The Fed is Playing with Fire

The Fed started playing with fire on Thursday, April 21, when Fed Chairman Jerome Powell described his plans to raise interest rates a half percent at the May 4 Fed meeting.

Afterward, the market slowly but surely melted down for the rest of the week. The Dow closed almost 1600 points lower than where it was before Mr. Powell spoke.

What bothered the market was not just the May 4 ½% rate hike (which was twice as big as the last rate hike in March), but Mr. Powell also clearly indicated that he plans more ½% rate hikes.

Let’s put this in perspective. Since the 2008 Financial Crisis, the Fed has been reluctant to raise interest rates – to say the least. In fact, the last time it had a back-to-back (one meeting after another) interest rate hike was 2006. So, any interest rate hike is unusual.

Also, compared with earlier, interest rates are very low now. A 1% rate hike when rates are at 6% (on the 10-year government bond) is very different (a smaller hike) than a 1% rate hike when interest rates are at 3%. Even worse is a 2% rate hike on what were 2% rates just a month ago. So, the Fed is not just raising rates by 1% in May and June, they are DOUBLING rates in a 3-month period. WOW!!

This is very different from the previous Fed outlook of a ¼% rate increase at every meeting. Also, it is very different from a Fed that had always been careful to say that it’s moves will be “data dependent” – meaning they will watch the stock market closely and reverse course if it causes a significant problem for the market.

At this point, Mr. Powell isn’t saying the next few rate hikes are “data-dependent,” but almost a given. No matter what the stock market says.

The Fed Is Throwing Gasoline on the Fire

The Fed has made another important move: It has STOPPED PRINTING MONEY. Clearly, that’s part of the reason interest rates are going up, but the Fed could have simply raised overnight rates and continued to buy long term bonds. It did not. Which means it is getting more serious about raising the interest rates that matter to the stock market – long term rates.

In addition to ending money printing, at its May 4 meeting the Fed said it would start taking money out of the system in June – about $45 billion a month. Then it would INCREASE the amount to $90 billion in September. That would be a body blow to long term interest rates.

Higher interest rates not only affect the stock market but, even more directly, the bond and real estate markets. The bond market has been slow to react to interest rate changes, but the damage is growing. The ETF TLT, which tracks the 20-year Treasury bond, is down 20% this year. Compare that to a 16% decline for the S&P. Most importantly, the upside to a bond paying a couple percent isn’t much compared to the upside of the stock market.

Bond investors are naturally risk averse, so taking a 20% hit is really scary, especially if interest rates keep going up. For decades, they have been accustomed to failing rates raising the value of their bonds. Now, the opposite is happening – rising rates are dramatically lowering the value of their bonds.
Mortgage rates have gone from a very comfortable 3.75% to just over 5%. That hasn’t hit home prices or sales that hard yet, but in time it will, especially if mortgage rates go over 6% in the next couple of months. High home prices and high interest rates don’t mix.

So, significantly higher interest rates are practically guaranteed to implode asset prices, especially bonds and real estate, harm the stock market, and blow up the economy.

Is the Fed Concerned?

So far, it seems the answer is NO. The Fed is very focused on restoring its reputation, respect, and premier position among central banks, which is now under threat. In fact, the cover on the Economist magazine last week read “The Fed That Failed.” OUCH!!!

Hence, we think it is likely that Fed will push through several more big rate hikes before reversing its policy due to the very negative effects that it will have on asset prices (and ultimately, on the economy).

At that point, it is also quite possible that bond investors will have begun to pull away from the market in large numbers as each purchase of a bond is a near guaranteed loss and the upside is nothing.

Hence, the bond market may force the Fed back into buying bonds due to a lack of private buyers even before the damage to the stock market or real estate market bothers the Fed.

So, What Does This Mean Longer Term?

Surprisingly, no big change in our longer-term view. The stock market will rebound when the Fed stops raising rates and starts printing more money. In fact, it will likely be a tremendous buying opportunity.

In the longer term, the Fed will be very reluctant, after getting so badly burned, to go back to big interest rate increases or any cessation in printing money. The stock market, real estate market, and bond market will profoundly agree!!!

So, we will have to get used to higher inflation long term. However, short term, we may find that inflation is heading down a bit. We are already seeing some early signs of a small peaking in inflation. That good luck could allow the Fed to more easily back off from additional rate hikes.

We don’t know exactly how the rate raising fiasco will play out. However, we think investors should be radically reducing their market exposure during this usual time.

When the Fed ceases or reverses its current policy of rapidly raising rates, we expect there to be an excellent buying opportunity.

Longer term, as we have said in Fake Money, Real Danger, your primary overarching long-term trade should be to move from stocks into gold when gold is continually outperforming stock.

We expect that to happen when the Fed can no longer keep interest rates down by printing more money. But, given that the Fed is trying to RAISE rates now, that is clearly a ways off in the future.