What “Dr. Fed” Is Not Telling Us
The medicine is going to kill the patient...
Typically, when we endure a sell-off as large as the one yesterday, which witnessed the Dow Jones falling 1200 points and closing down 4.2% in its worst day since March of 2020 ⁽¹⁾, the very next day we see what is known as a “relief rally,” where equities bounce higher due to oversold conditions.
Today’s equity market action didn’t offer much relief.
After a choppy day of trading, the major equity indexes closed the day 0.3% higher.
Today may offer the last chance to buckle up. We see far more pain on the horizon.
There are millions of trapped bulls who are just now coming to the reality that the next move in the equity market is most likely lower, and for a lot longer.
We hear the bulls touting the statistic that the “market has never been more bearish” which makes it a contrarian buy signal.⁽²⁾ That type of thinking works well in a bull market, not in a market facing the tightest financial conditions since 1981.
Do allow history to be your guide as you evaluate this missive.
At the beginning of the year, at a time when almost everyone in the world was bullish on risk assets, we made the case that 2022 would be a terrible year for stocks and bonds.
That prediction was based on our belief that inflation, despite the Fed’s willingness to admit it, had already become a huge problem. We predicted that CPI prints would continue to embarrass the Fed who waited far too long and added way too much free money to the system.
We correctly expected this reality would force the hand of the Federal Reserve to raise interest rates and reduce their balance sheet.
Since that call at the beginning of the year, the Fed has raised the fed funds rate from 0% to 2.4%⁽³⁾ and removed $110 billion from their balance sheet.⁽⁴⁾
As a result, the Dow Jones has dropped 15%, the S&P 500 has fallen nearly 18%, and the Nasdaq has sunk 26%. It's not only equities that have suffered. The iShares aggregate bond index (AGG) is down 12.5%.⁽⁵⁾ Bitcoin is down 56%.⁽⁶⁾
In short, we made the correct call because we had the right framework.
We believe we still do.
What we are about to share next is not investment advice.
It’s not our job to tell you that stocks and bonds and cryptocurrencies are all likely headed much lower. We leave that to Jeffrey Gundlach, who yesterday predicted the S&P 500 would drop to 3000 points ⁽⁷⁾, and Mike Wilson of Morgan Stanely, who has been consistently correct in his market calls and sees the broad index falling to 3400 points ⁽⁸⁾, and Jeremy Grantham who has maintained his call of the S&P 500 falling to 2400 points.⁽⁹⁾
What we can share with you is our framework for why we agree.
Much of our perspective was formed in 2018, the last time the Fed attempted to raise rates and shrink their balance sheet. Their move then indicated how susceptible our overleveraged markets are to a drying up of liquidity.
When the Fed tightens, paper assets fall. Bottom line.
The Fed is raising rates at the fastest pace in 40 years. One year ago the 2 YR Treasury bond paid a 0.21% rate. ⁽¹⁰⁾ Today the 2 YR treasury bond offers a yield of 3.77%.
It’s very hard to explain to everyday people the extremity of this move higher.
Keep in mind that from 2009 through 2016 the 2 YR Treasury traded in a range between 0.2% and 1.0%.⁽¹¹⁾ When the 2 YR did move during this time it moved in very gradual increments.
To see 2 YR Treasuries explode higher by more than 3.5% in just 12 months is remarkable and indicative of how wrong the Federal Reserve has been. What we still don’t know, because interest rate moves work with a lag in our economy, is the depth of the pain bond volatility is having on the real world.
We can expect even more volatility in the coming week. Because the Federal Reserve is nearly guaranteed to keep hiking interest rates very hard.
Next week the Federal Reserve will meet and announce their new policy decision.
Due to unexpectedly high inflation data released yesterday, it’s now a virtual certainty that the Fed will raise interest rates by another 75 basis points. ⁽¹²⁾ The odds of a 100 basis point hike now stand at 34% according to CME Fedwatch Tool.⁽¹³⁾
While the Federal Reserve’s rate hikes will get all of the attention, what most people will miss is that tomorrow marks the beginning of the balance sheet runoff increasing from $47 billion per month to $95 billion per month.⁽¹⁴⁾
We see this increase as the more critical risk to stocks and bonds.
Our perspective is colored by the memory of the last time the Fed doubled its balance sheet runoff back in 2018. The increased monetary tightening then was the main catalyst for what became a massive drop in stocks in the fourth quarter.
From September 21st through December 21st of 2018, the S&P 500 dropped 17.5%.⁽¹⁵⁾
It’s been said that “hindsight is 20/20.”
We believe foresight can also be 20/20, particularly when we apply the right framework.
On page 18 of Gold Is A Better Way, which was published in August of 2018, we included a chart of the balance sheet of the Federal Reserve and the increased bond selling that would occur in the final months of 2018.
We wrote:
“A seasonal change is upon us. The Federal Reserve is now unwinding its balance sheet…In the exact same way that Quantitative Easing allowed the stock market to soar higher, Quantitative Tightening will most likely cause the stock market to dive lower.”
Keep in mind that this was written before everyone in the world understood the dynamics of the Fed balance sheet.
We believed then, and even more so today, that what drives equities is liquidity. In fact, according to Larry McDonald of The Bear Traps Report, “Over 90% of the NASDAQ’s returns since Lehman have come with a very accommodative Fed.”
Unfortunately, while it seems every investor should already know this, there is more “hopium” among trapped bulls than we’ve ever witnessed. The last couple of years of extremely easy money have programmed retail investors to buy the dip.
This strategy works when the Fed is accommodating, it’s a disaster when they are not.
It’s why we believe stocks are headed much lower from here. The Fed is now behind the proverbial 8-ball. They have no choice but to raise rates and stay on pace to increase their balance sheet reduction.
This is important for our readers to understand. Every dollar lost in the market in the short term as the Fed is forced to follow through is a dollar that could be put into gold for the long term as the inevitable transpires in the coming months.
Stop trading and start investing. Think longer term and the opportunity will be impossible to miss. We said these same words when we wrote Gold Is A Better Way. Since that time, gold prices are up 42% compared to Dow Jones that’s up 22%.⁽¹⁶⁾
We believe that gold prices will dramatically outperform equities over the next 24 months.
We all know a Fed that is tightening against a Europe that is facing an energy crisis and a Japan that insists on continuing to buy bonds will cause the dollar to strengthen. This week the DXY hit 110.⁽¹⁷⁾
We also know that when the DXY strengthens, gold prices often fall. There is nothing to say that the DXY couldn’t rise to 120. Gold prices could fall further as a result.
We see a different story playing out. It’s a chess approach that we are convinced will end in dramatically higher gold prices.
It’s been said that inflation is a cancer that must be killed or it will metastasize and spread.
The Fed missed the chance to catch it early and cut inflation out of our system. The only way to treat the cancer now is through chemotherapy of higher interest rates and larger balance sheet reduction.
Yesterday’s high inflation print will force “Dr. Fed” to up the dose of the chemo.
Now, instead of a 50 basis point hike, we are likely to see injections of 75 or even 100 basis points. Worse than that, markets are now pricing in multiple 75 basis point chemo-like hikes through the end of the year and a Fed funds rate that ultimately gets to above 4% by Christmas.
That may turn out to be the case.
We must also realize that the result of this prescription, which is designed to kill the inflation cancer, also kill healthy cells too. The more the Fed is forced to up the dosage in their fight against inflation, the more they will kill healthy parts of the economy.
This prescription of even higher interest rates is likely to cause a severe recession.
When that occurs, “Dr. Fed” will be more concerned about keeping the patient alive than killing the inflation cancer.
The obvious prescription for that eventuality?
More money printing.
Don’t worry, it’s coming far sooner than anyone is telling you.
References:
3. https://fred.stlouisfed.org/series/FEDFUNDS
4. https://fred.stlouisfed.org/series/WALCL
7. https://seekingalpha.com/news/3882498-doublelines-gundlach-sees-the-sp-500-falling-20-25
9. https://apnews.com/article/financial-crisis-529b05236e4b4a38153f3e4f196a97ab
10. https://www.marketwatch.com/investing/bond/tmubmusd02y?countrycode=bx
11. https://www.marketwatch.com/investing/bond/tmubmusd02y?countrycode=bx
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