Which Way Next?

At its July 27th meeting, the Federal Reserve raised interest rates by .75% for the second time saying, “The 2.25%-2.50% range for the federal funds rate is now around the neutral level that is neither supportive nor restrictive on activity.”

The FOMC also vowed to continue to fight inflation until it meets their 2% target and further pledged… “As the stance of monetary policy is tightened further, it likely will become appropriate at some point to slow the pace of policy rate increases while assessing the effects of cumulative policy adjustments on economic activity and inflation.”

These later words were interpreted as dovish, and a rally ignited. Then on August 29, 2022, after hiking interest rates another .75%, Federal Reserve Chairman Powell said: “Restoring price stability will likely require maintaining a restrictive policy stance for some time. The historical record cautions strongly against prematurely loosening policy. Without price stability, the economy does not work for anyone.”

These words sent the market down in a tailspin although the Fed’s preferred Core PCE inflation indicator showed little progress. Progress was made on energy, housing and auto prices.

So the question is what will the Fed do this Wednesday? The answer will be known shortly, but we first want to point out three important takeaways from the last two meetings.

  1. The Fed said we had reached the “neutral rate” in July.
  2. The Fed hiked in August after the market rallied misinterpreting its message.
  3. The Fed’s words and actions make it clear they intend to reduce inflation.

But there is another important clue in their message ‘The historical record suggests loosening interest rates before price stability is achieved produces an economy that works for no one’.

The Fed is saying price stability is their goal but given that at current price levels for food, housing, heating, and autos, the economy does NOT work for anyone. Wouldn’t you expect their real goal to be to deflate prices so the economy works? We think so.

Yet because there is typically a 6-month lag before the effect of higher interest rates on the economy is known, it would be reasonable to raise interest rates aggressively and then wait and see what your rate hikes accomplish lest you overshoot your target. We therefore think the Fed should raise interest rates again but perhaps only by .50% instead of the consensus expectation of .75% to 1.0%. This would reverse the stock market’s downward trend because of priced-in expectations. Also a smaller than .75% interest rate hike would stabilize investor confidence which is part of the Fed’s goal. They do not want to wreck the market creating a broad recession. This is particularly true because they are quite aware of the US Treasury’s new problem, maintaining the US Dollar as the reserve currency of the world.

Some background. Since WWII the US Dollar has been the world’s reserve currency. In 1971, President Nixon ended Gold Standard or backing of the Dollar with gold and made an arrangement with friendly Middle East oil producers to require all oil trade be transacted in Dollars in exchange for security aide from the US. This created the “Petro Dollar” and assured global demand for Dollars.

But after the 2008 US housing crisis that nearly crashed the global financial system, China has wanted a basket of currencies instead of a Dollar only currency as the medium for international trade. Now with both Russia and Chinas’ sovereignty concerns over “the West’s” perceived hegemony—Russia’s that the US was trying to militarize Ukraine readying it to be a NATO country on their border and China’s that the US is dishonoring its commitment to the “One China” policy by directly recognizing and selling military arms to Taiwan—a competing initiative is underway to circumvent Dollar denominated trade.

The BRIC countries (Brazil, Russia, India and China) have recently offered membership to Saudi Arabia and Iran to enter into a trade pack whereby Russia and China will introduce a commodity-backed currency (digital and backed by oil and gold) to compete with the US Dollar. While there is likely no immediate danger to the US this year or next because the Dollar remains the safe haven currency of the world, in the mid to long term time horizon there appears to be a bi-polar world emerging that will lessen international demand for Dollars.

Less demand for US dollars means the Fed must attract new buyers for treasuries to finance US Debt and this could result in interest rates being raised higher for longer even though inflation wanes. The central banks in the developed world must also work to de-lever and buy the time to do so which likely means some years of turbulence in the financial markets is ahead.

We expect US monetary policy to be geared towards deflating debt meaning real interest rates (rates after inflation is subtracted) on fixed income will provide negative investment returns. Concurrently, this will also mean we can expect a disruptive political environment as it may very well be in the best interest of the status quo (West) to create fear in the stock market which will steer money into safe haven assets (bonds) buying the needed time to de-lever.

Our Treasury will surely maintain a strong dollar policy to counter the international Dollar threat wanting to maintain the Dollar as the world’s reserve currency. Yet this policy purports consequences for US multinational companies dependent on exports and solvency issues to Emerging market countries who have loans denominated in dollars. They will be stressed having to pay back more expensive dollars and without debt forgiveness and/or forbearance some debtor countries will likely default given their present high debt to GDP levels.

The Int’l Monetary Fund recently reported: “we have entered into a perfect long storm of lasting structural insecurities—geopolitical, economic, and existential.” What they are saying is inflation, supply chain disruptions, and high debt levels at central banks will stress the world financial system for years to come without intervention. Unfortunately, most policy actions required will be inflationary in the short term as losses and bailouts increase costs which are absorbed and passed on to taxpayers causing unemployment to rise and growth to further slow.

In conclusion, we believe we are at the end of a long-term debt cycle that will cause big changes in supply chains and economies of many countries around the world. In the short term greater global instability will cause protests in democratic countries and authoritarian actions by governments to enforce civility. In the mid to long term we expect governments to pursue “Deflationary” policies to bring prices down, deflate debt owed, and stabilize their economies.

Because capital can and will move to countries providing higher potential returns with less risk, we believe the US will attract capital and fair better versus many other countries. Yet we also expect that a multi-currency, bi-polar political world will exacerbate division and tensions between the East and West causing economic problems and goods shortages. Europe & Japan for example, disadvantaged by a lack of energy and heavily indebted, will see money flight benefiting the US. Yet no country is an island so the US will not be unaffected, but we have the resources and resolute will to compete and win. As manufacturing re-shores we expect the US will do just fine.

For the present we remain generally cautious because certain sectors, or segments therein, have more downside to go based on valuations. We believe client accounts are currently well-positioned heading into the last month of the third quarter though we pro-actively adjust asset allocations as things change. We continue to use Cash as an asset class to preserve value in this rising interest rate environment as we did during the first six months of this year, but as the storm passes, we’ll again allocate towards the best opportunities we can find.

We are not infallible, nor do we have a crystal ball to forecast the future. What we do have is insight from years of experience and institutional-grade tools to see the markets and identify when volatility is outside the normal range to make informed judgments. These judgments are made by following an investment process that was rigorously market-tested in the years prior to the Great Financial Crisis (2008-2009) and it worked well providing defense just as you witnessed leading up to and following the Covid-19 pandemic. Certainly all times are different and that's why we rely on our Total Return discipline that pivots to favor Income, Capital Gains, or Growth as valuations change to find the most compelling reward-for-risk opportunities.

Thank you for your trust and confidence. Please contact us if you have any questions or concerns and if any financial or personal circumstance arises that may change your investment objectives.