Headline: Wealth Effect In Jeopardy.
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So The Bond Market Was Destroyed In Q1 ’22.
The Worst Quarter For Fixed Income In Nearly 40 Years.
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…
- Corporate Bonds +
- High Yields +
- Municipals +
- U.S. Treasuries…
Thanks To A 13 Year U.S. Policy Of Ultra Easy Money Punctuated By The Fed’s Capitulative Money Printing Binge To Address Covid’s Detrimental Economic Impact.
Q1 2022 hedge fund letters, conferences and more
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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…Even Further…After It Was Indicated The Severely Bloated $9T Federal Reserve Balance Sheet Will FINALLY Be Culled…By $95B/Month.
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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…Even If You Halve The Normalized Inflation Rate To 4%.
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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.
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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 Or 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 Medium Terminal Interest Rate Of Just 2.50-2.75%.
But That Expectation 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.
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Furthermore…Much Intellectual Capital Has Been Recently Expended Comparing/Contrasting Inflation Of The 1980’s To Today’s Inflation…
And 1 Thing To Seriously Contemplate 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 For The 80’s…As Is Now Calculated In 2022…That 14% Inflation Of Yester-Year Translates To Around 8.5%.
So Inflation…No Doubt…Is Currently Perched At Generational Highs.
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As To How Inflation Evolves…Here Are Some Crucial Facts To Ponder:
- The War In Ukraine = Inflationary…
As Global Supplies Of Agricultural Commodities + Commercial Fertilizers + Industrial Metals + Oil Are Curtailed. - Global Supply Chain Bottlenecks = Inflationary…
As The Uncertainty Of Input Supply Leads To Over-Ordering And Purchasers Adjust To Diminished + Unreliable Allocations. - The “Green Agenda” = Inflationary…
Primarily Because The Implementation Is Too Fast…And Discourages Oil Production Despite Still Robust Global Petroleum Demand. - Global Central Bank Balance Sheet Volumes = Inflationary…
vis-a-vis Richly Valued Financial Assets + Real Estate. - Tight Labor Markets = Inflationary…
As Demand Continues To Outstrip Supply
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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.
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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 Nationally Well Dispersed & In Excess Of GDP Growth…Not Even Close.
Thus…Residential Real Estate Is Classic “Low Hanging Fruit” For The Fed To “Harvest“…In Its Attempt To Bring Inflation Down.
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And What Makes Real Estate An Even More Obvious Target Is That…Generally…Residential Real Estate 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.
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Also…Real Estate Is Further Levered As New Home Construction & Development Is Also…Generally Levered…
And Real Estate Development Consumes Many …Currently High Priced Commodities Such As…Concrete + Lumber + Metal + Plastics[Chemicals].
Even Then…Developers Compete For These Commodities With Existing Homeowners…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 Rate Regime.
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Moreover…Rock Bottom Interest Rates…While Naturally 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].
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 Lengthy Positive Feedback Loop Steeply Reverses.
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The Second Piece Of The Previously Mentioned “Low Hanging Fruit” For The Fed To Harvest…In Order To Fight Inflation =
Financial Asset Prices [Equities + Fixed Income] + Real Estate.
And The Cornerstone Of Financial Asset Price Appreciation = Low Interest Rates…Combined With The Expectation That They Will Remain Low…
Obviously….That Investment Ethos Has SHARPLY INVERTED.
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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…Just To Differing Degrees.
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.
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So This Triangulated Wealth Effect Of:
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.
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Contact The Author: Dominate@GlobalSlant.com
Article by Global Slant
