****************************************
Headline:
Wealth Effect In Jeopardy.
****************************************
The Bond Market Was Destroyed In Q1 ’22.
The Worst Quarter For Fixed Income In Nearly 40 Years.
****************************************
So After 1 Year Of Determined Inflation Denial…The Fed Suddenly Flipped + Folded To A Hawkish Monetary Position.
The Fixed Income Sell-Off That Followed Was Well Deserved…As Investor Complacency Was Deeply Rooted In All Products…Private + Public…Including:
1. Investment Grade Corporate Bonds +
2. High Yield Corporate Bonds +
3. Municipal Bonds +
4. U.S. Treasury Bills + Notes + Bonds…
Thanks To A 13 Year Federal Reserve Policy Of Ultra Easy Money…Punctuated By A Capitulative Dollar Printing Binge To Address Covid’s Detrimental Economic Impact.
****************************************
Now…Liquidity…The Primary Short Term Catalyst For Asset Prices…Is Being Sharply Reduced.
Naturally…The Bond Market’s Greatest Fears Have Come True…As The Sell-Off In Q1 ’22 Was Both Merciless + Relentless [see above chart].
Interest Rates Sharply Ramped Early In The Quarter…Even Further…After It Was Indicated The Severely Bloated $9T Federal Reserve Balance Sheet Will FINALLY Be Culled…By $95B/Month [see below chart].
****************************************
Nevertheless…There Is Much Market Chatter About…POSSIBLE…Peak Fed Hawkishness.
Perhaps…In The Near Term…As The Sell-Off Has Been So Rapid…& Fixed Income Sentiment Is So Bearish…That A Counter-Trend Rally Is Plausible.
Still…Consider The Following…Inflation Grips With An “8” Handle & The Current Fed Funds Rate Target = Just 25-50 Basis Points.
Historically…In Order To Tame A Sharp Inflationary Impulse…The Fed Funds Rate Ought To Be ABOVE The Annualized Rate Of Inflation.
Obviously…We Are Not Anywhere Close To That Level…Even If You Halve The Normalized Inflation Rate To 4%…And Fed Governors Have Acknowledged As Much.
****************************************
Of Course Capital Markets Are Well Skilled At Discounting Future Expectations…And Current Expectations Are For Short Term Interest Rates To Approximate 2.48%…By The End Of Calendar ’22.
That’s A Lot Of Actual Fed Tightening In The Next 8 Months…Just To Catch-Up With Real Time Market Pricing.
****************************************
Anyway…The Most Critical Unanswered Bond Market Question =
In Order To Dramatically Slow Inflation…Must The Fed Move Beyond The Perceived Terminal Fed Funds Rate…That Is…The Interest Rate That Is Neutral…Neither Stimulating Nor Restricting U.S. Economic Activity…In Order To Dampen Inflation?
And Therein…Lies The Answer To Future Bond Market Pricing…
Because Right Now…Though The U.S. Economy Is Indeed Slowing…The Fed’s Current Monetary Policy Is Still Massively Stimulative.
Despite The Steep Q1 Sell-Off…Market Actors…For Now…Presume A Terminal Interest Rate Of Just 2.50-2.75%.
But That Presumption Will Vacillate With Forthcoming Inflation Data…
And If/When The Market Merely Senses That The Terminal Interest Rate Might Reside At A Much Higher Level…Then…
…The Fixed Income Market Rout Will Resume.
****************************************
Furthermore…Much Intellectual Capital Has Been Recently Spent Comparing/Contrasting Inflation Of The 1980’s To Today’s Inflation…
And 1 Item To Seriously Contemplate…Regarding This Issue…Is That Inflationary Measures Have Adjusted…Quite A Bit…In The Last 40 Years.
If One Were To Apply The Same…More Liberal…Inflation Measuring Criteria To The 80’s…As Is Now Calculated In 2022…That 14% Inflation Rate In The ’80’s Currently Translates To Around 9.5%.
So Inflation…No Doubt…Is Currently Perched Near Generational Highs.
****************************************
As To How Inflation Evolves…Here Are Some Crucial Facts To Ponder:
1. The War In Ukraine = Inflationary…
As Global Supplies Of Agricultural Commodities + Commercial Fertilizers + Industrial Metals + Oil Are Curtailed.
2. Global Supply Chain Bottlenecks = Inflationary…
As The Uncertainty Of Input Supply Leads To Over-Ordering + Purchasers Aggressively Adjusting To Diminished + Unreliable Allocations.
3. The “Green Agenda” = Inflationary…
Primarily Because The Implementation Is Too Fast…And Discourages Oil Production Despite Still Robust Global Petroleum Demand.
4. Global Central Bank Balance Sheet Volumes = Inflationary…
vis-a-vis Richly Valued Financial Assets + Real Estate.
5. Tight Labor Markets = Inflationary...
As Demand Continues To Dramatically Outstrip Supply
****************************************
So…How To Combat This Daunting List Of Inflationary Challenges?
First Things First…The Fed Has Zero Control Over #1 & #2 Listed Above.
As For The Green Agenda [#3]…That’s A Political Issue…That Only Pivots If The U.S. Executive Branch Reverses In The Next U.S. Presidential Election.
So…Tactically…The Only Flanks For The Fed To Attack Are #4 & #5.
****************************************
In The Meantime…Fed-Speak Is As Hawkish As Ever…Though Never Precise.
But If You “Read Between Their Ambiguous Lines”…It Is Quite Clear That They Intend To…At The Very Least…Severely Dent The U.S. Residential Real Estate Market…
As Its 12 Year Bull Run Almost Perfectly Mirrors The Fed’s Balance Sheet Expansion…And Has Strongly Contributed To Legacy Based Goods Inflation + Financial Asset Inflation Too.
Consider This…
Existing Home Sale Prices…On A Year/Year Basis…Have Increased EVERY MONTH For The Last 120 Months/10 Years.
And The Price Increases Are Primarily Well Distributed Nationally & Ridiculously Exceed GDP Growth.
Thus…Residential Real Estate Is Classic “Low Hanging Fruit” For The Fed To “Harvest“…In Its Attempt To Bring Inflation Down.
****************************************
And What Makes Residential Real Estate An Even More Obvious Target Is That…Generally…It Is A HIGHLY LEVERED “LONG” TRANSACTION…
And While Leverage…
Amplifies Gains In A…
Rising Price Environment…
It Inversely Amplifies Pains In A…
Decreasing Price Environment.
****************************************
Residential Real Estate Is Even Further Levered As New Home Construction & Development Is Debt Financed.
And Real Estate Development Consumes Many Commodities… That Have Contributed To Goods Based Inflation…Such As…Concrete + Gypsum Board + Lumber + Metal + Plastics [Chemicals].
Even Then…Developers Compete For These Commodities With Existing Homeowners [a much larger market]…Further Driving Prices Upward…As The Lure Of High Home Prices + Low Financing Costs…Provide Great Incentives To Improve + Remodel Existing Dwellings.
So This Connection Between Housing Prices + Inflated Materials Cost = Highly Elastic…And Easily Susceptible To A Higher Interest Rate Regime.
****************************************
Moreover…Rock Bottom Interest Rates…While Encouraging New Home Purchases Also Stimulate Home Refinancing For Existing Homeowners…
Placing Even More Disposable Income In Their Pockets…Though That Has Already Reversed Quite A Bit [see Mortgage Bankers Association weekly data].
And Do Not Forget That Homeowners Also Spend Much Discretionary Income On Home Goods + Furnishings [Indoor & Outdoor]…Adding Another Stimulant To Aggregate Demand…That Ought To Wane With A Slowing Residential Real Estate Market.
So The Beautifully Levered Multiplier Effect Of Real Estate…That So Stimulates The U.S. Economy…Transmitted Through Developers + 1st Time Home Buyers + Existing Homeowners…Will Be …In All Likelihood…Harshly Slayed…As The Positive Feedback Loop Steeply Reverses.
****************************************
The Second Piece Of The Previously Mentioned “Low Hanging Fruit” For The Fed To Harvest…In Order To Fight Inflation Is:
Financial Asset Prices…Beyond Fixed Income + Real Estate…So Equities.
And The Cornerstone Of Equity Price Appreciation = Low Interest Rates…Combined With The Expectation That Rates Will Remain Low…
Obviously….That Investment Ethos Has SHARPLY INVERTED.
****************************************
For Equities…Generally…Higher Interest Rates Are Not Friendly To Share Prices…Especially Those That Do Not Generate Any Free Cash Flow.
Even Then…Higher Interest Rates Depress Valuation Metrics Almost Universally…Despite Free Cash Generation.
Plus…The Valuation Set-Up…After 13 Years Of QE + ZIRP…Is Not Compelling…
As Metrics Are Still Broadly Stretched…Especially In The Top Heavy Technology Sector…Predominant In Most Major Equity Indices.
And As Earnings Expectations Reset Lower In A Slowing Economy…Valuation Metrics Will Likely Get Clipped Further As Interest Rates …Ironically Rise…Thanks To The Fed’s Much Tardy Application Of Inflation Fighting Tools.
Finally These All Important Metrics Will Likely Overshoot To The Downside As Investor Anxiety Continues To Build.
****************************************
So This Troika-ed Wealth Effect Comprising:
EQUITIES + FIXED INCOME + REAL ESTATE =
Under INCREASINGLY INTENTIONAL PRESSURE…
And Ought To Remain So Until The Current Inflationary Impulse Is Quashed…And That Will Take Some Time…And Maybe Some Luck Too.
**********************************
Contact The Author: [email protected]