read this. As I’ve said many times over my career, the markets like good news and they really don’t care much about bad news, what they can’t deal with is uncertainty, and while the war in Ukraine isn’t helping matters, it’s really the unknowable Federal Reserve that is causing most of the anxiety.
First, to Haruspex. Haruspex is the Greek term for using the entrails, liver or other organs of sacrificed animals to divine the future. Movies love to portray the Oracle at Delphi or some Druid throwing bones on the ground because frankly the practice of Haruspex is gross, but it was probably the most common form of prophesizing and dates back to the earliest civilizations in Egypt and Mesopotamia. Or course it’s all utter nonsense, you learn nothing looking at the entrails of a sheep other than how disgusting and smelly the entrails of a sheep can be. But we might as well bring back this practice to figure out what the Federal Reserve is doing because it’s as likely to be accurate as any other methodology. So much for the more transparent Fed. At it’s meeting that ended March 16th, the Fed raised interest rates for the first time in several years, but by only a quarter of a point. Then within a day or two many Fed Governors were giving speeches or interviews saying they would need to get more aggressive and raise rates more quickly due to the fast pace of inflation. But you just had a meeting a few days ago!! No inflation numbers came out between March 16th and these statements that changed anything. If the Fed needs to raise rates more aggressively then shouldn’t they have gone a full half or three-quarters of a point at that meeting? The Fed doesn’t want to look “political” so they probably won’t do anything with rates in at their November meeting which is only a week before the mid-term election, they didn’t meet in April and don’t meet in October so that means they have at most five more meetings before year end which at a quarter point per meeting gets the Fed Funds rate to 1.5%, still a historically low rate. What’s more, the Fed Funds rate is probably the weakest lever the Fed has at its disposal right now. As Covid’s impact really started to hit around this time two years ago, the Fed restarted a version of the stimulus programs it put in place after the 2008 financial collapse, buying up bonds in the open market using money it literally just “printed” out of thin air. (Of course, it’s all electronic nothing is actually printed, thus the quotes.) They did this to keep interest rates down across the board, not just at the short-end of the curve where they control the rates directly through the Fed Funds rate. They bought mortgage bonds, treasury bonds of various maturity dates etc. By doing so, they kept the bond markets liquid and the rates low even as economic activity all but stopped for a few months in the Spring of 2020. The problem is, they never stopped. The money they created certainly contributed somewhat to the current inflation rate, how much exactly is debatable, and now they are discussing reversing those purchases. They will therefore be creating more supply of bonds in the market, while at the same time; since they are no longer purchasing bonds, lessening the demand. This will push up interest rates of course, but how much and where depends on what bonds the Fed decides to start selling; the mortgage bonds, the 10-year bonds, the 3-year bonds etc.; and how much each month. The 10-year Treasury rate has almost doubled since the year began just in anticipation of this, and mortgage rates have gone up along with it – even as the Fed has effectively done nothing.
This brings us to what the Fed will actually do. I don’t think the Fed wants to raise rates. I think they want to combat inflation, but I don’t think they really want to raise rates more than a quarter percent at a time and wouldn’t even do that if they hadn’t painted themselves into a corner. I think they’re trying to both talk down inflation and delay actions so things don’t look as bad giving themselves cover to not raise them too much. Here’s what I mean by that. I’ve already explained that interest rates have gone up so far this year without the Fed actually doing anything, just in anticipation. Right after not raising rates really at all in March, they started all this rhetoric about having to get “tough” to fight inflation. Raising rates combats inflation by slowing down economic growth and borrowing – if the rates actual people have to pay for mortgages, business loans, car loans and the like go up then that has the same effect even if the Fed keeps the actual Fed rate low. They’re hoping they can talk inflation down and can take the rate increases and bonds sales very, very slow. Plus, as this year goes on, inflation is going to start to look like it’s cooling. When you hear that big inflation number on the news, they are doing a year over year comparison of prices. The 7.87% rate in February and 8.54% rate in March was comparing prices in February and March of last year to the prices this year. Prices didn’t really start to rise significantly until May of last year. When the May inflation numbers come out, the difference in prices over that particular point-to-point may only be 4-5%, in June they may be a little lower and in July lower still. Now, a 4 or 5% inflation rate is still way too high and if it plateaus at that level, we’re all in for bad times ahead – but in the meantime it’s going to look like the inflation rate is easing from the 7-9% rate it was running in November – March. It’s going to look like it’s getting under control and this is going to give the Fed an excuse to make smaller increases or skip increases at some meetings altogether. At least that’s what my chicken livers are telling me.
But what if I’m wrong and it still doesn’t matter. This is where Quantum Physics obviously comes into play. In Classical or Newtonian Physics all those laws of motion you may have learned in high school science class all work wonderfully (as do laws about heat expansion and many other things.) But when you get into the subatomic realm these laws no longer apply. An object in motion will stay in motion unless acted upon by an outside force works fantastically when we put a satellite into orbit and it stays in orbit, but at the subatomic level sometimes particles stop moving, reverse motion or even disappear or appear seemingly out of nowhere. When things get very small, the rules change. This seems to be true of Classical economics when it comes to the Fed Funds rate as well. When the Fed Funds rate is 5% and is cut to 4.5% economic growth and inflation will both go up, we have many data points over the last century that prove this, likewise if the rate is raised from 3.5% to 4% it will slow down growth and inflation. But something seems to happen when the Fed Funds rate gets somewhere around 2%. At that point it seems like the impact of raising or lowering rates gets less and less to the point when at sub-1% those moves don’t seem to do anything at all. This is important because if the Fed is truly trying to get inflation under control, they may have to raise rates at least a full point before there is any impact, meaning at a quarter point per meeting they may not even be there before 2023; and then they probably have to go another full point before that impact is meaningful. If inflation does “level off” at 4-5% later this year, I wouldn’t count on the Fed being able to get it under that level for quite a while. Unless they really accelerate these rate increases, we may be dealing with above the 2% target inflation for another two to three years. Of course, a deep recession usually gets inflation under control as well, but that’s what the Fed is trying to avoid, they want to control inflation and keep the economy growing (also known as a “soft landing”) which may be impossible. They may have to choose one over the other and if you ask me based on their actual actions, they may be choosing growth and low unemployment over really getting inflation under control.
What does this mean for all of us? To butcher a Mark Twain quote, I think stories of a coming recession may be greatly exaggerated. Not that we won’t have one, but I just don’t see it happening in this calendar year without some major shock – like the war expands into Poland or something. I think inflation is going to look like it’s cooling down when it’s really just leveling of – but it will take until probably year end to figure that out. This also means that if the Fed is slower in raising rates than the consensus, and slower at selling bonds than the consensus, we could easily see a rebound in stock and bond markets that have been selling off out of fear of those things. This doesn’t mean we have a great year like 2021, but if the bottoms for 2022 are somewhere around those early March / Late April levels I wouldn’t be surprised. If this comes to pass, then investments that pay dividends or are positively correlated to inflation will continue to do well. The markets of course are always looking forward, so if it looks like we may fall into a recession in 2023 we could test these bottoms again in the Fall. But as we rebalance and reinvest dividends and interest, we can take some advantage of this volatility and hopefully keep you on track to meet your investment goals which is the most important thing.
By the time this comes out, the Fed will have had it’s May meeting and we’ll all know how aggressive they’ve decided to become. If the markets rocket upward, or spiral downward after that meeting, you’ll know if the decision was more or less aggressive than anticipated. We also may have some clarity about what bonds and in what volume they will start selling in June. We will certainly know more, but not everything, the Fed could just as easily reverse itself at the next meeting if they don’t like the direction things are going. So, grab your animal sacrifice and your electron microscope and we’ll see if we can figure this out together as the year goes on. As always, happy to answer any questions and we are accepting new clients.
