Vincent Besnault/DigitalVision via Getty Images
Meme Traders 1, The Federal Reserve 0
At its meeting this week, the Federal Reserve raised interest rates as expected by 0.25% annually to 4.50%-4.75%. The Fed press release appeared carefully written to dismiss market expectations of an imminent pivot, which markets had been clamoring for. Markets were down modestly going into the press conference, but everything changed with one question.
When asked (to paraphrase) whether Powell was concerned over the rapid easing in financial conditions since October, the Fed chair said he wasn’t. So what does Powell get when says he doesn’t care if financial conditions ease? Real-time financial conditions sharply eased even before anyone could even pass the mic for the next question! The furious rally was led by Carvana (CVNA), Tesla (TSLA), Nvidia (NVDA), AMC (AMC), and altcoins. This played right into the hands of market speculators who bought short-term call options going into the Fed meeting, hoping that a squeeze would develop.
You can timestamp this turning point at the bottom of the graph, shortly after 2:30 PM Eastern. By the closing bell, the S&P 500 (SPY) pushed from near the 4000 level to over 4100, while the NASDAQ (QQQ) rallied twice as hard. The Dow (DIA) was near flat on the day.
Powell had a prime opportunity to push back on massive bets that the Fed will soon pivot and restart quantitative easing to bail out stock market speculators. He didn’t call the market’s bluff, instead choosing to fold his cards and let the rally accelerate. Even more troubling, the market rallied further when Powell responded cryptically to whether the Fed would monetize the US federal debt if Congress refused to raise the debt ceiling. This fueled a powerful selloff in the US dollar and a drop in Treasury yields. Dollar selloffs aren’t unusual from dovish Fed meetings, but this one seemed to be fueled by traders that are beginning to lose confidence in the US dollar after pumping tons of money in after the war in Europe broke out last year.
The Fed Needs To Care About Easing Financial Conditions
Powell didn’t call the market’s bluff, and it may seem like no big deal, but the reaction from the stock market was immediate and powerful. Higher stock prices (especially in meme stocks) fuel a wealth effect among consumers, causing spending to rise. Lower bond yields encourage more borrowing. A weaker dollar works to push up import prices like clockwork. The risk here is that the Fed has been consistently wrong in forecasting inflation, so if they’re wrong again on the low side, then their credibility is totally shattered, just as it was in the 1970s.
There are some well-known factors that will push inflation down, mainly the decrease in home prices and used cars and an expectation that rents have peaked. But there also are some factors pushing it back up. The declining value of the dollar is a huge factor pushing prices back up, but there are also other factors including annual pay raises and yearly COLA adjustments from government programs like Social Security. The decrease in used car prices appears to have stopped while core services inflation has not yet shown any signs of slowing.
And don’t look now, but core inflation accelerated month-over-month in Spain and Italy. Core inflation for Tokyo also surprised traders for January. These were not tiny surprises to the upside either, with Spain’s core coming in 0.9% above estimates and Italy coming around a similar amount. What should we make of these? I don’t know for sure, but there’s no way I look at these and think they’re good news. There’s unfortunately a long history of policymakers trying and failing with half measures on inflation, only to be forced to double down later when inflation doesn’t go away.
These are all reasons that the Fed should absolutely have called the market’s bluff and pushed back on trader bets of a Fed pivot. Personally, I would focus less on the rate hikes, which are being repeatedly brushed off by traders, and more on the Fed’s balance sheet, particularly on its portfolio of mortgage-backed securities. That would have sent a clear message to traders intent on a Fed pivot.
The Market Won By Bluffing With Bad Cards
The S&P 500 is priced near 2021 bubble highs, particularly the tech sector, which was the biggest gainer today after the Fed meeting. Every stock in every market isn’t overvalued, but cash pays 0.25% more per year this month than it did last month, while the compensation you get from stocks has shrunk, because you’re paying about 108 cents for every dollar of stocks you could buy four weeks ago.
Why Powell didn’t call the market’s bluff and what the Fed is thinking internally is anyone’s guess. The Fed can brush off the speculative 2021 bubble in stocks as just another mania, no different than the tech bubble in the late 1990s when monetary policy was tight. But the Fed owns the pandemic housing bubble lock, stock, and barrel. They own it literally and figuratively since they own something like 30% of all outstanding mortgages. And they allowed workers to get completely crushed by pandemic money printing while using QE to drive up assets of the 0.01%. It would have been so trivial for Powell to say that the Fed was concerned by market speculation and might hike rates more to stop it, but he didn’t, at least not at this time.
You don’t have to participate in the casino if you don’t want to. Stocks could go to all-time highs on pivot mania and then crash later, and you’d still get about a 5% return on cash over the next year.
The problem going forward is that the Fed has put the market on a pedestal. If US inflation follows some early indicators abroad and surprises to the upside when the market has priced the fastest disinflation in history, then stocks will pay a steep price later despite successfully bluffing the Fed now. The word crash may be a little extreme, but past CPI shocks to the market have resulted in one-day index declines nearing 5%, and monthly declines nearing 10%. This may not catch the market this month or even next, but the combination of high valuations, rock-bottom consumer savings rates, malinvestment in the economy, and hundreds of zombie companies propped up by low interest rates are guaranteed to cause problems at some point.
Michael Burry shared just one word of advice for investors. “Sell.”
