The founders of our country never intended an unelected quasi-governmental entity to be given the power to vary the value of the currency on a daily basis.
The leading public theologian of the founding era, John Witherspoon, argued forcefully for a currency that was fixed in value, backed by something of value such as gold and silver, and he wrote about it so persuasively that early America embraced that policy. You can read his case here (On Money and Finance).
Eventually, under the influence of the atheist economist John Maynard Keynes, England then the U.S. abandoned these principles and embraced pro-inflation economic models. Inflation was seen as a way to stimulate "the animal spirits" of the markets (Keynes' phrase). Of course we're not animals and we don't need our spirit of consumption stimulated, quite to the contrary. Of course, even Keynes was conservative compared to his modern followers because he held that the inflationary stimulus of deficit spending and money creation should be used occasionally to get out recessions and then, during good times, debts should be paid off and monetary expansion reversed.
History has shown us, however, that government is only interested in the spending, borrowing, printing phase of the cycle. During good times, it doesn't reverse course and cut spending: it keeps the party going. And that's why once fixed a standard is abandoned the trend is almost entirely towards debasement.
For example, we have been in an almost continuous state of monetary stimulus since The Great Recession, and that includes a second massive round of stimulus to compensate for the COVID slowdowns. Now it's time to reverse course, cut spending, pay back public debt and restore the purchasing power of the dollar. But markets are beginning to see both how painful that will be and also the lack of the will to do so from our political class.
When Jerome Powell, Trump's appointee as the Chairman of the Fed, was up for reappointment, Biden was under pressure to appoint a successor who would follow easy money policies. Powell was far from a hard money Fed Chair, but Democratic politics had become enamored with the pro-inflation ideology of Modern Monetary Theory and they wanted someone who believed in that at the helm. Biden compromised by keeping Powell as Chair, but appointing a more pro-inflation economist as Vice Chair named Lael Brainard. Recently, there have been clues that Brainard and others with similar views think the Fed has been going too far, and that inflation is not as big a problem as most think. Last week, the Fed released minutes of its last meeting that confirmed there was indeed a faction of the Fed that wanted to throw in the towel in the fight against inflation.
Big Picture: Most economic news last week fed the narrative that the Fed may have gone too far in its fight against inflation and that it would need to pivot away from its inflation-fighting mandate to its recession-fighting mandate. Two of the surveys of supply chain managers (the ones who work in manufacturing and the ones who work in the service sector) were released last week. Both showed that sentiment had dropped into recessionary territory which was a worse outcome than forecasters had expected. That data fed the dove narrative because a worse economy means higher unemployment and one of the Fed's mandates is to fight unemployment. The mental model which governs the Fed's thinking holds that a slowing economy also tends to lower inflation because rising unemployment causes people to lose bargaining power in wage negotiations. Lower business costs allegedly mean businesses don't need to charge as much for goods and services. So last week's data points showing a slowing economy provided two servings of data to feed the narrative that the Fed needs to worry less about inflation and start worrying more about recession and unemployment.
But the biggest market move of the week was the release of the minutes from the previous Fed meeting. The Fed takes notes of the discussion in the meetings at which they decide and announce their new policy. However, they delay releasing those notes until later. So, on Fed meeting days, we know what they decided to do, but have to wait until later to find out why they decided to do it. The latest set of meeting minutes revealed that a dovish (ahem) wing had begun to speak up. So the combination of food for any possible doves and the revelation that there really is a dove group hungry for such a story, created a clearly discernible shift in what investors expect the Fed to do in the future. They expect the Fed to pivot at least partially to easier money.
We know the dove flight pattern well by now:
- Gold rises.
- The dollar falls.
- Stock markets rise.
- Bond markets rise.
- Real estate markets rise.
- Inflation hedges outpace similar investments.
And those are the things that happened last week.
One thing happened that is a bit nuanced. The Fed Funds implied future rates rose, although very slightly. That's not the usual dove trade. That number is called the WIRP report and is based on one particular model of using options to predict future rates. But there is another model, created by the CME, that focuses not so much on what the future rate will be, but rather on how probable that outcome is. The CME report showed that starting next March, the probabilities of the expected hikes were dropping. It's a little bit like a meteorologist telling you there will be two inches of rain tomorrow, but also telling you that the chances of that two inches of rainfall have dropped from 90% to 51%. The models' predictions of future hikes are not changing much, but their confidence about those predictions is dropping. In our view, that amounts to a dovish trade.
Sometimes a shift in expectations about future Fed policy also creates a shift in expectations about future growth prospects. In other words, often if there is a shift towards belief the Fed is going to be tighter, that shift is accompanied by anti-growth trades. This occurs because investors think that the tightening of monetary policy might cause the economy to slow down. Or, conversely, if investors think the Fed is going to pursue easier money policies, they often go on to conclude that this will stimulate growth, because it will provide more credit to business and consumers. And in that case, pro-growth trades are the result. But it's important to remember that the Fed policy question and the future growth question are not necessarily the same thing. Yes, usually high growth trades coincide with dovish Fed trade, but there are times when that is not the case, and last week was one of those times. Last week signaled easier money policies but did not signal growth with much clarity. There were some pro-growth elements to it: stocks mildly outperformed bonds and copper was positive, but other industrial commodity indices in general were down.
So, last week fit the dovish pattern very well when it comes to comparative returns between asset classes (stocks vs. bonds vs. commodities vs. real estate vs. currencies), and the growth signal was not so clear.
As we shall see in the detail below, the dovish pattern also appeared in the comparative returns within asset classes (e.g. one sector of stocks vs. another; one class of bonds vs. another, etc.). The growth picture was also mixed at that level of data: variations between sectors sent very mixed signals about growth. That suggests that investors think the Fed is going to take its foot off the brake pedal, but is not confident that it will do so in time to avoid a serious slowdown.
Next week we get a lot of new data. But the two areas with the potential for biggest market impact are the cluster of employment statistics that come out around the same time each month and the release of the PCE price index, which is the Fed's main inflation benchmark. That means that each of the Fed's two mandates will get data highly relevant to itself.
Bond Market Last Week: Stocks mildly outperformed bonds, which constitutes a growth signal, albeit a weak one. In addition, variations within the various types of bonds were generally sending pro-growth signals.
Bond markets were generally up last week, which fits the narrative of an easier Fed. After all, if the Fed is going to be buying more bonds (or at the very least selling fewer bonds), it's no surprise for bond investors to see that as good news for that asset class. But the macro-economic picture is magnified by taking a higher resolution look at the data, turning the magnification level up to see how different types of bonds reacted.
The smallest gains tended to be among higher-credit-quality bonds, which means investors were moving away from the safety zone. That's why treasury bonds, the ultimate safety play, underperformed high-credit-quality corporate bonds, which are considered a little riskier. The premise is simple: when business slows down, companies find it harder to make their debt payments, but the government can always tax or print more. So, lower-credit-quality bonds are more likely to default and forward-looking investors sell them now rather than risk being left holding the bag if a company defaults on its debt service payments. That works both ways, higher growth rates help those companies make their debt service payments. Last week, markets acted as though growth will be high enough for well-financed corporations to make those payments. That's called 'risk on'. However, if it was a very strong 'risk on' environment, low-credit-quality corporate bonds would outperform high credit quality ones. Those riskier bonds pay much higher interest in order to compensate for that risk. So, if investors get a lot more optimistic they focus more on that higher interest return and less on the risk of default. These bonds are usually called 'high yield' (for obvious reasons), but during tough times the old nickname 'junk bonds' also appears. Last week, regular corporates outperformed treasuries. But high yield did not outperform regular corporates. That means that investors reached somewhat towards more risk, but didn't reach deep into risk-taking territory. That's another mixed, but leaning pro-growth, signal.
Switching from the growth to the inflation topic, inflation-protected securities performed well compared to their non-inflation protected alternatives. That implies more fear of inflation. Because if investors buy inflation hedges, it is logical to consider it likely they are more worried about inflation. That also fits the dove trade: if the Fed stops fighting inflation, we'll probably get more inflation.
Real Estate Funds Last Week: REITS performed well, generally overperforming stocks and handily overperforming most bonds. This is what one would expect given the prevailing themes of the week: falling rate expectations, rising inflation risks and (maybe) acceleration in growth outlook. REITS do well with inflation (real estate is an inflation hedge), somewhat well with growth (because in seasons of higher growth renters can afford to pay more, but on the other hand long-term leases can act as a hedge against recession); and low interest rates (because it is a debt-dependent sector). Last week's trading pattern implied that two of those pro-REIT conditions were more likely to occur than previously thought and the third (growth) was unclear. So 2½ out of 3 pro-REIT factors were expected to improve.
U.S. Stock Markets Last Week: Domestic equity markets were generally up last week, but not equally so. Growth stocks significantly underperformed value stocks. That underperformance occurred across size categories. Growth tends to lag value when growth expectations are falling, because low growth presumably makes it harder for earnings to actually deliver on growth companies' high expectations. So, the weak growth performance is consistent with anti-growth trades.
But, growth stocks are more dependent on low interest rates than value stocks, so consequently, they also tend to overperform value stocks when interest rate expectations are falling, because their long time horizon causes the discounting effect of interest rates to play out over a longer period of expected future earnings. Whatever the discount rate is, it tends to have a larger effect when it is applied over a more years of discounting. The value-expanding effect of low rates helps companies whose investment premise is based on the long view more than those whose investment premise is based on the short view. Since last week was about a shift towards lower rate expectations, one might have expected growth to benefit more than value. But that's not what happened; therefore, interest rate effects were probably not the drive, so it is more likely that last week's lagging growth sector was about a slowing economy, not about discount rates.
That conclusion (that last week was about a slowing economy) was given further support by looking at the difference in performance between different stock sectors: S&P/NASDAQ, cyclical/defensive, discretionary/staples, discretionary/utilities, etc., generally showed a more pessimistic growth shift.
Bottom line: if falling rates didn't do the usual job of giving growth stocks a boost over value, then something else stopped that from happening, and the most likely suspect was fear of a hard landing.
International Stock Markets Last Week: International equity markets were generally up for the week, but not consistently. In general, U.S. lagged global stock markets in price returns. This occurred partly because of a falling dollar. In other words, foreign markets generally performed better than U.S. markets and part of reason for that was the fact that their currencies generally performed better than the dollar. This all suggests markets are continuing to back-off from the idea that the U.S. will be a refuge from the global recession. For most of the year, markets signaled that the U.S. might avoid the global recession. So far this quarter, including last week, markets have been less confident that we could avoid the global crash. Of course, this also fits the anti-growth U.S. equity trades.
In addition, DM was generally positive but EM was flat.
Jerry Bowyer is financial economist, president of Bowyer Research, and author of “The Maker Versus the Takers: What Jesus Really Said About Social Justice and Economics.”