Stock markets have been showing red colors as the Fed continues to tighten monetary policy more than expected. Stocks cannot escape an overly hot economy, while banks are taking huge hit from the inverted yield curve.
In this post, let's talk about Fed's Powell's recent rant about the future direction of monetary policy. Before that, a quick look at how public savings covertly support economy the US, which will further complicate the Fed's tightening efforts.
Public sector savings support the economy
A Bloomberg columnist had a good point about how municipalities and states have more money than usual left over for rainy day savings. Municipalities and states are losing tax revenue in the recession, which is encouraging them to cut spending. These cuts, in turn, deepen the recession. One person's spending is another person's income, and when someone cuts back on their spending someone else loses their income.
In the previous recessions of 2001 and 2008, there were enough savings for these operators to withstand a 5% drop in tax revenues for a year. Now it could be continued for a year, even if the drop is 12%. In total, the states have $135 billion up their sleeves, plus $150-200 billion in unused pandemic relief funds. In addition to these subsidies, local governments benefited hugely from increased VAT revenues as people who had been locked in their homes by COVID shopped for electronics and gadgets for their fortresses.
While the number of employees in the private sector has exceeded pre-pandemic levels, local government is still below them. With money to spare, there is no pressure on the public sector to make redundancies, but instead to recruit more staff to replace those needed in a pandemic.
Overall, the strong economic position of local governments is further heating up the economy, making it more difficult for the Fed to cool down. Let's talk about that next.
Powell keeps on running to and fro after data
The main market-moving news of the week has been Fed Governor Powell's speech to the US Congress. Powell went to explain monetary policy to politicians in the normal annual rhythm, although fortunately politicians have no direct influence on the central bank.
Powell's core message was that the central bank is ready to accelerate interest rate hikes again. In the market, interest rates reacted sharply, with the US 2-year bond rate plunging above the 5% threshold. The 10-year interest rate, which acts as a gravitational force for equities and is more reflective of the longer-term inflation and economic growth outlook, is flirting around 4%.
Powell's message was sharper than the one he delivered just over a month ago at the interest rate meeting, where he even slipped the term disinflation. At the time, the Fed was looking at December data, which was softer. Since then, the economic data has been scorching hot.
In general, the best indication of the central bank's future actions is the latest economic data. If it remains too strong, monetary policy will almost certainly become tighter.
Politicians, especially on the left, challenged the Fed's policy of trying to weaken employment and thereby cool the economy. While it hurts people to tighten monetary policy while interest rates rise and pinch their wallets, it would be an even more costly blunder to miss the 2% inflation target. The central bank regards it as a sacred thing. It's easy to agree with this comment, because if faith in the central bank's ability to control inflation were to disappear, as it did in the 1970s, the economy would be topsy-turvy. Then, the Fed would have to resort to even stronger interest rate hikes and an even larger number of honest working citizens would suffer. Powell must choose between varying degrees of bad choices.
This message of a 2% inflation commitment contrasts with the view sometimes presented in these posts, where the central bank would help the public sector to reduce its debt burden through higher inflation. Time will tell whether 2% can be maintained in a context of rising debt and ballooning social spending.
From the Fed's point of view, the risk that it will do too little is greater than that the tightening will go too far. In this sense, we return once again to the familiar fear that, in order to tackle a red-hot economy, monetary policy will have to be tightened so much that the economy will eventually slide into recession. A bit like a hasty person in a slow-reacting shower turns the tap on too quickly to cold, and eventually the hot shower suddenly turns freezing.
In the market, the message was poorly digested with the S&P 500 index falling back below the 4,000-point mark. Expectations on the trajectory of the Fed policy rate rose again. Now the policy rate is expected to peak at over 5.5% in the summer. The policy rate is 3.5% after 3 years. This graph shows the current interest rate expectation as a green curve and the December expectation as a yellow curve. Expectations have risen by almost one percentage point in just a few months. For investors, the idea of a policy rate of up to 6% in the near future already seems realistic.
The tighter monetary policy in the United States is spilling over to the rest of the world, especially to emerging economies with dollar-denominated debt. This graph shows the dollar index and the world stock market index on an inverted scale. Recently, the dollar's movements have been quite directly correlated to equities, which is of course logical. A stronger dollar should put further downward pressure on equities, in the sense that a stronger dollar reflects juicier risk-free rates in the US.
For investors, risk-free interest rates in the 4-5% range already offer a tantalizing alternative to equities, which have to tolerate huge uncertainty with inflation and recession risk. Although the real interest rate is more modest, especially at the short end, the real interest rate on the 10-year bond is solidly in the black, reflecting current interest rate expectations. This graph shows the interest rate on the inflation-protected bond, now at 1.6%. That's a guaranteed return, no matter what happens to inflation.
Interestingly, the strong interest rate environment doesn’t seem to be reflected in the banking sector anymore that benefits from it. While the banking sector in Europe is like a former fast runner risen from the grave, the S&P 500's banking index is under pressure. The forward-looking P/E ratio hovers around ten, which compared to recent years is low even for a low-earning sector. I understand that banks’ credit losses have so far remained low, but perhaps investors are foreseeing problems for the fragile sector in the future. Silicon Valley Banks problems might be harbinger of future. The inverted yield curve doesn’t make life much easier for the banks, which lend short money in and long money out.
Speaking of the yield curve, its inversion keeps on deepening. The yield curve looks at the difference between long and short interest rates. Often, the inversion of the yield curve has foreshadowed a recession within a couple of years. However, it’s possible that inflation has broken this indicator. The last time the yield curve inverted this much was in the late 1970s. I couldn't get any further data from Bloomberg, but I understand that similar inversions occurred in 1973, before the massive bear market, and in 1929, before the biggest crash in the history of the US market. So yeah, that’s pretty neat.
What will happen to equities when the rate hikes end? Not necessarily anything funny, at least immediately. Here's a wildcard: the development of the S&P 500 and the Fed policy rate over the last 70 years. The S&P500 is the blue curve on a logarithmic scale.
The inspiration for this came from the Inderes Investment Forum, where Jukka Lepikkö made a good point about how the end of Fed rate hikes has often foreshadowed a stock market rally for at least a year or two.
I color-coded those peaks so that the green bar represents several years of rise, the orange bar a rise of a few years or less before the going down, and the red bar an immediate decline.
In principle, the halt in the rise in policy rates doesn’t in itself tell us anything about the direction of the stock market in the longer term. It could go anywhere. On several occasions, however, there have been further rises. Of course, I must point out that the stock market goes up a lot of the time anyway.
Perhaps the most important thing is what is causing the rate hikes to stop and what will happen next in the economy. If they stop because the economy is roaring but inflation is easing, now that would be super cool. As in the 1994 interest rate pause, for example. In contrast, if interest rates continue to rise in a recession, the stock market will explode, as it did in 1974. If a peak in interest rates followed by a sharp fall in interest rates is due to a souring economy, it will not save equities as it did in 2008. Sometimes interest rates and stocks peak at the same time, but a fall in interest rates doesn’t save stocks in a bubble like in 2000. Stocks aren’t only driven by interest rates, but also by the direction of the economy as a whole, inflation and, of course, the valuation level at which stocks start to move. The problem in the current situation is that inflation is a bit out of control and at the same time stock valuations are high, as they were in the early 1970s. Of course, we don’t know directly in advance when the peak in interest rates will actually occur and what the economy will look like at that time. After all, market expectations of a peak in interest rates have been rising all along, and yet they are the best guess for future peaks.
Perhaps at the end of this interest rate review it’s worth recalling what matters most to the long-term equity owner. High and low interest rates come and go. Inflation will abate eventually. Good value-creating businesses navigate their way through all environments, and I wouldn't be surprised if at some point we see good buying opportunities in such businesses as the stock market takes a hit from these few years of woes. As Sisu1 pointed out on the forum yesterday, a long-term investor will only see that blue line on the graph.
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