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Inflation Moderation Lags Economic Slowing—Increases Uncertainties for Fed Decisions—M2 Money Stock Growth Rate Declining Rapidly—If Sustained–Economy May Slow Sooner Than Forecasts—Fed Pivoting Sooner?—Treasury Market Depth Below Historic Norms–Third Year of a Presidential Term—a Very Good Year for Stock Market Performance–Presidential Campaign Begins November 9th—Could Bring Pressure on Chair Powell to Pivot

Date Posted: November 10, 2022

Fed Recognizes Risks to the Economy from its Rapid Rate Increases—Result-Lower Rate Increases at a Measured Pace
As broadly noted, monetary policy impacts demand and inflation with long and variable lags. As important, if not more so, monetary changes take much longer to impact prices than to effect economic output. If this delay proves prescient, then the Fed will face difficult choices if the economy slows or declines while inflation persists. For that reason, some observers suggested the Fed may overshoot if it continues using current—really lagging– data to determine rate policies. The latest FOMC statement after its recent November meeting indicates the Fed’s awareness of these risks when it stated, “….the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation and economic and financial developments.” These comments indicate at their upcoming meetings the Fed will likely, first, reduce the level of rate increases. Then, the Fed will likely follow a more measured path for rate increases while judging the risks and impact of their polices. They intend to raise rates to a level that will prove “sufficiently restrictive to return inflation to 2 percent, over time.” Currently, futures markets project a terminal rate of 5–5 1/4 percent. Unfortunately, neither the Fed nor others know what higher terminal rate will prove sufficiently restrictive to slow inflation. As a result, the Fed may be caught between a rock and a hard place if their rates prove high enough to slow the economy or bring on a recession but still not sufficiently restrictive to moderate inflation. With a possible recession, the Fed will then face pressures to cut rates despite lingering inflation. These pressures could then lead to a repeat of the Fed’s “stop-and go” policy errors of the 70’s (see Figure 1.) Clearly, Fed Chair Powell and other Fed Board Governors make it very clear their goal will be to avoid a repeat of those errors–not so easy to carry out. Unfortunately, investors failed early on to appreciate that past policy errors helped guide current Fed policies. This failure resulted in more hope than realism on the part of many investors.

Figure 1

Fed’s 1970’s Stop-and-Go Attempts to Bring Down Inflation



Source: The Wall Street Journal, Labor Department, Federal Reserve

Quantitative Tightening —“Scant Evidence of Financial Market Effects”
This statement appeared in our January Commentary, “The Fed’s reversal of their two key monetary policies, nearly at the same time, greatly increases chances for error—adding to the likelihood for greater financial market volatility.” The Fed moved away from its accommodative monetary policies early in 2022 by raising its Fed funds rate at its fastest rate increase since the Volcker Fed of forty years ago (see Figure 2.) At the same time, the Fed shifted from adding to its balance sheet – Quantitative Easing (QE)— to reducing its balance sheet—Quantitative Tightening (QT.) A Kansas City Fed research paper stated, “there is scant empirical analysis of the broad financial market effects of the unwinding of the central bank’s balance sheet.” Despite “scant empirical analysis,” the Fed moved ahead with Quantitative Tightening (QT) by currently running off $60 billion of U.S. Treasury and $35 billion of Mortgage Backed securities monthly from its balance sheet (See Figure 3.) By reducing its purchase of Mortgage Backed securities, QT immediately impacted residential mortgage rates. Over the past decade, according to The Wall Street Journal, the spread between average national mortgage rates and 10-year Treasury yields averaged 1.8 percent. But with the Fed pulling back from the Mortgage Back market, mortgage rates shot up to over 7% (see Figure 4) or roughly a 3% spread over 10-year Treasury rates. Not surprisingly, home sales declined sharply following the higher mortgage rates. Ultimately, events will determine the impact from the Fed using dual strategies, at the same time, to fight inflation.

Figure2

Federal Funds Rate Change by Year

Source: Truist Advisory Services, The Daily Shot

Figure 3

Federal Reserve Balance Sheet Runoff—U.S. Treasury Securities and Mortgage Backed Securities


Source: The Daily Shot

Figure 4

30 Year Fixed Mortgage Rate


Source: Mortgagenewsmnd, The Daily Shot

Quantitative Tightening (QT)—Treasury Market Depth Below Historic Levels
Reduced Treasury market depth likely reflects the Fed’s lessened activity in that market as part of implementing its QT strategies. The Fed’s November Financial Stability Report shows that Treasury market liquidity or depth remains below historic levels. In particular, shorter-maturity Treasuries tend to experience a greater reduction in market depth, which results in higher volatility. Very simply, shorter-term Treasuries show a greater market response to changes in near-term economic news than do longer-life bonds. Further stress could impact the Treasury market, early next year. when the Federal Government reaches its debt ceiling. Nonetheless, the Treasury market should remain stable but the lesser market liquidity does expose that market to an unforeseen major shock.

Figure 5

Treasury Market Depth


Note: Market depth reflects the quantity of an asset available to buy or sell at the posted bid and ask prices.
Source: Inter Dealer Broker Community, Federal Reserve Board Financial Stability Report

M2 Money Stock Growth Declining Rapidly –If it Persists–Economic Slowdown may Occur Sooner Than Fed Forecasts—Rate Cut Sooner?
Chair Powell discounts the impact that changes in M2 Money Stock make on the rate of inflation. In testifying before Congress he said, “the growth of M2….doesn’t really have important implications for the economic outlook.” With that view, the Fed continues to use interest rates as its principal tool to suppress inflation. However, not all economists share his view. Monetary economists predict that when money stock grows faster than real output higher inflation will result. Figure 6 shows just that result. Conversely, if it persists, the current rapid decline of M2 Money Stock growth (see Figure 7) may negatively impact economic growth sooner than many forecast. It seems possible that the impact of declining M2 Money Stock growth may prove more important in controlling inflation than the Fed’s own policies. If economic growth slows sooner than expected, then inflation could also moderate–with a lag. That moderation may lead to a “true pivot”—a Fed funds rate cut—sooner than anticipated.

Figure 6

Money Supply Growth and Inflation, % Change, 2015-2022 Y/Y


Source: US Bureau of Statistics, the Federal Reserve Board, Bureau of Economic Research

Figure 7

Real M2 Money Stock, % Change—2007-2022


Source: Federal Reserve Bank of St. Louis

Presidential Campaign begins November 9th—Brings Potential Pressure on the Fed
November 9th , the day after the Congressional mid-term elections, begins the 2024 presidential campaign. The politics of that campaign will likely influence, or better still, pressure the Fed. A majority of economists forecast a recession beginning sometime later in 2023. This will provide campaign fodder for potential Presidential candidates. Either the current incumbent or the incumbent party will likely put increasing pressure on the Fed to ease its policies even if inflation remains an issue. No doubt, with the sharp political split in this country, the Fed will need to dance between raindrops to both carry out successful monetary policies and calm the politicians.

INVESTMENT CONCLUSIONS

Equities–“True Pivot”—Investors continuously look to the Fed to remove the cloudy investment outlook by so-called “pivoting.” Unfortunately, misreading how and when the Fed expects to reach its terminal rate disappointed many investors when the Fed did not “pivot.” No doubt, stock market rallies will continue based primarily on hope and the memory of the Fed “put.” Instead, the Fed puts reality back into the financial markets by regularly repeating its intentions to aggressively fight inflation. The reality of history also shows that bear markets bottom sometime after short-rates peak—the “true pivot.”

Equities–It Was a Very Good Year–On a cheerier note, the third year of a Presidential term–2023— generally show the strongest relative equity market gains during the four year Presidential cycle. Figure 8 uses data from Yardini Research to detail that pattern. Other research sources also show similar relative performance strength for the third year of a Presidential term. The theory rests on expectations that Presidents attempt to shore up the economy in the third year to improve their chances for reelection.

Figure 8

S&P 500 Index Performance By Presidential Term—since 1928-Present

FIRST YEAR 5.2%
SECOND YEAR 4.8%
THIRD YEAR 12.8%
FOURTH YEAR 5.7%
Source: Yardeni Research

Equities–Look Post-Covid and February 24th —Ukraine War–In the meantime, long-term investors should look beyond the current economic and global uncertainties. In doing so, investors should consider that post-COVID and February 24th, the economic and investment outlook will likely differ importantly from those experienced during the last decade. If that proves the case, then a further differentiation from the last decade will require greater investment selectivity. Therefore, one likely change will shift the attractiveness from broad market indices to more focused products. Recognizing the obvious risks, long-term investors should also consider gradually taking advantage of attractive valuations created by equity market declines. They should look to quality companies marked by strong balance sheets along with growing free cash flow and earnings which then leads to increasing dividends—important during a period of elevated inflation.

Fixed Income—With the end of zero interest rate policies, cash becomes a more important income generating asset. Employing cash, using short-duration Treasury notes and bills, should provide investors with both income and a counter against the high level of economic and financial market uncertainties. In the case of bonds, investors need to determine both how long they expect elevated inflation to persist and when and how deep the economy will slow. These two counterforces should determine the timing and allocation to longer-duration fixed income securities. Alternative investments can also be used for that portion of the portfolio historically committed to fix income; alternatives tend to be less correlated with stocks and bonds. That diversification will prove particularly valuable with today’s high level of economic and investment uncertainties.

Private Equity and Venture Capital–Economic growth depends on both workforce and productivity growth. With slowing U.S. workforce growth, increasing productivity will be key to economic expansion. Venture capital and private equity should provide one source of answers to improving productivity—both information and automation technologies– as well as rewarding to investors.