Last week I talked about a 1986 mid-cycle like slowdown. Today, I look at more history to help us dissect the Fed and markets.
Historical Fed Insights & Market Implications
* In the late 70s, the Fed undertook actions that looked like tightening but that did not have the effect of tightening. Interest rates moved up, yet people hurried to increase their borrowings because of their belief that rates will only be higher later. This lead to Paul Volcker's hundred basis point moves, to stall that speculation credit creation.
* This week I had the pleasure of interviewing Steve Drobny (should release next week, he runs DGA, home to 'very smart money' and author of Inside the House of Money), and one of the points he told me was the relatively low volatility of recent years in the markets.
* Steve also told me about the confusion amongst global macro hedge fund managers, confusion- which tends to cause major dislocations in the markets. Hence investors shouldn't get too comfortable because when change happens, if it doesn’t take place in small increments, it just might take place all at once in, causing large dislocations.
* Interest rates may be higher today than they were two and three years ago, but credit availability is undiminished and debt expansion undeterred. The economy and markets have experienced low volatility so far, but unless credit and debt growth are curtailed inflation is likely to follow.
* If that happens, the Fed’s preference for measured moves and transparent communications may have to be altered in order to stall speculation and increasing price pressures. Historically, policy lapses in the 1920s led first to excessive speculation and then, due to Fed overreaction, to 1930s depression.
* Fed action in the 70s led to pushing interest rate risk from lenders onto borrowers and then pushing that risk back to banks from consumers in the form of credit deterioration, defaults, bankruptcies (Inflation was almost 11%, so much for President Gerald Ford's 'Whip Inflation Now' campaign back in the 70s).
One way or another, the economy and the markets are likely to going to overcome inflationary
pressure if the Fed is unable to slow the credit and debt creation process.
Using the "R" word - Conflicting data
* Initial results indicate that US corporate earnings haven’t tampered off- 30% of the S&P 500 companies have reported and the majority has beaten estimates (though analysts have lowered 3rd Q estimates). The current market rally now seems to be supported by fundamentals.
* However, the yield on the 10-Year US Treasury is approaching weekly resistance at 4.548. The decline in yields is a warning that the economy could be sliding into a hard landing, and that The Fed may have to respond by lowering the fed funds rate.
* Investors seem stuck on home prices and housing as the most critical consumer driver, whereas I believe that job trends are far more influential because of the the tight relationship between changes in nonfarm payroll figures and real consumer spending. So as long as employers intend to hire more workers, I believe the consumer will stay healthy, so far it seems so (take a look at the image below).
Employment remains high and personal incomes strong, as are capital goods manufacturing and non-residential investment. Though growth has slowed, the consumer remains in good shape. A recession seems unlikely right now from the stock market's perspective, contrary to the bond market.
Investors have to make a choice: Will they put their faith in the stock or bond market? Both are leading economic indicators.