Powell Can’t Raise Rates As Economy Remains On Life-Support

Market Review and Update

Last week, we stated:

“With valuations still extended, the recent correction didn’t reduce speculative fervor. Furthermore, prices remain well deviated above long-term means, particularly in the small and mid-cap space.

While more stimulus will likely support prices over the next few weeks, the threat of rising inflation and interest rates could undermine growth expectations.”

Over the past week, the market didn’t make a lot of headway, as price rises were limited while intraday dips got repeatedly bought. Such is what we would expect with the “money flow” indicators we have discussed over the last several weeks back on “buy signals.” (Importantly, note that Friday’s early morning decline held the uptrend line from the October lows.)

However, while overall market action remains bullish, there are two concerning points shown in the chart below. The highlighted box shows money flows remain negative currently. As stated previously, such suggests rallies may stay limited for now. The second is the negative divergence of the actual index (red dashed line) which also confirms the weakness of the underlying “buying.”

With our indicators still on “buy signals” across the board, the bias of prices near term is to the upside. However, with the oscillator now pushing into the upper zones, and starting to roll over, with the market overbought, further price increases will become more challenging.

We suggest using rallies over the next week or so to raise cash and reduce risk.

Rate Surge

Another more critical concern remains interest rates. The recent surge in rates has caused problems over the “growth” trade. As shown, the annual rate of change in rates has surged by 146% in recent months. That spike is unprecedented over the last 20-years but is a function of rates hitting 0.50% during the pandemic.

However, the recent underperformance of Invesco QQQ Trust (NASDAQ:QQQ) versus iShares S&P 500 Value ETF (NYSE:IVE) is also unusual from a historical perspective. Previously, during swings higher in rates, the QQQ’s outperform IVE as investors sought companies that could generate earnings and had lower leverage.

Given the massive debt load corporations are carrying currently, combined with an inability to pass along higher input costs, I suspect we will see a rotation back towards growth. Such is particularly the case with companies already struggling with thin margins (especially in the small and mid-cap space.)

We suspect we may see a rotation from “value” (via SLYV) back to “growth” sooner than later given the massive overbought conditions of the “value trade.”

For now, we are primarily maintaining our core positions. However, we did recently take profits in the highly overbought energy and financial positioning. We are starting to seriously look at further increasing our “growth” side of the portfolio during the next correction.

Powell Says No Rate Hikes

On Wednesday, Jerome Powell announced the latest changes to monetary policy. Instead, it was the lack of changes to the policy that was the most interesting.

“The U.S. economy is heading for its strongest growth in nearly 40 years, the Federal Reserve said on Wednesday, and central bank policymakers are pledging to keep their foot on the gas despite an expected surge of inflation.” – Reuters

In other words, despite the Fed’s mandate of maximum employment and price stability, the Fed is opting to let things run “hot” for quite some time to ensure that growth is “sticky.”

That stance makes some sense, given the economy still requires massive liquidity support more than a decade after the financial crisis. As I discussed previously in “Forever Stimulus:”

“They are increasingly on what I call a no-exit paradigm.

To understand the problem, we have to go back to the beginning. As we noted in our article on financial rescues, the bailouts and stimulus programs started in 2008 when the Federal Reserve intervened with the insolvency of Bear Stearns. They haven’t stopped since.”

“To date, the Federal Reserve, and the Government, have pumped more than $36 Trillion into the economy. As shown below, the amount of economic growth achieved has been minimal during that same time frame. (The chart is the cumulative growth of interventions compared to the incremental increase in GDP.)”

“What this equates to is more than $12 of liquidity for each $1 of economic growth.”

Not Won’t, But Rather Can’t

The Federal Reserve stumbled into a trap where continual interventions are required to sustain lower economic growth rates. Whenever the Fed withdraws interventions, economic growth collapses.

Such is why the applause by the media that Powell “won’t” raise rates is “silly.” The Fed had “no choice” but to keep rates unchanged and continue buying $120 billion a month in bonds. Any other choice would have been a disaster.

History also shows why the Fed is trapped. Since the turn of the century, each economic cycle has failed to attain a higher growth rate than previously. The Federal Reserve lowers interest rates to stimulate growth without much return on the capital spent. However, after reaching the “zero bound,” lower rates alone were ineffective, forcing the Fed into liquidity measures.

The problem now is that even if they wanted to increase rates and slow bond purchases, they can’t. Therefore, their only option is to “hope” that inflation will rise without getting out of control.

I suspect the result will not be great.

An Economic Coma

“We stand at a monetary crossroads as we continue to double down and embark on monetary policy that is detrimental to society and to our financial markets.

Yesterday, current Fed Chair Powell, like former Fed Chair Bernanke exhibited that he is out of touch and that he lives in a bubble that he has helped to create.” – Doug Kass

The mainstream media missed another crucial point while tripping over each other to fawn over Powell’s statement. It also underscores our comment about why growth will remain elusive.

In the short-term, yes, there will be a surge in economic growth. However, as the table of the average of the Fed’s projections shows, after a short-term bump of activity, the economy will quickly slip back into its “coma” from the last decade.

The chart below shows that the Fed tends to be overly optimistic in its assumptions in almost all cases. The actual real GDP growth rate disappoints more often than not.

The point here is that despite protestations from the financial media, monetary policy does not create or sustain economic growth or employment. All monetary policy does is drag forward future consumption.

Growth, as a result, is primarily an illusion.

(From the peak in 2007 through year-end 2020, the S&P rose 165%, actual revenue increased by only 43%, while economic growth struggled to rise a cumulative 23%.)

While the Fed hopes they can sustain inflation above 2% for 3-years, I think the Fed realizes deflation remains a more significant threat. (here)

The Rate Trap

I want to be very clear.

In the short-term, we will see rising inflationary pressures and economic activity from the massive amount of liquidity flooding into the economy.

However, longer-term, it is all deflationary. My partner Michael Lebowitz made an important observation on Wednesday in “The Next Crisis:”

The Fed’s problem is that while they may not be hiking rates, the bond market is doing it for them. Given the Fed’s actions are what causes rates to rise, by shifting risk preference, the result is a deflationary crash requiring more interventions and lower rates.

Wash. Rinse. Repeat.

I am going to leave you with one question:

“If monetary policy does create economic growth, inflation and sustainable employment, then why, after more than a decade, is the Fed still having to support the financial markets?”

Portfolio Update

The market continued to fluctuate this past week, as recent highs remain a challenge to hold onto. While over the last two weeks, we repeated steps to rebalance portfolio risk, portfolios continued to remain under pressure on the “growth” side.