Powell: Between A Rock and A Hard Place – January 28, 2022

Powell: Between A Rock and A Hard Place – January 28, 2022
Morgan Lewis Posted on January 29, 2022

Powell: Between A Rock and A Hard Place

This was another wild week for markets. Non-stop volatility and dramatic intraday reversals defined price action Monday through Friday. Both the Dow Jones Industrial Average and the S&P 500 finished this volatile week with gains. The tech-heavy Nasdaq was flat on the week, and the Russell 2000 small cap index ended with losses. Nasdaq action on Monday illustrates one of many good examples of the truly extreme volatility plaguing markets in recent weeks. After plunging 8% the previous week, the tech index fully fell out of bed, and the wrong side of it, Monday morning. The Nasdaq opened the day by selling off aggressively and crashing more than 5% in a panic decline. After the morning panic, however, the index staged a historic intraday reversal and remarkable comeback. By the end of the day, the index finished Monday’s session with solid gains. The Nasdaq’s intraday about-face was one of the biggest daily reversals by a major market index in decades of trading.

Cumulatively, the last few weeks have delivered heavy doses of technical damage to major market indices. At the same time, market sentiment has plummeted. In fact, the widely followed investor sentiment survey by the American Association of Individual Investors (AAII) this week recorded the lowest spread of bulls vs. bears since 2013. The extreme nature of the bear-heavy sentiment reading was notable for several reasons. For one thing, the sentiment reading is a contrary indicator. Extremely bearish sentiment is not typically a recipe for a continuation of crashing markets, but rather is typically significant fuel for a bounce. Secondly, after off-the-chart bullish sentiment prevailed for most of 2021, the rapid switch to bearish extremes is all the more remarkable for the fact that it has happened, not far removed in either time or price, from record all-time index highs. 

Lastly, the rapid breakdown in sentiment hints at the fragile foundations underpinning bullish arguments. To a large extent, the bullish sentiment for this market is neither firmly rooted in, nor inspired by, broad strength in fundamental macro data, robust future projections, or attractive valuations. Rather, much of the bullish rationale for this market rests tenuously upon an assumed constant “Fed put,” positive liquidity inflow momentum, and positive technical price trends. When the Fed no longer inspires confidence in the Fed put, when positive price trends and momentum crack and turn negative, these bulls will scatter fast, and in numbers. This stock market version of the “running of the bulls” is what we’ve been seeing since the start of the year in response to the escalation of hawkish Fed rhetoric.

This week’s Federal reserve FOMC meeting represented the latest, and arguably most significant, step towards enacting a new hawkish policy regime. On Wednesday, all eyes were trained on Fed Chairman Powell. In his statement, Powell indicated that interest rates will rise in the near-term for the first time since December 2018. Powell said, “With inflation well above two percent and a strong labor market, the committee expects it will soon be appropriate to raise the target range for the federal funds rate.” In addition, FOMC members agreed on a set of principles for “significantly reducing” the size of the Fed’s massive balance sheet. Officials said that the plan is to initiate the balance sheet runoff after the liftoff in interest rates. The Fed neglected, at this point, to specify an exact date, pace, or balance sheet target size.

Chairman Powell said the Federal Reserve will be flexible, humble, and nimble as it adjusts monetary policy to keep persistently high inflation from becoming entrenched. Tellingly, stocks started to aggressively sell-off when Mr. Powell said that policymakers have “quite a bit of room to raise interest rates without threatening the labor market.” The widely held market expectations are now for the Fed to raise its benchmark overnight interest rate from the current near-zero level at the next meeting in mid-March. Federal funds futures have now priced in another three rate hikes in 2022 after the March liftoff.

Powell contributed to uncertainty and a market sell-off when he didn’t rule out the possibility of raising rates at every FOMC meeting this year. In the Q&A portion of the press conference, Powell emphasized that interest rates would be the “active tool of monetary policy.” He also seemed to betray a palpable skittishness over the issue of balance sheet reduction. He failed to inspire confidence when he said there’s “an element of uncertainty around the balance sheet. I think we have a much better sense, frankly, of how rate increases affect financial conditions and, hence, economic conditions. Balance sheet is still a relatively new thing for the markets and for us, so we’re less certain about that.” The yield curve flattened in response to the meeting as the two-year Treasury yield surged from around 1.07% to 1.19%.

Let’s appreciate the magnitude of the moment. This Fed is clearly in a pretty pickle. On the one hand, high inflation is now raging and severely threatening to become entrenched and devastate the consumer on a secular basis. Just this week, market guru Jeremy Grantham told Bloomberg that while CPI inflation won’t move higher in a straight line, “Inflation will always be part of the discussion from here on out.” After being absent the macro scene for decades, he said inflation will now “be part of the scenery.”

On the other hand, the inflation problem is a consequence, both direct and indirect, of policy tools used to keep markets inflated and the economy growing. In that ongoing Fed effort to apply policies aimed at avoiding economic pain, they have blown a bubble. According to Grantham, those stimulative policies have not only birthed a bubble, but a “superbubble.” This week, Grantham distinguished between the differing degrees of bubbles by saying that rather than just hurt you, a superbubble “can really wipe you out, like 1929 did.” He went on to state unambiguously, “That’s where we are right now.”

So, the Fed’s pickle? It may be an awful choice between a new era of devastating consumer inflation or a popped superbubble. This week, Bank of America’s chief investment strategist Michael Hartnett also well framed the Fed’s bind. As Hartnett points out, with a scorching 7% CPI, the Fed now has to confront the reality that it is “hysterically behind-the-curve” on inflation and will need to be very hawkish for a prolonged period of many months to avoid losing the pending battle with inflation. As Hartnett points out, I think correctly, the Fed can’t slay inflation on Main Street without inducing deflation on Wall Street. As history teaches, bubbles either continue to inflate, or they pop. Hartnett’s observation suggests that at this point, if the Fed seriously intends to bring inflation under control, it may necessitate a popped bubble.

In this week’s FOMC, Chairman Powell leaned heavily on the strength of this economy to be able to weather a tightening cycle without adversely impacting a continued prolonged economic expansion. Past HAI’s have described the Fed as having to walk a perilous tightrope to achieve a goldilocks outcome. This week, Chairman Powell seemed to make clear that the goldilocks outcome is exactly what the Fed will attempt to accomplish. In his statement, Powell said, “We will use our tools both to support the economy and a strong labor market and to prevent higher inflation from becoming entrenched.” Powell’s intention sounds great, but in reality, the tools that might prevent higher inflation from becoming entrenched will put pressure on markets, the consumer, the labor market, and the economy more broadly. So, it would seem, the hope for goldilocks success rests upon the underlying strength of the economy to continue to expand despite headwinds.

There are several factors, however, that call into question whether this economy really has the strength to arrive at such a goldilocks outcome. This week, a slew of factors contributed to new post-Covid highs in oil prices and a renewed surge in natural gas prices. Energy is a key input for the production of virtually every good. Therefore, high energy prices directly impact inflation and the increased cost of goods throughout the economy. At the same time, the increased cost of energy and goods weighs on economic growth. This aspect of high energy prices causing price inflation while restraining growth was a key contributor to the structural stagflation of the 1970s.

This week, the escalation of geopolitical tensions and the threat of conflict between Russia and Ukraine pressured energy prices higher. While a White House briefing indicated that Western allies would not sanction Russian energy supplies, there were subsequent mixed reports suggesting gas production could be sanctioned. In addition, the CEO of Saudi Aramco indicated in the press that oil demand is already back to pre-Covid levels despite continued travel restrictions and Covid related impacts. In the US, future oil and gas supplies took a hit as climate change considerations caused a judge to throw out government oil and gas lease sales to energy producers in the Gulf of Mexico. This week also saw bullish inventory drawdowns of 5.3mb of crude and refined products. All in all, in a troubling sign for the Fed, energy prices were undeterred and continued to scream higher this week despite the hawkish signaling from the Fed.

As mentioned in last week’s HAI, another major area of concern threatening Fed hopes that the current economic strength will support a tightening cycle comes from consumer surveys. This Friday the final results for January’s University of Michigan Surveys of Consumers report was released. “Sentiment fell throughout January, posting a cumulative loss of 4.8%, sinking to its lowest level since November 2011.” In addition to recording the lowest consumer sentiment readings in over a decade, and making the sobering suggestion that a full-fledged inflationary wage-price spiral has been initiated; survey chief economist Richard Curtin makes some critically important observations on household spending.

The goods and services that American consumers buy and pay for account for roughly 70% of economic activity and GDP. Over the past couple of decades, consumer spending has grown at a faster rate than other parts of the economy. As a result, it has become an ever more vital component of GDP. As William R. Emmons, the co-founder and former lead economist at the St. Louis Federal Reserve Bank’s Center for Household Financial Stability put it, “Consumer spending is punching above its weight, if you will.”

According to Dr. Curtin, household consumer spending has “been supported by an extraordinary pace of rising home and stock prices that is likely to turn negative in the year ahead.” Especially in the context of overall confidence in government economic policies being at the lowest level since 2014, Curtin says “consumers may misinterpret the Fed’s policy moves to slow the economy as part of the problem rather than part of the solution. The danger is that consumers may overreact.”

In other words, Dr. Curtin is suggesting that hawkish Fed policy initiatives will turn the “extraordinary pace of rising home and stock prices” negative. As a consequence, what has been the most critical consumer spending tailwind is poised to become a serious consumer spending headwind. Under these conditions, Curtin suggests an imminent danger that consumers slam shut their wallets and close purse strings. If correct, Dr. Curtin is highlighting a chain reaction culminating in a devastating blow to consumer spending’s roughly 70% contribution to GDP.

With grim consumer sentiment already in place ahead of the Fed tightening cycle, and the obvious risks to consumer spending, legitimate economic growth concerns are back on the table. While Q4 2021 GDP was extremely strong at 6.9%, both the Citigroup Economic Surprise Index and the JP Morgan Economic Activity Surprise Index have already turned negative, reflecting US macro-economic data that has recently started to disappoint.

Friday delivered another shockingly heavy body blow to the credibility of Fed Chair Powell’s assertions that the especially robust strength of this economy will be the key to the success of this tightening cycle. On Friday the Atlanta Fed released its initial GDPNow model estimate for Q1 2022 real GDP. The estimate was a stunning 0.1%. For perspective, the reading represents a total collapse from the model’s final estimate of 6.5% for Q4 2021.

The history of inflation and Fed tightening cycles is that ultimately they resolve in recession. There exists a laundry list of reasons to suggest that this tightening cycle, if pursued aggressively enough to tackle inflation, would eventually be no different. The real question will be, is the Fed ready and fully committed to backing out of its unsustainable circular policy trap? Is Powell finally ready to fully retire the Fed put? Extremely doubtful. Much more likely is that the Fed put remains alive and well, but now resides at lower levels.

This also seems to be the message being sent by the impressive relative resilience of gold, as well as by aspects of the yield curve. While gold was down this week, the real story, for now, in the gold market is that despite the Fed’s hawkish pivot, and a surging US dollar index, gold is holding strong well above $1,750 and maintains its uptrend since early August. If Jeremy Grantham’s scenario of a popping superbubble unfolds courtesy of this Fed tightening cycle, we may find out just where that lower Fed put resides. For now, gold appears to be anticipating that moment. In the meantime, the yellow metal has been building a strong elevated base from which it appears well poised to react to the next round of Fed intervention.

Weekly performance: The S&P 500 rebounded a bit from last week’s bloodbath this week by 0.77%. Gold was down 2.47%, silver lost 8.31%, and platinum was off 2.75%. Palladium was again the standout within the PM complex, surging 12.88% on the week. The HUI gold miners index lost 6.26%. The IFRA iShares US Infrastructure ETF was slightly lower by 0.28% for the week. Energy commodities were higher. WTI crude oil gained 1.97% and natural gas surged 22.69% on the week. The CRB Commodity Index was up 1.14%, while copper lost 4.73%. The Dow Jones US Specialty Real Estate Investment Trust Index was up 3.37% on the week, while the Vanguard Utilities ETF (VPU) was off by 1.00%. The US Dollar Index surged higher this week by 1.71% to close the week at 97.27. The yield on the 10-year Treasury closed the week higher by 3 bps to close at 1.78%.

Have a wonderful weekend!

Best Regards,

David McAlvany
Chief Executive Officer

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