Why the Fed Isn't Done Yet

Recently I had a chance to go experience Disneyworld's Star Wars Galactic Starcruiser. It was amazing, and if you are a Star Wars fan, this has to be on your bucket list. It was also a stark reminder that people often like to live in their own fantasy worlds.

For several months now, I have been hearing all the conjecture about inflation and the rationales for why it really isn't that bad. The latest one is that the Fed is looking at lagging indicators and they should ignore the cost of housing in plotting monetary policy. In the Fall of 2022, there were prognosticators saying we'd already be down at 4% by now and blow through the Fed's target so quick that the Fed would have to pivot before year end. Or remember the whole "excluding the more volatile food and energy costs" argument to get to the "core" number? We've been engaging in that fantasy for decades now. It is amazing that medical and education costs magically never seem to be important factors in the CPI discussion, yet they probably among the top-five dollar expenditures of most households. Point is, we can all keep fantasizing that if we exclude enough variables, inflation is fine. Yes, CPI may be coming down finally off recent peaks, but most real people in middle America still have real problems with their own cost of living. In fact, I would argue their cost of living has been a big problem for a lot longer than we care to admit. If you know anyone who has had to pay out-of-pocket for non-standard medical treatments, or private education for kids with special learning needs, I promise you none of them would say inflation is simply a phenomenon of the last 18 months alone.

Fantasies aside, the recent retrenchment of CPI off the highs has been a positive for equity markets and the recent rally off the bottom feels like a huge relief after the drubbing we experienced in 2022. No doubt, we were due for a stock market bounce last Fall. There were technical, sentiment, and other indicators showing we were approaching oversold levels. But don't get too excited — unfortunately I still think we have more turmoil in front of us.

A number of the indicators that I watch that were flashing oversold during the last few months of 2022 (for example, the volatility index, equity put-call ratio, S&P 500 short interest and days to cover, long-term Treasury yields, and the U.S. Dollar) have flipped and become concerning once again with the hopium stock market bounce in 2023 year-to-date.

In fact, a few strategists out there have now become so optimistic lately that they've shifted from debating about a "soft landing" to now a "no landing" scenario. I love this one — I think this is the first time in my career I've heard the term "no landing" bandied about. Essentially, some on Wall Street are now starting to believe that this recent stock market rally is foreshadowing that the economy will not only avoid a recession but keep growing like nothing has happened over the last year.

Well, as wonderful as this sounds, the reality is we've just experienced the most intense increase in the Fed Fund rate and the most inverted yield curve I've ever seen in my career. So forgive me if I'm not there yet because the impact of these two factors alone are just starting to filter into the economy and will continue to do so throughout 2023. So wake me up on that theory in a year and then tell me again that this time IS different. For now, I'm not buying it.

Unfortunately, I'm still sitting with the concerns I cited in my September article, all of which still seem quite relevant today, and are still on the come:

• S&P 500 consensus earnings are still at significant risk in 2023 (and now perhaps 2024 as well). Currently, Wall Street consensus has S&P 500 earnings pegged at about 223 for 2023 and nearly 250 for 2024. With the headwinds cited above and below, it seems a lot of things need to go right to achieve these levels, not the least of which is significant cost cutting by companies that bulked up during the pandemic to maintain profit margins. This is why many individual stocks are rallying lately when they announce layoffs because it provides some hope that optimistic forward estimates may be achievable and also they could keep the Fed from raising rates further (or even lowering rates sooner than expected). But that thought process is also circular, since most consumers are not prepared to be out of work for an extended period of time, and continued corporate layoffs could have a more negative impact on consumer spending than in the past (see below).
• Treasury yields and cash returns at 5% (and going higher) are competing again for money that would have gone into stocks, real estate, or cryptocurrency by default during the pandemic, when risk-free rates went to zero. Treasury yields across the yield curve have started to creep back up again as investors are increasingly concerned that inflation isn't falling as fast as they'd like (oops -- this is what happens when economists and strategists try to extrapolate an inflation forecast on short-term data and lack experience with that phenomena in their lifetimes). Yes, inflation is coming down. But while a 4% inflation rate looks potentially achievable and amazing in comparison to what we experienced in 2022, this level still would have been considered highly problematic just 18 months ago. Let's not get too excited just yet about the death of inflation.
• Employment and real estate prices still need to fall. We're just starting to see the leading edge of these trends, and so they are not yet filtering into consumer spending. But this could change meaningfully during 2023 and into 2024. I would argue that even a small 1% rise in unemployment from here will have a more disproportionate effect on consumer spending this economic cycle than in past cycles because consumers have exhausted their savings (which was really mostly government stimulus) while simultaneously increasing their debt levels to all-time highs since mid-2021. There also will be a clear knock-on effect on real estate prices as a result of consumer balance sheets being unprepared for income disruptions and higher variable-rate mortgages, which could flow through as lower demand for homes and as higher mortgage delinquencies and defaults during the next two years.

I am particularly struck by the fact that recently the stock market bounce has held up despite an extremely important reversal in U.S. Treasury yields across the curve (it's been a while since investors could earn 5% on short-term risk-free paper). I do believe yields still have room to rise across the curve (and forget about it if we were to go into any kind of standoff around the debt ceiling, which could put more a lot more near-term pressure on bond prices and further increase yields if we play politics for too long).

The other issue I have a tough time measuring is global risks. What I do believe is that they are significantly understated today in asset valuations. For one, I don't think Russia is giving up on the Ukraine any time soon — this situation is more likely to escalate again versus go away, and the U.S. is increasingly involved now. But this is hardly the only international risk factor out there, and the U.S. is hardly the only country trying to deal with the dilemma of managing massive debt, stubborn inflation, and economic and political stability. As bad as things felt in 2022, financial markets still seem quite forgiving when it comes to assessing global risk premium in discounting forward asset valuations.

On the positive side, there's no doubt there are also plenty of people who believe a recession is coming too, so there is definitely much more risk being priced into the market calculus compared with just 18 months ago. Also, the heavy lifting of Fed rate hikes hopefully should be behind us now.

But I don't think the Fed is done yet. In fact, looking at money supply or M2 (shown in the headline chart above), it is clear that the Fed has more wood to chop to get back to trendline M2 growth and feel better about future inflation risks (after expanding M2 so rapidly and irresponsibly during the pandemic).

Put another way: People that are still arguing that the Fed is being too restrictive right now and should have stopped raising rates last year have REALLY short memories and just want their punch bowls back. Just look at the M2 chart above for some perspective on where we have been and where we need to go. A Fed Funds rate 4.5% is hardly high by historical standards. In fact, I would argue it's more healthy than harmful especially when you compare it to ZIRP. Also consider that inflation (while on a path downward) still remains higher than the level of interest rates today. So arguably, the Fed is STILL not restrictive enough to get inflation sustainably down to its target.

Inflation is like a vampire — you may think you've killed it, but it might come back and bite unless you decapitate it. This is why I think this Fed will err on the side of overshooting and the terminal Fed Funds rate could end up being at least 5.5% (which is still 75-100 bps higher from current levels, and higher than consensus today). This is a level where the Fed can officially peg interest rates higher than inflation in the coming quarters as annualized inflation hopefully continues to moderate below the 5% level.

Amazingly, I still read pieces today from professionals arguing that the Fed will need to pivot in 2023 and start lowering rates again. Why are people so afraid of a recession at any cost? A recession could be actually healthy and just what we need!

I'm not only 100% convinced that a Fed pivot will not happen in 2023, but I now think there's less than a 50% chance the Fed will lower rates in 2024. And if they do lower rates, I believe it would be more to do with a liquidity-driven or other global risk that manifests itself and could cause more economic damage than a mere recession.

Net/net —the recent bounce was fun while it lasted, but it's time to buckle up again and prepare again for a bumpy ride ahead.

One last side note: I am proud to report that none of this article was written by generative AI. That is an article for another day...for now, I choose to live my own fantasy that I can still write better than artificial intelligence. ;-)

**All commentary in this article represent my own personal views and opinions, and are not representative of those of my current or past employers, nor intended to do so. None of my comments are intended as or should be viewed as personal investment advice, nor am I compensated to provide any of the commentary above.**