As you peruse our notes below in today’s Market Minute, you will see how we feel about Fed Chair Powell’s commitment to a very aggressive strategy. Our comments there are based on the logic of taking Powell at his word – at full face value. It’s always a good idea to put the strongest consideration towards what people have declared. However, there is a growing feeling in some circles that there may also exist a ‘plan B’. So, let’s take a look at that.
For those who recall the days of ‘The Great Inflation’ of the late 70’s (thank you, Jimmy Carter) and also recall the tactics of Paul Volker to ‘WIN’ (‘Whip Inflation Now’) you will recall that much of the conversation centered on the money supply, specifically the version known as M2.
M2 is a basket of ‘money’ that includes cash, checking deposits and other assets that are ‘near cash’. M2 has an important, some say ‘direct’, relationship to inflation because “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output. ~ Milt Friedman. In other words, ‘too much money chasing too few goods’.
Oddly, M2 is not getting much press these days. Instead, we hear a lot about supply chain issues and foreign wars, not to mention ‘price gouging corporations’. Some of that is undoubtedly true and does help to account for the ‘too few goods’ part of the equation. But, in our humble opinion, more attention should also be paid to the ‘too much money’ part.
Powell accurately explains that the Fed controls the rate of inflation through three “blunt tools”: 1) raising and lowering the interest rates it charges other banks for money, 2) buying and selling assets on the open market, and 3) signaling its future intentions to the market.
So, what have they been actually doing?
First, the Fed lowered interest rates by 1½% in March 2020, from about 1½% to just above 0%. That cut nearly all of the banks in the country’s cost of borrowing to nothing. Then they went on a buying spree. Starting around the beginning of March 2020 the Fed bought nearly $6 trillion in assets (mostly bonds and other long-term securities) with money they created (and which added to the money supply). This includes $3 trillion in just the four months beginning March 2020. These purchases by the Fed were intended to put more money into the economy. Economist Roger Cryan notes: ‘The Fed’s actions drove a $6.4 trillion increase in the M2 money supply between March 2020 and the end of 2021. This was an unprecedented 42% increase in only 22 months, far more than could be absorbed by economic growth, even with the strong recovery we have had.’
It seems clear that if Powell and the Fed gang will back up the tough talk with action, they will, at some point have to become more vocal with regard to the administration’s money expanding efforts. Things like the Inflation Reduction Act and Student Debt Relief work against contracting the money supply. Instead, those things aggravate inflation, so why does the Fed ignore their effects?
Ron’s Market Minute — Surprise!
To my surprise, and apparently almost everyone else’s, it appears that the Fed is actually serious about bringing inflation down. Most likely that means interest rates will be going higher than we all previously estimated and staying high longer than expected. That makes an actual recession much more likely – perhaps this year, but in my opinion, most certainly by next year.
Recessions are most commonly accompanied by a bear market in stocks. Our markets started to price in a recession after Powell’s last comments (FOMC meeting last week). The initial market response to his comments has been a swift, broad decline, but there could easily be more downside ahead; perhaps quite a bit more.
Currently the markets are oversold and therefore overdue for a rally. Almost always, a bear market rally is initially based on short covering. That means the rally(s) can be very strong, but also typically not of long duration. Investors and advisors who can catch falling knives may have an opportunity for some short-term gains this week. Personally, we have an aversion to falling knives and don’t intend to try to catch this one.
Here’s the good news: I believe a generational opportunity is now developing for those who are patient and remain focused on capital preservation until the longer-term market environment improves. WHEN inflation begins to decline in a meaningful way and the Fed (therefore) begins to hint at rate stabilization, it will be the time to begin looking for these opportunities.
One of those opportunities that we will be looking at first will most likely be high yield bonds. The Junk Bond index (usually a good indicator of what’s coming for equities) has dropped over 16% from its peak. This is unusual and has happened only a couple of times in the 26-year history of this index. In each case a long, low-volatility uptrend came next. Perhaps — in an ideal market world — we’ll see the index drop another 10% to really goose the possibilities for gains, but that could be asking for too much, or maybe not.
For an idea of how incredibly volatile bear markets can be, have a look at this chart of the bear market rallies of the 2007-2009 environment.
I count 12 rallies, some of which were over +15%, before the market reached its ultimate bottom with the S&P Index reading a minus -57%! I’m certainly not predicting a bottom in that range, but merely indicating what has happened before.
Ronald P. Denk, CFP®
Denk Strategic Wealth Partners
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