Whatever happened to all the speculation about the world ending when interest rates started edging above zero? Here we are, days from what could be the Fed’s first tightening move in years . . . and markets are barely flinching.
The phrase “priced in” is overused, but that’s evidently what’s happening here. While Wall Street might not be thrilled with long-term Treasury yields at these levels, we’re a long way from free fall.
It looks a little like acceptance. And now it’s time for people peddling fear to find new targets in their crusade to scare investors away from the stock market.
After all, the last few weeks have reminded the world that the Fed controls dollar policy . . . but global energy markets have an inflationary will of their own.
That commodity logic drove the inflation spike of the 1970s. Now, once again, it looks like the Fed has been pushed to the sidelines for the immediate future.
Rate hikes will help to clear up the free money that flooded the economy in the COVID era. But we’re stuck with high fuel prices until someone convinces producers to pump more crude.
That’s not great news for Americans who are already groaning every time it’s time to refill the tank. I don’t think Wall Street has figured that part out yet.
If anything, big banks like Goldman Sachs are still operating in a world where the Fed will tighten until inflation is back under control . . . even if it means draining all the juice out of the economy.
I just saw a report from Goldman fretting over the yield curve inverting. As you probably recall, that means short-term interest rates rising above their longer-term counterparts.
It’s usually a signal of a recession, which is why the Fed took care before the pandemic to lower short-term rates the last time the curve inverted.
This time around, it can only happen if demand for long-term bonds increases while the Fed pushes the short end of the curve up with rate hikes.
I don’t see that happening. On the long end, demand is actually declining despite short-term flights to bonds whenever the world looks scary.
Fewer bond buyers as the Fed steps back from that market mean less support for prices. Weaker bond prices mean higher yields . . . not lower ones.
But even if somehow the world got so scary that money crowds into Treasury debt as a refuge, it’s going to take a lot of fear and Fed action to invert the curve.
And it’s going to take time. Right now the bond market suggests that the Fed is going to raise the short end of the curve by about 1 percentage point in the coming year.
For the long end to cross under that level, global fear has got to rise to the point where it matches the pandemic shock. We can all imagine scenarios where that happens, but they’re all going to come to the Fed’s attention.
The Fed is not going to keep tightening interest rates in the face of a recession or worse. They’ve proved that their primary bias is supportive . . . a weak job market is the greatest threat on their radar, leaving inflation to twist.
Never forget that they committed to keep the short end at zero until inflation accelerated beyond 2% for an extended period of time. That’s the lowest rate of price pressure the Fed will accept.
Of course there’s an upper limit as well and it’s probably safe to say we’re in that zone. But given the choice of letting a recession unfold and letting inflation rage, the Fed will embrace inflation.
Prices will climb. The yield curve is extremely unlikely to invert . . . unlike the energy market, the Fed has fairly good control over individual points on the curve.
And that means Goldman Sachs is simply whistling into the wind, concocting scary scenarios that aren’t likely to become much of a threat in the coming year at least. We have plenty of time to pivot.
For now, however, it’s fairly clear that Wall Street is relatively comfortable with the long end of the curve testing above 2% in recent weeks. It hasn’t been an extremely bullish season, but it hasn’t been apocalyptic, either.
Corrections come and go. We’re a long way from catastrophe territory. And we’re only days away from the Fed’s next chance to start raising the short end.
Meanwhile, high commodity prices do part of the heavy lifting for the Fed by vacuuming free money out of the economy and transferring those dollars to energy producer balance sheets.
The money isn’t going to Russia, which is nice. A lot of it will stay in North America . . . keeping people employed in shale country, paying for equipment and services.
The difference: you now need to work for those dollars. You need to help the producers pump those barrels of crude out of the ground.
It’s no longer free money. Let’s see if that makes a difference. And as for the rest of us, who simply consume the energy other people produce . . . nobody likes it, but it’s a return to economic reality.
Our investments need to keep up with ambient inflation and commodity shocks in particular. We’ve known for years that means earning at least 2% just to preserve purchasing power in the world the Fed seems so eager to build.
Even now, long-term bonds struggle to provide that minimal return. Bank accounts are hopeless here.
Just about every sector managed to generate enough earnings growth to beat inflation last year. Only the utilities, prisoners of energy costs, faltered.
In the coming year, assume that inflation will continue until we see evidence to the contrary. That’s going to be tough on the banks . . . and again, the utilities.
But communications and consumer stocks will also feel the drag. While there will be obvious winners in these groups, it’s not going to be the kind of environment where all stocks have the fundamentals it takes to create wealth faster than inflation will take purchasing power away.
Energy obviously is on fire. So are the industrials, Big Tech and even real estate. If you can find a REIT paying more than 7% a year in dividends, seriously consider locking in that yield.
Which ones? We’ll talk about that soon. For now, just open your eyes to the opportunities. It isn’t all grim out there.