Federal Reserve's Credibility Destroyed by Hot Money

Mar 29, 2022

Going, Going, Gone... 2’s and 10’s finally invert.

Hot money destroys the Fed’s credibility...

The stock market just told the Fed… It no longer matters what you say, it only matters what you do. Investors throw caution to the wind, meme stocks explode and equities ignore a more hawkish Fed. But don’t be fooled… Bonds have been listening very closely.

“Crying wolf may have been the boy’s undoing, but the irony was that the wolves were always lurking nearby”

― Wes Fesler

Here we go again.

Another day where the Federal Reserve “promises” aggressive action.

Another day where the hot money in the market ignores all signs and destroys the Federal Reserve’s most powerful tool, forward guidance.

Today Philadelphia Fed President, Patrick Harker, promised aggressive action and said “I am very open to going faster” when referring to 50 basis point hikes.

What did the bond market do? The yield curve between the 2 year and 10-year treasuries inverted, virtually guaranteeing a recession is imminent.

What did the stock market do? Exploded higher.

What will the Fed do? Perhaps it’s time for an emergency rate hike.

Over the last 15 years, the Federal Reserve has been able to jawbone markets with their words. It’s been their most successful and effective tool. The refrain for the last decade has been “we will remain accommodative.” These words told the market to front-run the Fed and buy risk across financial assets.

These words have fueled the greatest asset bubble in human history.

These words have distorted the price of money. These words were responsible for the greatest wealth gap in human history. They are arguably the root cause of Russia’s war in Ukraine.

But the Federal Reserve has changed their tune. They are now decidedly hawkish and promising a new regime, one that makes fighting inflation their top priority.

Despite an army of Fed speakers over the last week calling for 50 basis point hikes, investment banks from Goldman to Morgan Stanley all calling for multiple meetings with 50 basis point hikes, and the entire world forewarned of a hawkish Fed now all-in on their approach to inflation, risk assets continue to soar higher.

Apple stock, which accounts for 7% of the weighting of the S&P 500, has risen every single day since March 14th. For an epic two-week climb of 18%.

This big move in a blue chip name like Apple is not necessarily something to worry about. The action in the meme stocks, however, is something altogether more worrying.

Since March 14th, shares of Gamestop (GME) have risen over 130%, shares of AMC Theaters (AMC) have risen 117%, and Ape Coin, a new cryptocurrency which was launched on March 16th, is up 1250%.

What does it all mean? The inmates are now in control of the asylum. Call buying retail traders have turned the Federal Reserve into a laughing stock.

The Fed’s number one policy tool, forward guidance, is now broken, at least as it relates to the apes and equities.

On March 21st, Jerome Powell attempted to forward guide and take the air out of risk assets.

“The labor market is very strong, and inflation is much too high,” Powell told a National Association for Business Economics conference. “There is an obvious need to move expeditiously.”

Powell has rarely been more direct. But since that statement, stocks have ignored the warning and soared. Dip buyers afraid to miss out are coming out of the woodwork.

The top headline across virtually all financial publications was how the yield curve inverted, and why the Fed must now take even more aggressive actions.

The stock market has forgotten the lesson to not fight the Fed and is acting with a pavlovian auto-response to buy, buy, buy. They likely see a Federal Reserve so far behind the curve that a 50 basis points hike 5 weeks from now provides all the time in the world to ride the liquidity train.

Bonds are much less sanguine. In fact, bond yields are signaling a giant recession is headed our way.

While stocks have exploded higher again, bonds are getting thrashed.

The curve between 2’s and 10’s briefly inverted today, each crossing the 2.39% threshold. The spread on the 2’s and 10's closed the day down to just 2 basis points.

Here is our latest Fed in Trouble gauge firsthand.

Short-term rates are soaring. Long-term rates are falling. The yield curve is inverting and signaling a recession. And equity markets have become unhinged.

What could go wrong?

Don’t be surprised if the Fed needed to do an “expeditious” emergency 50 basis point hike before May’s meeting to convince the markets they actually mean what they say.

Until then, it’s sure to be one heck of a ride.

Best,

Adam Baratta

Editor-in-Chief

Brentwood Research