Fed Has Difficult Task to Contain Inflation Without Crashing Markets
By the Curmudgeon
News and views you mightve missed this week, which the mainstream media tends to downplay or ignore. Please let us know what you think.
U.S. Trade Deficit at Record High:
The U.S. Census Bureau and the U.S. Bureau of Economic Analysis announced on Thursday that the U.S. goods and services trade deficit was $80.2 billion in November, up $13.0 billion from $67.2 billion in October, revised.
November exports were $224.2 billion, $0.4 billion more than October exports. November imports were $304.4 billion, $13.4 billion more than October imports.
The trade deficit with China increased to $32.3 billion in November, from $30.6 billion in November 2020. So much for Trumps China deal.
Curmudgeon Comment: A trade deficit, in theory, should weaken the U.S. currency due to net dollar outflows as imports exceed exports. Yet the U.S. dollar hasnt weakened (yet) because its the worlds reserve currency. However, when the DXY index declines, we expect it to decisively take out the June 2021 low of 81. The DXY closed Friday at 95.74 which was -0.6% lower than Thursdays close.
Once the Federal Reserve stops buying assets, it could keep the holdings steady by reinvesting the proceeds of maturing securities into new ones, which should have an economically neutral effect. Alternatively, the Fed could allow its holdings to shrink by allowing bonds to mature or run off. [The Fed would remit the proceeds of maturing bonds to the U.S. Treasury, thereby shrinking its balance sheet]
If the Fed allowed the securities in its $8.76 trillion asset portfolio to mature without reinvesting the proceeds, its holdings of Treasury securities would shrink relatively quicklyby about $2.5 trillion over three years.
When the Fed began the run-off process in late 2017, the economy was weaker than it is now: Inflation was below the Feds 2% target, and the unemployment rate was higher.
The economy is so much stronger now, so much closer to full employment, Mr. Powell said at a Dec. 15 news conference. This is just a different situation, and those differences should inform the decisions we make about the balance sheet at this time. [Note that at the current 3.9% unemployment rate, the U.S. economy has reached full employment.]
Curmudgeon Comment: Shrinking the Feds bond portfolio faster or sooner could come as a surprise to most investors and speculators. It represents a huge market risk that has yet to be discounted.
The Fed will say they are worried about inflation, but deep down, all the policy settings were put in place to get this result.
If the Fed tightens too much, they will end up with an equity market and a real estate crash. I think the Fed will try to continue on the side of always being late. And this is based on my core belief that todays inflation rate is not a bug. Its a feature. Its what they want. Its how you deal with an excessive amount of debt. So, they will say they are worried about inflation, but deep down, all the policy settings were put in place to get this result. Its just like the 1950s and 1960s: You know, we came out of World War II with very high levels of debt to GDP, and we took care of it through 15 years of negative real rates. Its the same plan this time around.
B of A Research Comment (via email):
Ethan Harris continues to believe the Fed is behind the curve and expects a total of eight rate hikes over the next two years. The Fed has taken notice and FOMC minutes revealed some members thought Quantitative Tightening (QT) could start soon after hikes. Our rates strategists expect QT to be announced at the September FOMC, though they suggest there is a chance it could happen by early summer.
A year-opening bond rout has pushed longer-term interest rates to new pandemic-era highs, sending shock waves across financial markets.
The yield on the benchmark 10-year Treasury note, which rises when bond prices fall, jumped in just one day from its year-end close of 1.496% to 1.628%. By Friday, it had settled at 1.769%, smashing through its 2021 closing high of 1.749% to reach its highest level since January 2020, before officials reported the first Covid-19 case in the U.S. The average 30-year mortgage rate reaching a nearly two-year high at 3.22%.
The Nasdaq Composite lost 4.5% in its worst week in more than 10 months, as rising yields hit shares of technology companies and other businesses that derive much of their value from profits expected further in the future. The tech heavy ARK Innovation ETF lost 11%.
A near-record number of tech stocks have plunged by some 50% in an echo of the dot-com crash.
Roughly four in every 10 companies on the Nasdaq Composite Index have seen their market values cut in half from their 52-week highs, while the majority of gauge members are mired in bear markets, according to Jason Goepfert, chief research officer at Sundial Capital Research (which publishes the excellent SentimenTrader newsletter.
Whatever the fundamental and macro considerations, there is no doubt that investors have been selling first and trying to figure out the rest later, Goepfert said in a note to subscribers.
At no other point since the bursting of the dot-com bubble have so many companies fallen like this while the index itself was so close to a peak.
Valuations are at historical highs, companies are raising billions based on fairy dust, and the Fed is signaling a tightening cycle, Goepfert said. All of these are scaring investors that were on the cusp of a repeat of 1999-2000.
For investors looking back on
the long bull market that commenced in March 2009, it may now feel like
research is unnecessary, unrewarded, and more likely to reduce than enhance
returns. The free cash flow yield of the
S&P 500 excluding financials is 3.4%the lowest level since
2002.Considering inflation, real free cash flow yields are negative and
have never been lower.
The market feels like a
bubble. Does it matter? Evidently
not, to new investors. Between
NFTs, crypto, and GameStop, AMC, and other meme stocks, money has rarely felt
more fake. Or, at the very least, value has rarely felt so disconnected from
Rich Uncle Pennybags, the Monopoly game figure, shows some of his funny money as he prepares to strike the opening bell at the American Stock Exchange in New York in February 1995. Bob Stron/AFP via Getty Images
The concept of value is a fuzzy one, and valuation is often more art than it is science. Psychology has always played a role in money and investing and there have always been bubbles, too, where the price of an asset takes off at a rapid pace and disconnects from the fundamental value. As Jacob Goldstein wrote in Money: The True Story of a Made-Up Thing, all money is sort of a collective myth. Money feels cold and mathematical and outside the realm of fuzzy human relationships. It isnt, he wrote. Money is a made-up thing, a shared fiction. Money is fundamentally, unalterably social.
If and when the bubble around some of these hyped investments bursts, a lot of people are going to get hurt and lose money. In NFTs, evidence suggests those who are already wealthy and powerful are the ones ruling the roost, just like in the stock market.
While there are true believers in crypto projects, so much of it is just speculation, and venture capitalists and hedge funds are more likely to win the speculation game than the little guys caught up in the mania.
Robert Prechters Elliott Wave Theorist--January 5, 2022, Update:
Blue chip indexes appear to have topped in the first three trading days of January 2022. The Dow Jones Industrial Average and the NYSE Composite index each made a daily closing high on January 4 and an intra-day high on January 5 (at 36,952.65).
For cyclical reasons detailed in the June 2021 issue, I think 2022-2024 will witness the biggest bear market ever recorded.
Stay healthy, enjoy life,
success, good luck and all the best for 2022.
Till next time....
Follow the Curmudgeon on Twitter @ajwdct247
Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.
Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.
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