The Fed’s Great Unwinding Will Undercut Both Bonds And Stocks

The Federal Reserve’s tapering and interest-raising just swung from maybe later to for-sure now. That shift is the ominous inflation signal that means bonds and stocks are destined to fall.

Call it the Fed’s Great Unwinding. It is more than simply tapering bond buying or incrementally increasing interest rates. It is the reversal of the Fed’s nearly 14-year experiment in which it overrode capitalism’s key strength: Market-determined prices, especially interest rates.

The Fed’s colossal mistake launched inflation cycle

Pre-Covid, the Federal Reserve governors were shifting toward market-determined interest rates (what Chairman Powell called “neutral” rates). Then, when Covid hit, they completely reversed, throwing away all that they had accomplished. Worse, they encouraged and supported the government’s “stimulus” spending – i.e., the massive deficit-funded cash distribution. That set the stage for the risk of inflation taking over – and here we are.

Note: It hasn’t helped Wall Street’s view of inflation that Powell’s predecessor, economist Janet Yellen, was selected U.S. Treasury Secretary. As the U.S. Government was discussing $trillions more in deficit spending, Wall Street would have preferred someone from the capital markets side. Such an appointment would have provided higher confidence that the government’s finances wouldn’t get out of hand.

The Fed governors know from experience that letting inflation get a toehold can ignite a vicious cycle: The raising of inflation expectations, which cause actions that boost inflation further. Can they stop it this time? No. They’ve done too much and gone too far. Worse, they are once again at ground zero, only this time conditions are against them. Now they must chase the rising “neutral” rate ever higher.

There’s simply too much money floating about, so inflation has gotten a firm grip on consumers and businesses. Both groups now are working hard to boost income/revenues. For consumers, the big problem is that employee pay increases lag price rises, meaning employees (consumers) feel inflation’s pinch and must cut/shift spending to compensate. That, in turn, hits the economy and businesses, who then…. You get the picture, and we read about it every day now. (How about those noises that the new $15 minimum wage isn’t high enough?)

Fed’s reversals mean hurtful bond price drops

Understanding that bonds drop when interest rates rise is clear. What has been lost over the past 14-year, Fed-controlled period is the basic truth of bond investing. When markets operate freely, investors demand a real (inflation-adjusted) return to compensate for the risks of maturity (from committing to a fixed long-term bond’s yield) and credit quality (from taking on the uncertainty of a non-U.S. Government bond).

When inflation hovered around 2%, the Fed was able to keep short-term rates near zero, even though that meant investors/savers were losing 2% per year in purchasing power. All other yields eventually worked off that abnormally low yield. Now, with inflation well above 2%, that willingness is evaporating. That means short-term rates could easily rise to 3-5%, depending on the inflation outlook. Longer-term and riskier bonds normally would sell above that yield.

The scary outlook is that the Fed will need to raise short rates well above the inflation rate in order to dampen inflation’s rise. For example, a 3-5% inflation rate would likely require a 5-8% short-term yield. That short-term rate might even rise above long-term rates, inverting the yield curve as money becomes “tight.” And, yes, that means igniting a recession – the necessary pain to calm things down, although not necessarily a long-term inflation fix.

Shouldn’t stocks do well in an inflationary period?

Generally, they do. Prices rise in dollar terms as company revenues and earnings increase, along with dividend payouts. However, there are three situations in which they don’t:

• First, during a time like now, in which the financial system is adjusting and catching up with changed circumstances. Add in the Federal Reserve’s need to return interest rates to market-determined levels, and that’s the period we are in. Also, it doesn’t help that in 2021, investors pushed stock valuations higher, engaged in flawed bouts of speculation (IPOs, biotechs, SPACs, and meme stocks) and made wide use of leverage and options. All of this means the stock market is in an excellent position to have a major shakeout.
• Second, also during a time like now, in which the government steps in to control and punish companies/industries that raise prices. Such ideas and blame are already being tossed about.
• Third, a period we hope not to see: runaway inflation, like in the early 1980s. Back then, Fed chair Paul Volcker raised short rates very high, creating dual recessions. The first one didn’t kill the inflation cycle, but the second, longer one did. The stock market was messy.

So, stocks will be desirable, but not yet. They are optimistically valued, and investors are keen on owning them. Such a stock market has many weak holders who will be shaken out by a sharp drop as the positive outlooks deteriorate. The decline could be large before this shakeout is complete.

The bottom line – When stock market clouds move in, get indoors

It never pays to wait for the storm to hit. By then, a big drop will have occurred, and worries about selling at the bottom will keep nervous investors in limbo. Then, when the next plunge occurs, it will seemingly signal worse to come, and investors will sell – right into the hands of Wall Street.

But, what if the first drop doesn’t happen? Well, that’s the risk of investing in stocks. Nobody can accurately time every market swing. However… A missed gain from a cautionary move whose rationale then dissipates is not a mistake. At that point, it’s on with the show and the search for the next promising opportunities. Such missed moves mean an investor is controlling risk by being selective when pursuing returns.