One of the most important dictums in finance is this: “Don’t fight the Fed.” And this could get ugly.
During the money-printing binge and interest rate repression starting in March 2020, the Wall Street hype organs repeated this endlessly, “Don’t fight the Fed.”
If the Federal Reserve cuts interest rates and prints money, then asset prices are going to jump, and yields are going to fall, so don’t fight the Fed, jump in with both feet, borrow, lever up, and buy assets and ride that baby all the way to the moon. And that worked.
And then we got inflation. A lot of inflation. Last fall, the Fed finally stopped brushing off inflation and started taking it seriously and pivoted. It announced a slow path to tightening its loosey-goosey monetary policies. And at each meeting, the tightening announcements became faster and steeper and more urgent.
The Fed ended Quantitative Easing early this year. In March, it hiked its policy interest rates by a quarter percentage point, and in April it hiked them by half a percentage point. And it indicated that it would hike more, and that it would frontload the rate hikes, etc.
And throughout the first five months of the year, interest rates soared, yields soared, even junk bond yields rose, and the spread – so that’s the difference – between yields of junk bonds and yields of Treasury securities widened. Mortgage rates soared.
And when yields rise, bond prices fall, and they did fall by a lot. And stocks and cryptos fell, and housing started to show the first signs of a slowdown, and commercial real estate was suddenly confronted with soaring cap rates and dropping prices.
These are all signs of tightening financial conditions, meaning it gets harder and more expensive to borrow, for companies and for consumers, and these tighter financial conditions will eventually translate into less borrowing, and therefor into less investment and consumption, and as demand backs off some, it takes pressure off prices. And if that lasts long enough, inflation begins to back off. That’s how the Fed cracks down on inflation.
In other words, earlier this year, markets believed what the Fed was telling them, that its number one concern was inflation, and that it would tighten its policies, and raise interest rates and reduce its balance sheet – called “quantitative tightening” – in order to tighten financial conditions, which makes borrowing more difficult and more expensive, and which then reduces demand, which eventually maybe removes the fuel from this inflation.
So markets played along with what the Fed was trying to accomplish. Yields jumped, as they were supposed to, which made borrowing more expensive. And asset prices fell, which is part of the deal.
Then in June, to hammer home the message that it was serious about getting on top of this raging inflation, the Fed raised its policy rates by three-quarters of a percentage point, the biggest rate-hike since 1994.
And then this past week, it raised its policy interest rates by another three-quarters of a percentage point. And quantitative tightening started in July, and its balance sheet has started to shrink.
And that’s when the markets began fighting the Fed. The rhetoric that markets spread around was amazing and self-contradictory, it was funny really, and it was carried out in the financial media and by an army of trolls that spread nonsense around the internet. But the rhetoric didn’t matter.
What mattered was that the markets weren’t doing what the Federal Reserve was relying on them do, namely transmit its monetary policies to the financial conditions, making them tighter, and thereby transmitting them to the economy.
But instead, markets went in the opposite direction:
On June 14, the day before the Fed hiked by three-quarter percentage points for the first time since 1994, the 10-year US Treasury yield reached 3.5%, the highest in years.
The next day, June 15, the day of the big rate hike, the 10-year yield began to fall, and it fell and fell and fell. And then last Wednesday, so that was July 27th, the Fed hit markets with another 75-basis point rate hike, and bond yields continued to fall.
On Friday, so July 29th, the 10-year yield closed at 2.67%, the lowest since early April.
And junk bond yields fell since mid-June, and mortgage rates started coming down, and spreads between junk bonds and Treasuries narrowed. And stocks jumped, and it all boiled down to this:
Since June 15, when the Fed started doing the big rate hikes in order to get markets to tighten financial conditions, markets have done the opposite, and financial conditions have loosened.
The Fed has spent years trying very hard to destroy, wipe out, annihilate, and incinerate its credibility as an inflation fighter.
The money-printing binge that started in 2008 has turned the Fed into a money-printer, not an inflation fighter. This money-printing continued even in 2021, as inflation had already begun to rage. And this created the Fed’s rock-solid credibility as an inflation arsonist.
And that’s the reputation the Fed now has, and cannot shake. Markets don’t believe the Fed. They expect that the Fed will buckle and pivot, instead of tightening further. And so they refuse to transmit its monetary policies, and instead start betting on a pivot and rate cuts and money-printing or whatever.
The rhetoric right now goes kind of like this: these big rate hikes will cause a recession, and the Fed will then pivot and cut rates in September or whenever. And so in anticipation of these rate cuts, asset prices soared and yields plunged.
But this rhetoric is self-contradictory. Why? Because by betting on the pivot and driving down yields and driving up asset prices, the markets have loosened financial conditions. But by loosening these financial conditions, the markets are throwing more fuel on the inflation fire and are fueling more demand, thereby reducing the chances of a recession big enough to trigger a major decline in inflation and a pivot by the Fed.
By loosening the financial conditions, the markets themselves have torpedoed their own reasoning for a Fed pivot. That’s the irony. Markets have become totally delusional about this.
But the Fed isn’t going to pivot until this raging inflation is headed back to 2%, and now we’re at 9%.
And by loosening financial conditions and pushing yields down and asset prices up, the markets have, ironically, taken any and all pressure off the Fed to actually pivot. Like I said, markets are delusional right now.
Last time the Fed did a rate-cut pivot was indicated in December 2018. At that time, inflation was below the Fed’s target, President Trump was yelling at Powell on Twitter and in front of microphones on a daily basis to pressure him to end QT and to cut rates, and there was talk that he was trying to figure out how to fire Powell. And markets screamed at Powell because the S&P 500 was down 20% and mortgage rates were over 5%, and yet inflation was below the Fed’s target. And so the Fed pivoted.
Now there’s 9% inflation. And that changes everything.
In the press conference on Wednesday, Powell said that the Fed, “wouldn’t hesitate” to hike rates by a full percentage point – so by 100 basis points – if needed. And he put another 75-basis point rate hike on the table for September. He said it was “necessary” to lower demand, and “necessary” to soften the labor market. And he said you cannot have a long-term strong labor market when there is lots of inflation. He said that in order to achieve their dual mandate of price stability and full employment, they would have to get inflation back down.
He said the Fed is “determined” to get this inflation under control. And he brushed off the possibility of a recession and even if it happened, it wouldn’t change monetary policies until inflation is heading back to 2%.
He said these things many times during the press conference so that everyone would get it.
This was the most hawkish press conference in decades. And yet, the markets which have now turned into tightening-deniers, picked out of context a couple of lines from the Q&A during the press conference and came up with their own theory. It was really funny how that happened.
But there is a huge problem with that: The Fed relies on the markets to transmit the Fed’s monetary policies to the financial conditions – meaning higher interest rates, wider spreads, lower asset prices, etc. – so that these tighter financial conditions would then transmit the Fed’s monetary policies to the overall economy and reduce demand, which then slowly dials down the inflationary pressures, and prices go up less because there is less demand, and inflation begins to fizzle.
That’s the hope. But markets have done the opposite.
Since the press conference last week, two Fed governors – both very big doves, Bostic and Kashkari – have come out saying that the markets essentially got it wrong. And there will be more governors speaking out on this.
[Update: the original podcast came out Jul 31. By now, the morning of Aug 3, four more Fed governors have come out leaning against the market’s interpretation: Mester, Daly, Evans,and Bullard. Each talked about the Fed’s unrelenting anti-inflation stance. They all see significantly higher rates and no pivot anytime soon].
If markets refuse to transmit the Fed’s monetary policies to the financial conditions and the economy, then the Fed will have to keep knocking the markets over the head with rate hikes until they get the memo and start transmitting them.
The markets’ refusal to transmit the Fed’s monetary policies can fuel inflation further, drag it out further, drive it up further, entrench it further and make it that much harder and more painful to get under control, and it will ultimately cause the Fed to hike further, much further than expected.
And when markets ultimately get it and start transmitting the policies, and with rates far higher than they would have been, and with inflation higher and more entrenched than it would have been, reality in the markets can get a lot uglier fast. And if markets keep fighting the Fed, they’re going to be confronted with this worst-case scenario.
Paul Volcker, chairman of the Federal Reserve in the late 1970s and 1980s, during the huge spike of inflation, ran into the same problem: markets were fighting the Fed, and they weren’t listening to him, and he couldn’t get through to them, and he ended up having to go far higher with Fed tightening, as inflation kept coming back, until the Fed finally took short-term rates to ridiculous highs, which then did the trick – but it caused the nasty second dip of the double-dip recession and all kinds of economic upheaval.
The Fed needs the markets to transmit its monetary policies to where they reach the economy. And if markets refuse to transmit, and instead keep sending out their tightening-deniers in droves, and bet on a pivot, the Fed will keep tightening until everyone gets the memo. And the longer this goes on, the uglier it’s going to get when markets finally stop fighting the Fed.
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