The Fed Was 17 Months Late In Raising Rates

 The Fed printed a gusher of money during 2020-21, and then hid its head in the sand ignoring inflationary pressures, labeling them “transitory”.  Finally, they woke up from their dream state and started raising rates all in a rush.  How much time did they lose, how far behind the curve were they?  The short answer is they were at least 17 months late - way too late in my opinion. 

Here's a chart.

  The blue line is the yield on the 2 year Treasury, which is anchored by the Fed funds rate.  The red line is the yield of the 10 year Treasury which is entirely dependent on the market.  Notice how the red line starts to creep higher starting in August 2021, even as the 2 year remains flat.  Meaning, the market was already pricing in higher inflation, way before the Fed started raising rates in October 2022; that's a whole 17 months where the market was telling the Fed to get its head out of the sand - to no avail. 

By the time the Fed acted, the 10-2 spread was already at 100 basis points (the black arrows).  The Fed has been playing catch up ever since, causing the spread to - finally - go negative.  Yet, rates are still lower than headline inflation and the ocean of liquidity created by the Fed is still almost entirely untrained.  The “easy” part of inflation moderation is now finished as fuel prices have stopped dropping, and it is highly likely that inflation will, if anything, start rising again as higher wages kick in.  And that’s when the Fed will, at last, truly wake up.

If The Fed And ECB Were "Regular" Banks They Would Be Bust

 The Fed and ECB are now running huge operating losses PLUS enormous mark to market losses. To wit:

1. There is a wide gap/mismatch between paying high short term rates (eg on the Fed's reverse repo) and low returns on their bond portfolios.  This is a classic borrow short - lend long problem, exactly the same as the Savings and Loan Crisis of the late 1980s.
2. Central banks are holding long term bonds on their balance sheets that are now priced much lower than what they bought them for.  The unrealized mark to market losses are in the trillions of dollars/euros.

This article explains things pretty clearly.  I wonder how much longer the monetary world will continue to operate as if the Emperor's clothes are real...

 

Inflation Will Not Come Down Until And Unless Money/Liquidity Is Drained Away By The Fed

 Inflation has come down from the highs registered last summer, but most recent data is showing that it's becoming "stickier" at uncomfortably high levels. For example, PPI released yesterday came in at the highest reading since last June.

This is prompting various analysts to revise upwards their terminal Fed Funds target rate, now expected to peak at 5.25-5.50% from 4.50-4.75% currently.  That's 0.25% higher than previously expected.

At the risk of my becoming repetitively boring, that's not enough.  Until and unless the Fed truly bites the bullet and starts to drain liquidity in earnest, ie to sharply reduce the size of its own balance sheet, inflation won't come down rapidly.  Why? Because inflation is a monetary phenomenon, more money = more inflation.

Looking at monthly changes in the Fed's assets, we see the pumping of huge amounts of cash into the system, as much as $590 billion per week, during the COVID era (see chart below-red circle).  By comparison, the draining of this flood is extremely timid, at around $ 20-25 billion/week (yellow highlight).

Once again, then: if the Fed really wants to fight inflation it better look at its own house first and start selling bonds from its portfolio.

Be My Valentine

 On this Valentine Day index lovers must send lots of chocolates and roses to AAPL and XOM.  The pair are a spike lover’s delight.

EXXON

APPLE

The 10-2 Treasury Yield Spread Conundrum

The 10-year minus 2-year Treasury yield spread is considered one of the best recession predictors. When it goes negative, ie when the 2-year note yields more than the 10-year bond, a recession soon follows (chart below, recessions in grey). Will the past repeat?

I think there is something different and unusual about this episode of yield curve inversion. 

• For one, it comes after a very prolonged and unprecedented period zero/negative short interest rates.  Meaning, short rates were extraordinarily low and had a ways to go higher before they normalized. By comparison, long rates had not fallen as much. Therefore, it is logical for the spread to be more negative than otherwise.
• Secondly, there is a growing feeling that the Fed will be successful in quashing inflation in the next few months, and thus long rates need not be as high as current inflation implies. Therefore, while short term rates are high, long rates are still low ---> spread more negative than otherwise.

Markets are definitely acting along those two concepts above.  Are they correct?  I have no idea, but if they are not we are going to see a major "disillusionment" drop in all markets.

Putting it another way, the near record negative spread is more an indicator of markets defying the Fed (and common sense) than anything else. It’s an indicator of excessive speculative optimism which may be proven unfounded.

Personal Saving Rate At All Time Low

Right before the Great Debt Crisis of 2006 - 10 Americans' personal saving rate had dropped to an all time low around 3.5%.  After rebounding significantly to around 7.5-9% (excluding the COVID period) it has now collapsed back down to all time lows (see chart below).

Personal Saving Rate At All Time Low

Another way to look at it is that Americans spend 96.5% of their income, the highest percentage in the world.  This statistic goes a long way in explaining the current resilience of the US economy despite soaring inflation and slow wage growth.  But this resilience is hollow: people just can't keep raiding their savings forever.  And given sharply higher interest rates they can't keep piling on more debt.

In fact, what keeps piling on are warning signs that all is not well.  But, as usual, people are ignoring them.

National Financial Conditions Index And Inflation

The Chicago Fed publishes a national financial conditions index (NFCI) which rises when conditions tighten (eg when interest rates rise and risk appetite decreases).  Obviously, as financial conditions tighten the economy faces headwinds and slows down, while inflation also eases (at least theoretically).

Here's a chart of NFCI (blue line) and CPI inflation (red line).

NFCI And Inflation

An immediate conclusion here is that financial conditions are still rather loose (blue line below zero) while inflation is still near historic highs.  And that's despite the Fed's rapid increase in interest rates.

If history is any guide, it will take much tighter financial conditions to bring down inflation to more manageable levels.