After three sessions that knocked the major averages down by a cumulative 7%+, yesterday’s modest loss almost seemed to be a victory. Today’s FOMC meeting outcome and an ensuing press conference with Fed Chair Jerome Powell will set the table for the markets’ next collective move.
After last Friday’s dismal CPI report, a consensus seems to be growing for a 75-basis point increase in the Fed Funds rate this afternoon. Reflecting that thought, the yield on 90-day Treasury bills rose by almost a quarter of a percentage point yesterday alone to just shy of 1.75%. A year ago, the yield was 0.1%. 10-year Treasuries now yield 3.48%, two full percentage points above where they traded a year ago. Of course, these huge changes reflect the need for the Fed to accelerate the pace and size of rate increases to battle inflation that has gotten completely out of hand.
Using the spread between 10-year Treasuries and 10-year TIPS as a guide to long-term inflation expectations, Treasury bonds now provide a positive real return for the first time in two years. Money is no longer free. The rise in real rates has completely debunked modern monetary theory promoted by progressives that said countries operating within their own fiat currency could spend as much as wanted/needed without causing real rates to rise. Instead, it has caused speculators who used “free money” leverage to speculate, to have their heads handed to them. The symbols of speculation, whether they be SPACs, Bitcoin, or the ARK Innovation ETF, are all down 60% or more from recent highs and have shown no signs of a bottom.
This speculative purge only gets magnified as rates continue to surge upward. The eradication of excesses is an overlay on a stock market fixated on the future path of interest rates and the pending damage that higher rates will do to our economy. Against this backdrop, Jerome Powell and the FOMC have to adjust their strategies. They need to convince investors that they are on an aggressive path toward defeating inflation. Thus far, they have taken baby steps when giant steps were needed. At the last FOMC meeting in April, Powell predicted a 50-basis point rise today. Now 75 basis points seems more likely. Perhaps 100 basis points is what is really needed to set the proper tone.
Investors anxiously want to see the path forward that the Fed thinks will accomplish these goals. Today, in addition to its rate hike decision, the FOMC will publish a dot plot of the forward projections of all committee attendees. While Wall Street will pay attention, the exercise is almost useless.
The FOMC meets 8 times a year, approximately once every six weeks. Last Fall the Fed said it would start the process of raising rates in March after slowly winding down its pace of bond purchases. These purchases, often labeled quantitative easing, injected massive amounts of money into a banking system already bloated with money. It was non-sensical at the time to be fueling growth, job creation and inflation when prices were already rising and the number of jobs available already exceed the number of unemployed workers. We, along with others, noted this.
Finally, in March, the Fed took its first baby steps to tighten by increasing rates 25 basis points. At the time it thought it might increase rates 25 basis points at each meeting, but by April the need for more medicine became apparent. It raised rates 50 basis points and suggested it would do the same at the next two meetings in June and July.
Now it’s June and 50 basis points no longer looks like enough. 75 basis points now seems likely (we’ll know in a few hours). The point is that the Fed underestimated in March what it needed to do in April. Then in April it underestimated what it needed to do in June. And people want me to opine on what some collective dot plot consensus might be 12+ months out? Hogwash. Despite any statements that Mr. Powell makes this afternoon, none of us know what the FOMC will do in July.
Here’s what we actually do know. Inflation is much more pervasive today than anyone at the Fed expected a year, six months, or even two weeks ago. The fight to bring it down will require a higher Fed Funds rate than previously anticipated. Treasury yields across the curve are well above consensus forecasts versus even a week ago. I have used the following analogy before, but it is apt. If you are driving on the highway and traffic is stopped ahead, when do you start breaking? A quarter mile allows a gentle slowing. A few hundred feet means slam on the brakes. 50 feet means an accident. Most likely the Fed has run out of room to gently tap the brakes. Whether an accident (i.e., recession) can be avoided is still an open question, but odds are rising that recession is unavoidable.
So, what can Powell say today to placate investors? To raise rates 50 basis points, consistent with his June declaration, and promise a higher terminal rate before year end or early next year would be an unsatisfactory response. If a sick patient gets sicker, you give them more medicine now, not promise it in six weeks. Beyond a 75-basis point increase, Mr. Powell needs to do some confessing. He needs to acknowledge that the Fed is behind the curve, further behind than he realized just six weeks ago. If the Fed Funds rate needs to go to 3% or 4% or whatever, he needs to lay out that probability regardless of whether such action might create a recession or not. Politically, this isn’t easy. Mr. Powell will be asked whether recession is now inevitable. He won’t and shouldn’t answer that question, because any answer today is only a guess.
Will that make investors happy? No. Happy is the wrong word. Higher rates and increased odds of recession never make anyone happy. But a lot of negativity is already built into markets. One-year Treasuries now yield over 3%. Two-year Treasuries yield almost 3.5%. Markets now expect the Fed Funds rate to end up at a 3.5% or higher. Being frank with investors will be accepted a lot better than any attempt to sugarcoat. We all know the thought that you can’t just talk the talk, you have to walk the walk. While the Fed has increased its hawkish tone in recent months, it has persistently held to a path too slow to win any battle. In military terms, it has been outgunned by today’s inflationary pressures. The Fed has two mandates, price stability and promoting growth. Its focus has increasingly been on the former, but it doesn’t want to ignore the latter. But growth can’t be sustained with inflation out of hand. If the Fed were to raise rates too rapidly over the next few meetings, there is plenty of time to adjust. Is 75 basis points the right size increase? Is 100 basis points more realistic? A good doctor never wants to overmedicate, as there are unintended consequences of such actions. The Fed could stop inflation by crushing the economy, but that’s not the most palatable route. Some investors are crying today for a series of 100-point rate increases. That’s probably too much, but Mr. Powell should take nothing off the table. Last meeting, he made a mistake laying out the glidepath through July. Today, the proper message is to approach each meeting with a clean piece of paper. If inflation starts to recede over the Summer, we may never need to see 100-basis point increases. If it accelerates, we will. Mortgage rates now exceed 6%. Housing demand is falling quickly. Higher rates work, and that will slow the rest of the economy this Fall. The Fed can’t overcome restricted oil supplies, but it can lower demand. It’s on the right path, it just has to move faster.
One final comment about the Fed. If you haven’t noticed, markets lately have been increasingly volatile. It isn’t just the stock market. It is bonds, it is currencies, it is Bitcoin. As part of its arsenal to dampen the economy, the Fed has laid out a plan to reduce the size of its balance sheet by letting bonds roll off at maturity, and later actually selling some assets. Such action is designed to soak up excess money, reduce speculation, lower asset prices, and let a negative wealth effect further dampen inflationary pressures.
In concept that may sound good, but right now it is probably not a good idea. The Fed and the world can tolerate a bear market for stocks, but it can’t tolerate credit markets that are dysfunctional. When bond yields move 25 basis points in one day, that is monumental, but if overnight repo markets seize up, that’s a big problem. The Fed would be very smart to let higher interest rates do the heavy lifting. Letting mortgages run off may be tolerable, but selling assets and soaking remaining liquidity out of the market is a terrible idea when markets are already stressed. This isn’t a game of checkers, it’s a game of chess. Looking one move ahead doesn’t work. The Fed saw that the economy was at peak employment too late. It recognized inflation too late. I don’t want to see the Fed selling assets and then be forced to explain why credit markets are seizing.
The size of the Fed’s balance sheet doesn’t matter. For the most part it owns Government debt. Changes in the size of the balance sheet either add money to the economy (quantitative easing QE), or subtract (quantitative tightening QT). Both are impactful. No change equals no impact. Raising rates and reducing liquidity through QT at the same time that markets are already stressed seems too risky to me.
Today, Neil Patrick Harris is 49. Ice Cube is 53. Not sure if that is the name on his birth certificate. Chinese leader Xi Jinping is 69.
James M. Meyer, CFA 610-260-2220