I am tempted to say financial markets have already done the Fed’s work. However, it is very likely that the minute the Federal Reserve even hints that rate cuts could be delayed until next year, the resulting tantrum in financial markets could be epic. The Fed is loathe to disappoint markets, and the message from the last meeting and subsequently from Jerome Powell has been to promise a rate cut sooner than later. Financial markets have persistently focused on any and all dovish twinges in Fed-related pronouncements. For example, from Powell’s testimony to Congress on March 6th (emphasis mine):

“We believe that our policy rate is likely at its peak for this tightening cycle. If the economy evolves broadly as expected, it will likely be appropriate to begin dialing back policy restraint at some point this year. But the economic outlook is uncertain, and ongoing progress toward our 2 percent inflation objective is not assured. Reducing policy restraint too soon or too much could result in a reversal of progress we have seen in inflation and ultimately require even tighter policy to get inflation back to 2 percent. At the same time, reducing policy restraint too late or too little could unduly weaken economic activity and employment.”

Powell can insert all the standard caveats he wants. Markets read this statement as saying rate cuts are on their way!

A Nervous Bond Market

Yet, bond markets have been a little “nervous” all year. For example, the iShares 20+ Year Treasury Bond ETF (TLT) has trended downward (meaning higher bond yields) so far this year with lower highs and lower lows. From TradingView:

TLT is just a fresh low of the year away from finally catching the stock market’s attention again.

Copper, Lumber, and Oil – oh my!

The bond market has good reason for some jitters. Several commodities have sprung back to life this year. Copper miner Freeport-McMoRan Inc (FCX) is welcoming the upcoming Fed meeting with a 7+ month high. FCX is up 19.8% in less than two weeks. (FCX has been stuck in a trading range since the beginning of 2021).

Lumber bottomed out in early 2023. This month, lumber broke out above last summer’s high and is back to levels last seen in August, 2022.

Oil, everyone’s favorite non-core component of inflation, has been in “stealth” rally mode all year. The United States Oil Fund, LP (USO) looks ready to launch parabolically on the wings of rate cuts.

Where will these prices go with rate cuts? I vote higher.

The Golden Touch

Speaking of getting ready for rate cuts, gold, my favorite hedge enjoyed a spectacular (and overdue) breakout this month. SPDR Gold Shares (GLD) traded at an all-time high at its peak this month.

I like buying the dips in GLD going forward. The odds seem sufficiently high for the Fed to feel “forced” into easing into a sea of market liquidity.

Straining to See the Weakness in Labor Markets

So maybe the Fed can strain its economic gaze and find an excuse to do a “proactive” rate cut. The graph below shows the unemployment rate has likely bottomed out (left axis and blue line) Yet, it remains near historic lows. Initial unemployment claims have been trendless with a recent peak set last summer (right axis and green line). Finally, real GDP quarter-over-quarter growth has levitated in positive territory and for the last two years has defied overly persistent expectations for a recession (right axis and red line). From my perch, I see no excuse for a rate cut here, but perhaps I am not creative enough with the data.

Sources: U.S. Bureau of Labor Statistics, Unemployment Rate [UNRATE], retrieved from FRED, Federal Reserve Bank of St. Louis; U.S. Employment and Training Administration, Initial Claims [ICSA], retrieved from FRED, Federal Reserve Bank of St. Louis; U.S. Bureau of Economic Analysis, Real Gross Domestic Product [GDPC1], retrieved from FRED, Federal Reserve Bank of St. Louis.

The Stock Market’s Giddy Anticipation

The stock market’s giddy anticipation of rate cuts is poetic. The stock market has soared on loosening financial conditions and has been able to ignore just about any bad news the macro environment tries to toss out there. Recent successive all-time highs speak volumes to the buffer the Fed can enjoy if it so chooses to wait out the Presidential election before making changes to monetary policy.

Conclusion

With market breadth increasingly lagging the stock market’s ascension, I have been a skeptic about the overall rally for several weeks. The Federal Reserve is probably the last catalyst between now and the Presidential election that has a chance of validating my skepticism. If the Fed complies with the market’s giddiness, there is no telling how high the market could soar in coming months. If the Fed decides to wait things out, the stock market will lose a major contributor to the upward and higher fund. Then again, maybe the Fed pulls off a magical “hawkish rate cut” (one and done rate cut with a warning about the potential for inflation to rise from the ashes). The Fed could figure out just the right balance between disappointing the stock market and fueling ever increasing levels of speculation and higher commodity prices…

Be careful out there!

Full disclosure: long GLD

The post Financial Conditions Make A Monetary Roundtrip and Undercut the Need for Rate Cuts appeared first on Inflation Watch.

• Starting in 2019: The Federal Reserve warned Silicon Valley Bank about risks in the bank.
• 2021: “The Fed identified significant vulnerabilities in the bank’s containment of risk, but the bank did not rectify the weaknesses.” Ironically enough, one of the six fines issued to SVB included “a note on the bank’s failure to retain enough accessible cash for a potential downturn.”
• July, 2022: a full supervisory review revealed the bank as “deficient for governance and controls.”
• Fall 2022: the Federal Reserve of San Francisco met with “top officials at the bank to address the lack of accessible cash and the potential risks posed by rising interest rates.”

In other words, tight monetary policy was not the root problem of the bank’s problems. Tighter monetary conditions finally forced the issue of disciplining the bank. Tighter monetary policy is supposed to mop up excesses in the economy, and Silicon Valley Bank is starting to look like yet one more egregious example of the excess enabled by the prior era of easy money. It will be interesting to see whether the Fed’s review of its regulatory supervision includes claims that it lacked the authority to force SVB to change its ways.

The Fed Gives Us What We Want

Regardless, as I continue to see blame heaped on the Fed for this latest episode of financial instability, I have surprisingly adopted a more sympathetic view of the Fed’s work. The Federal Reserve has a near impossible job. It seems every major change in monetary policy sets the seeds for the next financial drama. Every financial drama raises the Fed’s prominence yet higher as a centralized economic planner, never able to return to the background of a free market. The Fed now must constantly tinker with interest rates with no clear terminal point. In particular, the economy has set up the Fed to bias towards keeping monetary policy as accommodative as possible for as long as possible. The Fed gives us what we want: policy that supports higher asset prices from stocks to real estate.

The index of financial conditions, as measured by the National Financial Conditions Index (NFCI), since the Great Financial Crisis (GFC) shows extended periods of very easy financial conditions. It is remarkable how little time the economy has been stuck with a positive index, or even a component on the positive side of danger…even in the aftermath of the economic shutdowns from the pandemic.

The Fed’s balance sheet is an even better example of how the Fed gives us what we want in the form of accommodative monetary policy. The Fed was never able to reduce its balance sheet after the GFC. The current tightening cycle barely put a dent in the Fed’s balance sheet. I have a sneaking suspicion that the Fed will never get its balance sheet back to pre-pandemic levels either. Note how the balance sheet ticked up as of last Wednesday in the wake of the rescue programs rolled out to backstop failing banks.

Board of Governors of the Federal Reserve System (US), Assets: Total Assets: Total Assets: Wednesday Level [RESPPANWW], retrieved from FRED, Federal Reserve Bank of St. Louis, March 21, 2023.

Before the GFC, this kind of balance sheet expansion was considered unthinkable. Surely, such a growth in the balance sheet would cause dangerous inflation levels. Given the on-going duration and size of this expansion, I am guessing economic theories will slowly but surely normalize the existence of this balance sheet. Yet, the longer this largesse continues, the more the economy will depend on sustaining these high levels. Thus, the economy will remain vulnerable to instability whenever economic conditions force the Fed into tightening policy. (Recall how the previous tightening cycle moved at a snail’s pace but still eventually forced the entry of a “Plunge Protection Team” to put a floor under the stock market).

What We Want Is Not Free

In a July, 2022 interview on Bloomberg’s Odd Lots (starting at the 14:35 point), famous short-seller Jim Chanos presciently claimed (emphasis mine):

“The one thing people are not prepared for is interest rates resetting meaningfully higher…It just hasn’t happened in most investors’ lifetimes…the idea that actually interest rates are not going to be 2 or 3% for the foreseeable future is going to be hard for a lot of investors to deal with. If we go back to what I would think are more reasonable rates based on what we’re seeing in the economy…this market will not be able to handle 5 or 6% 10-year. It just won’t. So many business models that we look at are extremely low return on invested capital because capital has been so plentiful for the past 12 years.”

The subtext here is that the Fed’s bias has been to leave monetary policy as accommodative as possible for as long as possible. Deflation was the great imperative chasing the Fed into monetary corners. The response to the pandemic was the logical conclusion of this policy as the Fed decided it had the luxury to keep driving unemployment ever lower by holding rates lower for longer. The economy appeared to be in another era where liquidity and massive stimulus could be conjured up for free. The pandemic’s inflationary pulse eventually turned the tables. What we want can actually be quite costly.

Thus, the Fed finds itself in a new trap. I feel for the Fed, but I don’t blame them…we prefer easy money…and many eagerly await the Fed getting disciplined back into cooperation by the Panic of 2023. The Fed Fund futures suddenly expect a long string of rate cuts to follow peak rates in May. I sure hope inflation cooperates as well!

Source: CME FedWatch Tool as of March 21, 2023

A Golden Epilogue

Gold received a new burst of life thanks to the Panic of 2023. As soon as the Fed blinks, I expect gold to rally further. I am keeping the buy button close as we go into the next several decisions on monetary policy starting with March’s. The Sprott Physical Gold Trust ETV (PHYS) broke out to an 11-month high. Today’s 2.0% pullback from over-extended price action looks like it is setting up the next buying opportunity.

Source: TradingView.com

Be careful out there!

Full disclosure: long GLD

The post Don’t Blame the Fed: The Fed Gives Us What We Want appeared first on Inflation Watch.