Date: 06/20/2021
Author: Kent Moors, Ph.D.
As I noted in my Friday market analysis for subscribers, the Fed has an irritating habit of attracting attention. The pundits quickly picked up on the Fed – or actually the Federal Open Market Committee (FOMC) portion of the Reserve board – talking about raising interest rates.
That will certainly attract the market’s attention. Of course, lost in investor overreaction (the indices declined on Thursday and tanked on Friday) was the disclaimer that this would not happen until 2022 or 2023. A subsequent informal poll of Fed governors put the consensus at 2023 rather than next year, despite the more “hawkish” 2022 comments from two of them.
Never to hold back, the Chicken Littles were quick to cry about skies falling.
And there is some reason for these doomsayers to attract additional TV visibility. Inflation is coming back, augmented by a distorted recovery from historic 2020 economic lows. COVID, after all, makes the traditional year-on-year comparisons meaningless. The huge increases in virtually any of the primary indicators reflects more a patient recovering from just about brain dead status than it does one going up in flames.
As the indicators of inflation begin attracting attention, the normal cyclical nature of investor response kicks in. The problem this time lies in the fact that the stock market has experienced a broad-based advance over the past year, accelerating to one record level after another. That leaves less room for traditional cycling.
As additional waves of investment flooded in, a number of stocks that would otherwise have remained on the sidelines were included in an elevator ride straight up. When the Fed telegraphs a move like this week’s, these more outlier shares are the first to plummet. Unlike other times, there is simply less room for the cyclical moves to take effect. Too much of the market’s marginal shares are in play (and overpriced), assuring some declines moving forward short-term.
The addition of Reddit-fueled raids on shorted stocks, providing unwarranted spikes in valuations resulting from short squeezes as holders cover their positions, is not helping any either. There is going to be an avalanche of losses as the elevated prices come crashing down. There are no fundamentals justifying the huge rises in price resulting from an artificial attack on other investors (those who shorted targeted stocks in the first place).
It is the worst gaming this side of a Vegas roulette wheel, a Ponzi scheme waiting to be investigated. After all, the mandarins of the “reverse short” cannot make money unless there is a consistently increasing flow of fresh cash rushing into the stock buys meant to require a short squeeze. All of that money is coming from small investors crowding in after the move is made.
It is the most ill-advised route for normal retail investors. Making investment decisions based on how many times a stock receives “wink wink” mentions on a discussion board is less successful than making choices based on reading tea leaves.
Then there is the situation that has been building for some time. We all know that markets are awaiting a correction. This could happen all at once (as some Chicken Littles proclaim, hoping then to rush to the bank and deposit winnings from their own latest shorts). But a more plausible scenario is a phased unwinding over a more protracted period. That allows for investment approaches to compensate.
Additionally, if matters do get out of hand, the Fed is likely to act to mitigate the impact. Yes, that is undesirable for pure market adherents. But get used to it. Such machinations are here to stay, especially with an election cycle coming up.
When this begins, do not embark on some “vacation of a lifetime!” The accompanying volatility will be significant.
Investors have not witnessed a genuine bout with inflation for some time and most retail stock pickers are not used to navigating in such an environment. Three matters to keep in mind here.
First, when inflation hits there is no certainty that it will be protracted. We have yet to see any of the substantive factors signaling accelerating inflation without also reflecting the rebound from COVID. Until we do, the rapidly recovering figures address a quick movement off of an economic shutdown rather than anything else.
A number of analysts have suggested that inflation this time around will carry an initial impact but will also not have much staying power. That remains to be seen. But recognize that there are always counter-inflationary stock moves available.
Second, there has been no effect at all on the liquidity and credit markets. These continue to provide levels at the highest levels in decades. The onset of serious inflation will always adversely impact the availability of money. Usually this unfolds by either making the cost of margin accounts (directly effecting liquidity) or debt (increasing the yields on lines of credit) so high they become unattractive or simply unavailable.
The exception, of course, are select investment rated bond yields, at least during early periods of inflation. Initially, as overall prices rise, yield hikes make some fixed paper more attractive. This has been especially the case with sovereign paper, where nations attempt to attract foreign bond investment by offering returns greater than competitors.
This never works as inflation intensifies. It requires a rising of interest rates (i.e., yields) to levels that are unsustainable, heating up the domestic currency in the process, ushering in a local inflationary spiral on steroids, and progressively paralyzing effective economic activity.
Look at the basket case Venezuela has become for a recent example, or the collapse of the baht and the Thai economy a decade earlier.
This brings into focus the third matter to consider. Rising bond yields are the readiest indicator of oncoming inflation. Yet here, as I told subscribers on Friday, interest rates, the canary in the coalmine when it comes to inflationary pressures, remain subdued.
The 10-year note yield, the most relied upon standard, closed on Friday at 1.45 percent. That is a decline of 10.3 basis points (bps) over the last three days (i.e., the period covering the initial reaction to the Fed announcement) and 3.5 bps for the week. Nonetheless, some analysts are predicting a rise in the 10-year rate to over 2 percent in the medium-term.
When this discussion begins in earnest, commentators turn to the yield curve for guidance. Normally, shorter-duration paper carries a lower interest rate than longer-duration. That stands to reason since the interest rate represents what an issuer needs to pay a holder. Higher rates represent higher risk and the time frame is always a major component in that risk calculation. Conversely, the price, or cost, of the paper moves in the other direction – when the rate goes up, the price goes down and vice versa.
Due to a range of factors that tradeoff is not holding up. Rather, some of the bellwether bond funds that usually provide a window into the dynamics of fixed income investing are finding prices and yields moving almost in tandem.
On the other hand, when the yield curve inverts, that is, when two-year notes offer an interest rate higher that 10-year or even 30-year bonds, it is a substantive sign that the market is pricing in inflation. An inversion signal started Friday in line with (as noted above) the decline in 10-year yields along with a rise in the two-year.
Yet, keep the following in mind. In each of the last two recent actual inversions (when two-year yields were trading higher than 10-year), no inflation resulted. The inversion was short-lived and the market shrugged it off.
After all, the sage forecasters using yield curve inversions as a trip wire for investment misery are largely the same guys who predicted seven of the last two recessions.
The 10-year situation is most likely to reverse and start moving higher. That is also a signal for inflation but at least a rise that allows for some absorption.
The genuine objective is to be able to calculate the real, inflation-adjusted, or “natural” interest rate expected to prevail when the economy is operating full steam ahead. Economists call this natural rate the r* (r-star). Unfortunately, it sometimes resembles a barroom brawl when attempting to decipher the best way to reach it.
As I noted on Friday, the FOMC providing some perspective by indicating that a rate hike may be required at some point by 2023 is hardly a lightning bolt from the blue. If the Fed pairs this off with a phasing out of the tapering policy (in which it continues to buy corporate bonds on the open market), the effect should be manageable.
And then there is still the comforting recognition that there are plenty of ways to make money regardless of what happens.
This is an installment of Classified Intelligence Brief, your guide to what’s really happening behind the headlines… and how to profit from it. Dr. Kent Moors served the United States for 30 years as one of the most highly decorated intelligence operatives alive today (including THREE Presidential commendations).
After moving through the inner circles of royalty, oligarchs, billionaires, and the uber-rich, he discovered some of the most important secrets regarding finance, geo-politics, and business. As a result, he built one of the most impressive rolodexes in the world. His insights and network of contacts took him from a Vietnam veteran to becoming one of the globe’s most sought after consultants, with clients including six of the largest energy companies and the United States government.
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