Powell will face a tough audience in Jackson Hole next week.
“In his 2021 address, Powell got it wrong in several important ways.”
Former NY Fed President Bill Dudley
With the passage of time, the Fed’s choices continue to get harder. Inflation is still far too high relative to interest rates to credibly stop raising the Fed Funds target rates. Yet at the same time the economy is relentlessly weakening. Credibility is the key word because Powell has made several poor judgements and statements since last years Jackson Hole meeting.
The Fed may benefit from adding QT and liquidity management to its interest rate tool, but this will likely be a direct hit on the stock market.
The first chart shows that inventories are still growing and, ex autos, are still at record levels. This is likely to hold back growth until excesses are cleared out. The second chart shows that record earnings growth is long gone as, ex energy, earnings growth is only just positive.
Then, as shown below, existing home sales are now at a level below the 2019 lows continuing their dramatic fall.
Interest rates directly impact housing as well as so many other components of the economy. Now, in addition, QT liquidity contraction is beginning to have an impact. The chart below shows that the correlation between liquidity and the stock market is tight. The fall in the stock market that liquidity now projects needs to be factored in as it is far from insignificant at a further 10% by year end.
These Weekly Insights have talked in detail about credit, liquidity, interest rates and allocation. As shown in Bridgewater’s stagflation allocation analysis these are challenging conditions while interest rates are still rising. Adding in liquidity constraints is also a significant factor through this period.
I believe that risk needs to be low until conditions change. With higher interest rates USFR, US government Floating Rate Notes, have a place. Then also VTIP, up to 5 year Treasury Inflation Protected Securities, continues to be an option as it still remains attractive relative to fixed income treasuries. Beyond that, I believe that options trades – discussed in last week’s Weekly Insight – may be a more attractive way to take risk given the uncertainty and extreme conditions.
The chart below shows that even though TIPS have benefitted from higher inflation, real yields have been risen to offset the gain. Now all maturities out to 5 years have a positive real yield. It may be a long time before 5 year Treasuries will be able to say the same!
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