Inspector Gadget Fed

No shortage of drama in this market. I called for a bounce in my last post which we got but it was very short lived and it's been nothing but pain since. The "poor" August inflation data was the trigger that started this latest shit show. The Fed's subsequent hike of 75 bps was expected, but it was the Fed's hawkish upward revision of rate hikes to 4.5-5% by March 2023 which cratered the markets. This outlook was no doubt fueled by the result of this single backward looking CPI report which is quite asinine. Meanwhile, the oil price, one of the main culprits of the inflation problem, has just about given up all its gains YTD.  Several other commodity prices and many other inflation pressure points have been abating since June as well.. One of the things the Fed cited as a concern was shelter costs but that too has rolled over, it just hasn't showed up in the data yet. The pipeline inflation pressures are clearly collapsing. 5 Year break even rates which is probably one of the best forward looking indicators peaked in April at 3.41%  and is making new lows almost  daily currently at 2.19%. back to normalized levels which is so significant but of course, the Fed doesn't seem to care. Instead they panicked over a single month's worth of rear view mirror inflation data. 

Here's the funny thing....interest policy won't do shit to move the needle in inflation the way most people seem to think it can. The obsession of the  Fed and interest rates reminds me of a cartoon I used to watch called Inspector Gadget who's job it was to thwart the evil schemes of the sinister Dr. Claw. When Gadget was assigned a case he was always accompanied by his niece Penny and her dog Brain. It was Penny and Brain secretly doing all the work to solve the case while Gadget was fumbling and bumbling chasing false clues often times interfering with the good work of  Penny and Brain. Near the end of each episode Gadget  just happens to be in the right place at the right time to get all the credit in foiling Dr. Claw when it was Penny and Brain all along who truly deserved the credit.  

Everyone seems to think that the Fed has the ability to reign in inflation via monetary policy because of the myth of how Paul Volker supposedly broke the back of inflation in 1982 by jacking up rates. I'd like to see how inflation would have  broke without the peak and subsequent long term decline in the oil price from 1982-1999 which was the result of the significant increase in the SUPPLY OF OIL spurred by significant new production from non-OPEC countries. Interest rates had fuck all to do with this. The mid-late 1940s had an episode of high inflation as a result of hampered supply which couldn't keep up with a surge in consumer spending post WW2. Sound familiar?  Inflation got as high as 18% in 1947. It eventually came down hard and by 1949 there was actually deflation of 2%. Surely the Fed had to jack up rates to break the back of this inflation right? Nope. Rates were rock bottom the whole time. T-bills were yielding less than 0.5% all through out the 1940s.   The economy eventually rebalanced on its own and perhaps was aided by government programs to restrict consumer borrowing which  directly targeted  demand for goods and supply of credit. Everyone points out the demand destruction that rate hikes can cause but nobody ever mentions or even realizes the impact to the supply side of the equation. Rate hikes increase the cost of capital which encourages prices hikes and makes capital investment to increase supply less attractive - both of which ADD to inflation pressures. 

Let's revisit the credit restrictions enacted in the late 1940s. In the US it was required that consumers  put down at least 33% for the purchase of household appliances and autos and must repay the balance within 12 months. At the time interest rates were very low as mentioned. Now, let's say that there had been no such borrowing restrictions but instead, interest rates were jacked up by 10%. Which of these 2 measures would have been more restrictive for spending? It would still clearly be the original scenario.  With the higher interest rate scenario, it would be lucrative for lenders to offer consumers loans to purchase goods with  little or no money down with the option to pay back the balance over several years. There would no doubt be a greater pool of qualified and willing borrowers than the first scenario. That's the other things about higher rates - it makes bank lending more attractive and therefore can inflame inflation as there would be more willingness for banks  to lend. More loans = more money supply and therefore higher inflation pressures. Also, higher rates means higher interest payments on interest bearing securities, which increases money supply.  The credit restrictions used in the 1940s were draconian and anti-free market no doubt, but they were probably more effective than hiking rates would have been since it directly and specifically targeted demand by suppressing the supply of credit for the purchase of certain goods. So, the bottom line is that changes in interest rates have several offsetting impacts when it comes to inflation -it's not simply a case of demand destruction or creation. Hiking interest rates won't directly target the root causes of inflation unless it happens to be mainly related to housing.

During the pandemic there was a clear mismatch between demand and supply and prices surged....we all know why.  These problems got exacerbated once people realized the situation and start hoarding, triple ordering supplies and so forth.  Eventually, this will self correct once everyone has had their fill. This is the so called "transitory" inflation the Fed was expecting. It is indeed transitory but it took longer than the Fed had expected. The war and Chinese lockdowns obviously made things even worse. The Fed eventually caved into the narrative that they had to "do something" about all the inflation....as if the Fed is the master of the universe.  I mentioned in a prior post that I believe rate hikes were a good thing to cool off housing as prices were getting way out of whack which if left unchecked would likely result in even more pain down the road. Given the weakness we have seen in housing, the job has been done with regards to what  part of the inflation equation rate hikes actual have a direct impact on.  By insisting on higher rates the Fed is wrecking unnecessary havoc in the global economy and markets. In addition some aspects of rate hikes are actually inflationary as I have explained. The inflation problem will naturally correct itself but if authorities want to help speed up the process they need to target the root causes of the inflation, directly addressing them much as they can and stop with this myopic and misguided obsession that monetary policy is the answer. If we do get a recession and inflation drops as a result,  unless the root causes of high inflation have been addressed, it will come back quickly and could actually be worse due to the decline in capital spending you get in recessions, but it would appear that a lot of inflation pressures are naturally abating making a Fed induced recession unnecessary. 

Wow that was a long winded post.  I really wanted to get my thoughts off out my head and into the open. Next post will be about the current conditions of the markets. Obviously things are not looking good right now.  

Labor Day thoughts

Past couple of weeks have been pretty nasty in the markets. We are seeing the opposite of the action we saw in late June and July i.e. falling yields and tech leadership. July Job numbers released at month end were fairly robust. At first the market response was positive but by end of the day it was negative.  You always got to be careful to give too much credence in the market's reaction to a single data point. These types of headlines often create knee jerk, emotional type moves and a game of chicken element amongst traders who have made bets on either side of the market. One thing I noticed is that when the market had been up on the day the put/call ratio was high which says there was plenty of hedging/bearish betting going on which is contrarian bullish even though the market reversed course and closed in the red. Put/call ratios have rapidly risen during this market slide, fund flows have reverted back to negative and NAAIM exposure has retreated to 33% and is probably in the 20s right now as the latest figure was as of Wednesday's close. AAII sentiment last week had 50% bears vs 22% bulls. That's back to a lopsided 2:1 ratio you typically see at a market low. The market is also now ST oversold. All of this is suggesting that that the market is ripe for at least a strong bounce and supports the notion of a base building scenario unfolding rather than a market that is primed to make major lows....at least at this point right now.  AAII positioning showed a marginal uptick of equity exposure to 65.5% for end of August. That's disappointing if you're hoping for an eventual bullish resolution to this market. Once again, AAII is showing a clear disconnect of how they are feeling vs how they are positioned and suggests that if the bulls make some kind of stand here, we're not going to be out of the woods. Granted, this is just one indicator and you should never hang your hat on just one indicator. I've showed plenty of other positional indicators which suggest extremes in bearish positioning. Bottom line is that market action looks ugly but there's enough pessimism to suggest a bounce is immanent. At the very least, not an ideal time to be going short here.

There's this narrative that strong job data automatically equates for the need for higher rates. This is such naïve and dangerous thinking.  From 2010-2020 we had generally strong job creation with a fed Funds rate averaging sub 1%. Where was the hyper inflation that this should have created? Even when the labor market was considered tight in 2018 and 2019 inflation was tame. Low rates did however contribute to asset price inflation i.e. housing and equities but not in the CPI/PPI as many doomers were predicting. 

Inflation pressures have recently been generally abating despite the strong payroll numbers we've been seeing in recent months.. In Europe, not as much due to obvious reasons.  To try and kill the economy in order to reign in inflation  due to the external factors causing it is ludicrous. That's like cutting off a healthy foot  in order to deal with a mangled toe. If the Fed hikes rates high enough for long enough, that will probably induce a recession and the bankruptcies and liquidations which result will temporarily help suppress inflation but unless the fundamental factors which created the inflation in the first place aren't dealt with, it will come back with a vengeance. If while in recession the factors that actually created the high inflation are sorted out, it, then the Fed may end getting undeserved credit. That's what happened in the 80s when Paul Volker was given credit for "breaking the back of inflation" which is bullshit....that will be the topic for another day. All I have to say for now is look at the high inflation rates in countries like Turkey and Argentina and you will see how toothless high interest rates were in taming it. Alternatively, look at Japan which has struggled with deflation for decades with 0% interest rates.