When Fed Ability Fails, Credibility Follows

The U.S. financial markets rest on how much investors trust the almighty Fed. Can they engineer a soft landing after so many egregious miscalculations and deteriorating credibility?

Key Takeaways:

  • Wall Street is dumping their risky assets onto Main Street. Individual investors now represent a deteriorating bastion of stock market bulls.
  • The Fed believes they can pop this financial bubble while engineering a “soft landing” for the economy – a tough task, to say the least.
  • Gold is the ultimate hedge against central banking. Fed failure will likely be the primary driver of the gold price in coming years.

Don’t be Wall Street’s Sucker

The most recent inflation stats remind us of just how badly the Fed, a.k.a. the smartest economists in the world, can miscalculate. Consumer prices rose 8.5% from March 2021 to March 2022. In other words, your dollar has lost nearly 10% of its purchasing power in a single year.

The 10-year treasury currently yields 1.4%. If we subtract 8.5% CPI, we get a real yield of negative 7.1%. Crazy stuff. Treasuries are now trading at the most negative real yield in U.S. financial market history.

Despite these frightening stats, the stock market is only a few percentage points from its all-time high. The S&P 500 has risen nearly 8% from its February low. Before we call it a comeback, perhaps we should look at what is going on beneath the surface.

According to reports from Goldman Sachs, JPMorgan, and Morgan Stanley, institutional investors are offloading their risky assets onto individual investors, who are eagerly buying the dip. A recent report from Morgan Stanley’s Prime Brokers stated, “into every uptick during this latest rally that started in late February, institutional selling has been relentless.”

This behavior constitutes a fundamental change in market dynamics. Institutional investors have displayed confident “perma-bull” behavior since 2020; now they are leaning decidedly bearish. Really, it all comes down to confidence in the Fed.

The “Soft Landing” Hypothesis

Jerome Powell, the chairman of the Federal Reserve, would have us believe his aggressive interest rate hikes will peacefully guide the economy to a comfortable landing. Those who are buying risk assets in this environment – mostly individual investors – believe in the “soft landing” hypothesis. Pay no attention to the inverted yield curve. Pay no attention to near double-digit inflation. Sure, these have been the top two indicators of an impending recession throughout history, but this time is different.

If Powell’s ”soft landing” hypothesis ends up as flawed as his “transitory inflation” hypothesis, we are in for a rough few years. Let’s not forget that, in early 2021, most central bankers thought CPI would stay under 3%.

Popping the Bubble…Peacefully?

Never in human history has a financial bubble popped with the kind of blissful elegance the Fed imagines. Central bankers will always cling to the idea that they can engineer perfect economic outcomes. That is their job, after all! Unfortunately, history tells a different tale.

Financial tightening requires a shock to the system. To end the positive feedback loop of higher asset prices, uncontrolled credit expansion, and rising inflation, the Fed is usually forced to take drastic actions.

To knock down 1970’s inflation, Paul Volcker (the Federal Reserve chairman at the time) had to jack up interest rates to 20%. This caused two recessions with significant damage to financial markets. However, most economists now consider his decision wise and necessary.

Volcker's interest rate hikes caused two recessions in the '80s

Here’s the difference: back then, stock and bond markets weren’t in bubble territory. When Volcker raised rates, the total U.S. stock market was valued at 37% of GDP. U.S. federal debt stood at 31% GDP. Today, the total stock market capitalization is 190% of GDP. The federal debt has reached 123%.

When asset values far exceed GDP, tightening monetary policy poses a much greater threat to financial markets. The stock and bond markets have a lot more to lose, and a lot further to fall. Yet, Fed officials claim today’s hawkish policy will cause significantly less damage than Volcker did in the ‘80s.

To that we say: good luck.

Where to go from here

As stocks and bonds continue to struggle, safe havens are behaving as expected. The recent rally in tangible assets indicates investors are seeking something real.

Gold keeps climbing on inflation data and safe haven demand

The U.S. dollar and gold have both provided shelter for investors leaving risk and speculation behind. Typically, gold and the dollar are inversely correlated because they compete for safe haven demand. Recently, the opposite has been true.

The dollar and gold are rising simultaneously

Ever since the COVID-19 crash, U.S. dollar strength served as one of the primary drivers of the gold price. Dollar strength meant gold weakness, and vice versa. However, since October 2021, that relationship has broken down. Both the U.S. dollar and gold rose precipitously in Q1 2022, reflecting a broad move toward safe haven assets.

Dollar and gold were inversely correlated, now they are correlated

Over the long term, we expect the normal pattern to return. If inflation persists in any significant way, investors and money managers will be forced to move their significant cash holdings elsewhere. Rising interest rates and tightening financial conditions make stocks, bonds, and real estate dangerous choices.

Gold is the obvious alternative to cash because it is the most reliable store of wealth. It allows money managers to preserve purchasing power until valuations come back to earth, at which point they can redeploy capital back to risky assets.

This pattern has occurred twice in recent history:

  • 1970 to 1980: gold rose from $35 per ounce to $680 per ounce
  • 2000 to 2011: gold rose from $260 per ounce to $1,830 per ounce

1970 to 1980: gold rose from $35/oz to $680/oz

2000 to 2011: gold rose from $260/oz to $1,830/oz

Gold bull markets are quite generous for those lucky enough to get in at the beginning. When all else fails (specifically the Fed, the dollar, equities, and bonds), gold is the place to be.

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Additional Resources:

Inflation Wave Reaches Asia With Signs Worst Is Yet to Come (Yahoo Finance)

Monetary policy must serve the real economy not just financial markets (Financial Times)

Inflation Hits Fastest Pace Since 1981, at 8.5% Through March (New York Times)

Hubris and isolation led Vladimir Putin to misjudge Ukraine (The Washington Post)

Finland, Sweden set to join NATO as soon as summer (Reuters)