The Fed is Trapped
https://www.crescat.net/may-research-letter-too-soon/
The Fed’s main policy tool for fighting inflation is to hike interest rates. This reduces the demand side of the economy by tightening credit conditions and causing financial asset prices to decline which crimps investor savings and consumer demand and increases unemployment. But raising interest rates does not stimulate commodity supplies, the core inflationary problem today. In fact, raising interest rates could have the opposite effect because it makes the cost of capital for investment in new commodity production higher.
After years of money printing and interest rate suppression, policy makers have created a historic speculative environment in financial assets. But now, the inflation genie is out of the bottle, and to restore its credibility, the Fed has no choice but to burst the bubble. At the same time, it is powerless to stop commodity inflation. To illustrate just how trapped the Fed is, it has never ended a hiking cycle with the Fed Funds Rate below CPI. But the implied terminal rate in the Fed Funds Futures market is now just 2.9% in early 2023 while CPI is still at 8.3%. If the efficient market hypothesis holds, which it rarely does, CPI must drop precipitously over the next three quarters. Such is highly unlikely based on our commodity supply analysis shown above. There is a much bigger risk based on our work that inflation stays elevated, and the Fed ends up having to hike more and for longer than is currently priced in, as in all past tightening cycles. Alternatively, there is the risk that the stock market correction continues under the existing planned increases and the Fed panics and ends its hiking cycle for the first time with real rates still in negative territory. In all cases, the market seems to be in state of delusion today with the average participant still buying the dip in overvalued tech, crypto, and fixed income assets, hoping for a return to those manias, while underestimating the risk of continued high inflation in valuable, scarce, tangible resources.
Too Soon to Buy the Dip, Unless It’s Commodities
The valuation of the Wilshire 5000 US Total Stock Market Index reached a historic high of 207% of GDP in 2021 in the wake of the Covid-19 stimulus and record corporate earnings. We are now entering what in Crescat’s analysis is an inflationary recession. The index is off 15% from its all-time highs but still trading at 187% of GDP. During comparable stagflations of the early 1970s and 1980s, the associated equity bear markets did not end until the total stock market capitalization traded down to an average of 35% of GDP. Even if nominal GDP were to grow a full 20% over the next two years, not out of reason in today’s historically high inflationary environment, there is the potential for a further 78% decline in stock prices from current levels to settle at the low multiples of the last stagflationary era. While the market could bottom at higher multiples this time around, we must acknowledge the downside risk if we are indeed in just the early stages of new stagflationary regime.