The comparisons are being made between the current wind down of QE (and projected rate tightening cycle), and the “taper tantrum” of 2013.
As you may recall, back in May of 2013, after three rounds of QE, Bernanke indicated that the Fed would begin winding down QE by the end of the year.
The interest rate market did this …
This time around, the Fed’s July 2021 minutes hinted toward a tapering of QE by year end. The 10-year yield has since done this …
What was a big difference between now and then?
In 2013-2014, with a soft-fragile economy, and inflation running around 1.5%, the risk of a Fed policy mistake was skewed toward the Fed being too aggressive (pre-mature) and crushing feeble growth. With that, after the knee-jerk reaction in the interest rate markets, the 10-year yield ultimately gave way to a more rational level of around 2%.
What about this time? Inflation is hot. The economy is hot. And the risk of a policy mistake is skewed toward the Fed being too late, and not aggressive enough. With that, the likelihood of a sharp spike higher in market interest rates, after the Fed exits the bond market in March, is high.
We talked yesterday about the regime shift for markets for the new year. This is the first year in a very long time that the Fed will have the task of inflation fighting. And they are behind.
On that note, as we also discussed yesterday, the markets are beginning to price in a more aggressive Fed. Higher rates are bad news for high growth, high valuation stocks. We saw a continuation of that today.
The media will point to the Fed minutes today as some sort of trigger for a sell off in stocks. But the minutes only confirmed what Jay Powell told us a few weeks ago.
Powell set the table for rate hikes, as early as March, in his December (post FOMC) press conference. And he also said in that press conference, that the committee had discussed shrinking the Fed’s balance sheet, and in a manner that would be more aggressive than last time, due to the nature of the strength of the current economy and the inflation threat.
So, with this guidance, we should expect the interest rate market to move higher. It is. The 10-year traded to 1.70% today … and 2% is coming. As you can see in the chart, that would be pre-covid levels.
With this chart above in mind, the Fed has been in control of the interest rate market since March of 2020. By March of this year, they will be out of it. That means we could see a reality check in the coming months — for market interest rates to finally (and maybe quickly) begin reflecting an economy dealing with 7% inflation.
Markets are already adjusting into the second day of the new year.
And the adjustment has everything to do with inflation and the interest rate path.
Remember, last month, the Fed calmed markets by suggesting it would indeed start a tightening cycle. But, importantly, they projected a shallow path for interest rates (never needing to exceed the Fed’s long-term target Fed Funds rate of 2.5% over the coming years). Stocks liked that, particularly the high flying, high multiple stocks (i.e. big tech “innovators”).
So, staring down the barrel of 7% inflation, the Fed told us, just a few weeks ago, that they would tame inflation, to land close to their 2% target, by this year (2022).
And they told us that they would do so, this year, while producing a 4% growth economy (well above trend) at 3.5% unemployment (near record levels) — all while keeping the Fed Funds rate under 1%.
Those are the expectations the Fed attempted to set for the market.
The market is now beginning to price in a more realistic scenario. That scenario entails hot inflation, and a more aggressive rate hiking campaign.
With that, over the past two days, the interest rate market has been on the move. What was priced in to be a June liftoff in rates is now looking like March.
As we discussed into the end to the year, a rising rate environment all sets up for money to move out of the high flyer/no eps stocks, and into value stocks with strong cash flow. A more aggressive Fed would only amplify this rotation.
When you think of value and cash flow, energy fits the bill. This is the only sector in the S&P 500 that is in the red over the past five year period. And with an anti-fossil fuel regulatory environment restricting new investment, the survivors of the storm are selling production at higher prices, and instead of plowing money into exploration, they are producing cash and returning that cash to shareholders. With that formula, no surprise that oil stocks have been on a tear to open the year.
With a sharply steepening yield curve over the past two days, the bank stocks have been on fire. Bank of America is up 8% in two days. Wells is up 10%. Goldman is up 6.6% in two days. And Citi is up over 5%.
Now, with the above in mind, we shouldn’t underestimate the power of the calendar. With a new year, often comes regime changes in markets. We’re seeing signs of it.
As we’ve discussed, this will be the year the Fed is tested, and bad policy may be exposed. With that, we should keep a close eye on these three spots (gold, the dollar and bonds).
If you came in last year loading up on gold (the historic inflation hedge), in anticipation of hot inflation, you got the hot inflation. But gold lost 4% on the year. The dollar didn’t unravel under the pressure of extravagant deficit spending and money printing (in the face of a hot economy). The dollar went up in value against major currencies, not down. And Treasuries, which would, in theory, be dumped under inflationary policies, did very little on the year.
We have another day with a lot of green on the screens: stocks, commodities … everything UP.
Remember, we looked at this chart on Monday …
The S&P 500 was trading into this big trendline (circled). The Nasdaq was trading into a similar trendline (originating from the Fed's massive March 2020 response).
As we discussed, with this big technical support in play, and adding the catalyst of an optimal outcome to the "Build Back Better" negotiations (i.e. a "no deal"), this set up for what looked like a big bounce. We've had it, just in a couple of days.
I suspect we will see new highs, and plenty of fuel for stocks into the New Year, until we hit the date of the Fed's first rate hike (which could come anywhere from March to June). Then, if history is our guide, we should expect a shift to a market that rewards good stock picking (value, over growth and momentum).
As of tomorrow afternoon, I'll be taking the remainder of the year off to spend time with my family.
So this will be my last Pro Perspectives note for the year. For my Billionaire's Portfolio members, please keep an eye out for a note from me tomorrow morning. We will be making a new addition to the portfolio.
If you are not a member, I'd like to invite you to join us. You can get involved by clicking here.
Thank you for being a loyal reader of my daily Pro Perspectives notes. I want to extend my best wishes for a Merry Christmas and a Happy and Healthy New Year!
For much of the year, the market has climbed the wall of worry, on several fronts:
Worry #1) the virus and, more importantly, the prospects of draconian government responses,
Worry #2) Russia and China taking advantage of our position of weakness and flexing on their enlargement aspirations,
Worry #3) the lack of acknowledgement from the Fed on inflation, and therefore a catastrophic policy mistake, and…
Worry #4) related to #3 – the firing of the final, but toxic and inflationary fiscal bazooka, in the form of a tear down and rebuild of America spending plan.
In less than a week, it looks like three of these worries have beenresolved.
No lockdowns. The Fed is moving on inflation. And Build Back Better is dead (for now).
With that, we talked about the set up for a bounce back in stocks yesterday, particularly small caps (the Russell). Indeed the Russell finished the day up over 3%.
Remember earlier this month we compared the current period to 2014, where the domestic and geopolitical noise was high, and the Fed was ending its QE response to the financial crisis – and setting the table for the rate liftoff.
Through the Fed's taper, stocks went up — about 10%.
From this graphic from Putnam, we can see which sectors performed the best in that period …
Over the past month, we've talked about the reappointment of Jay Powell, and how his subsequent flip-flop on inflation may have made it much more difficult for the Democrat controlled Congress to justify the final fiscal spending bazooka (i.e. the transformative "green" and social spending plan).
If anything, the new positioning by the Fed, from inflation denier to inflation fighter, has given the swing voter in Congress (Manchin) the cover to reject the administration's big wish-list spend.
And here we are, Manchin has now given it a hard no.
As we've discussed in past notes, at this stage, "a smaller deal, or (even better) a nodeal, would be among the best outcomes for markets and the economy. It would be a relief valve on inflation pressure. And it would remove the obstruction of uncertainty on a recovering economy that already has $5 trillion of excess money floating around."
So, at the moment, we have a no deal. This should be good for markets, good for the outlook.
With that, let's take a look at some key charts, after this morning's knee jerk selloff …
As you can see in the chart above, the S&P 500 traded into this big trendline today. This line represents the rise from election day, which was on the anticipation of a big fiscal spending agenda.
We have indeed had another $1.9 trillion, plus another $1.2 trillion. And as we trade into the support of this big trendline (a little more than a year later), we have very accommodative monetary policy (still), strong corporate and consumer balance sheets, a hot labor market and the expiration of debt and real estate moratoriums (which should fuel employment and economic activity).
With this mix, now excluding a toxic and disruptive inflation fire (with a no deal on "Build Back Better"), we get a bounce from this trendline today.
And we have similar technical support holding today in the Nasdaq …
The Nasdaq trades today into this big line, which originates from the March lows — the day the Fed fired the bazooka of monetary policy (intervening in the corporate bond market).
With the above in mind: With these big market proxies bouncing this afternoon from technical support, and with the prospect of an optimal outcome coming from the recent fiscal spending negotiations, this next market (chart) becomes the most attractive buy into the final trading days of the year…
As we discussed yesterday, it looks like the Fed guidance this week served as confirmation of the end of globally coordinated easy money policies.
The question is how aggressive will the tightening cycle be?
Thus far, the Fed wants us to believe that the cycle won't be aggressive. And to justify that, they keep our eyes on the supply chain disruption as the only factor driving inflation. They say it will ultimately normalize. That's reasonable to assume.
In their outlook, they ignore that $5 trillion of new money supply created over the past 20 months. And they ignore the wage growth, which is hot, and sticky (going higher, and will stick).
With that, let's take a look at this chart of wage growth vs. productivity…
As you can see, over the past forty-years, each hour of work generated far more income for all stakeholders, than it did for the average worker. Translation: The lion's share went to the few.
But this productivity/pay gap is about to narrow, thanks to hazard pay through the pandemic, overly generous and lengthy federal unemployment subsidies, and (subsequently and consequently) an imbalanced job market (more jobs than job seekers). Wages are going up, fast.
With that in mind, the gap in the above chart gave us nearly four decades of falling inflation and falling interest rates. Logic would tell us that rising wages and a narrowing of the wage/productivity gap will fuel the opposite.
It looks like the Fed started the end of globally coordinated easy money yesterday.
This morning the Bank of England raised rates this morning, with a surprise 25 basis points. That's the first major central bank to raise rates. The European Central Bank telegraphed an end to its pandemic/emergency asset buying program by March. The Bank of Japan decides on policy tonight.
That said, emerging market central banks have already been moving on rates for much of the year. These are central banks that don't have the luxury of representing 90% of the world's foreign currency reserves (like the U.S., UK, Japan and Europe). They couldn't afford to sit around, waiting and watching inflation. They had to act.
Mexico, South Korea, South Africa, Chile, Brazil, Czech Republic, Hungary, New Zealand, Norway, Poland, Russia, Turkey — all have been raising rates to fight inflation and to defend against capital flight.
So with major central banks joining over the past 24 hours, the change in direction of global monetary policy is probably official now.
With that, as we've discussed, a higher rate outlook makes the high multiple stocks most vulnerable, which includes the no-earnings/ innovation story stocks.
For perspective on today's losses in the big indexes, let's take a look at the sector performance on the day.
As you can see, money moved out of technology (high multiple stocks) and consumer discretionary (a beneficiary of stimulus). And into financials and commodity related stocks (materials). This is the "growth to value" rotation we've been talking about. It's early days.
This afternoon markets rallied following the Fed decision, where Jay Powell guided to a faster end of QE, and three rate hikes next year.
We expected that the Fed might double the cuts to its bond purchases. They did. We expected that the move would open the door to a rate liftoff as soon as March. It did.
While June remains the most probable month for liftoff, the Fed Chair indicated that they could liftoff when bond purchases are ended, which would be March.
On the face of it, this all sounds like a more hawkish Fed communication today than even expected.
But markets liked it. Why?
Because the Fed is forecasting a very shallow rate hiking cycle. That's because they remain arrogant enough to forecast an inflation rate that will reverse (from 7%) and land close to their 2% target, by next year.
With that, maybe the biggest message that markets came away with today: The Fed will not become inflation fighters.
Of course, that may or may not happen. But that was the takeaway today.
If you believe Jay Powell, you expect a hot economy to continue to strengthen, with a Fed that will perfectly thread the monetary policy needle, to produce just 2.6% inflation from a 4% growth economy (well above trend) at 3.5% unemployment (near record levels) — all while keeping the Fed Funds rate under 1% — and over the coming years, never needing to exceed the Fed's long-term target Fed funds rate of 2.5%.
That would be magic.
But remember, the Fed cares more about shaping expectations than they do about forecasting. They have a good record on the former, and a bad record on the latter. What matters most for markets, in the near term is the former. With that, markets go up today. And if we look back at the analogue of 2014, when the Fed was tapering its last round of QE, stocks went up. Only after the Fed actually made its first interest rate hike, in late 2015, did the path become tougher for risk assets.
With the Fed meeting tomorrow, bets were increased today that we could see a first rate hike as soon as March (about a 35% chance).
And the market is now pricing in an 80% chance of a hike by June. It was a 50% chance yesterday.
Over the past six weeks, the consensus view in a Reuters economist poll has gone from the view of: no rate hikes until 2023, to a rate hike in Q4 of next year, to a rate hike in Q3 of next year.
That view will likely get pulled forward again tomorrow.
Let's take a look at real estate, for some insight into what this might mean for record high prices.
The above chart is the Case-Shiller Home Price Index (index of 20 major cities).
It's 47% higher than the pre-financial crisis peak.
Does that mean its a bubble? No. Even though money is easy, and the Fed is pumping liquidity into the mortgage bond market, it doesn't mean that risk in the housing market has elevated.
You can see in the graphic below, the risk profile is very different, which aligns with the current environment of high creditworthiness (low debt service, high savings) and stringent lending standards (post-financial crisis).
The real estate bubble that popped in 2006 was primarily driven by credit agencies AAA stamping high risk/high yielding mortgage portfolios. With a AAA rating and a high yield, massive pension funds had no choice, if not an obligation to plow money into those investments. And with that insatiable demand, mortgage brokers and bankers were incentivized to keep sourcing them and packaging them. So, whether it was fraud or incompetence (or both) somehow the ratings agencies survived.
Bottom line, this housing environment looks much less vulnerable to rate hikes.
What looks likely, in the face of a rate tightening cycle, is that real estate prices just stay persistently high, and even continue higher — driven by multi-decade high economic growth, massive new money supply floating around, and a very tight labor market. And at higher rates, it will just cost more to live.
Consider this above chart of Australian housing prices. Pre-Global Financial Crisis, the fundamentals of the Australian housing market were every bit as dislocated as U.S. housing (housing price to rent ratio, home price to income ratio), but they didn't have a bust – it just kept going.
