Not being a Fed-watcher, I have been rather slow to this particular narrative, I’m afraid, and it only really dawned on me last week as I was losing money trying to catch falling knives in the stock market.
It was Zoltan Pozsar writing for Credit Suisse who switched on the lightbulb for me. He’s the new rockstar among institutional market strategists.
A couple of other analysts have reached the same conclusion.
It’s this: the Federal Reserve and America’s other policy-making powers that be, actually want the stock market lower…
The Federal Reserve really does want to fight inflation
I’ve heard so much hot air coming out of government officials’ mouths over the years that I think my mind is actually programmed now not to believe a word they say.
It’s not that I’m treating what they say with a healthy dose of cynicism. I’ve reached unhealthy levels of cynicism. My default, so low is my trust, is now not only not to believe a word they say: it is to assume they are lying. Probably not a good place.
It turns out that sometimes those in power do actually tell the truth. I got my first surprise dose of this earlier this year from Foreign Secretary Liz Truss, when she warned that the Russian troops on the other side of the Ukraine border were about to invade.
Pull the other one, I thought. Russia wouldn’t do that. It turned out that Truss was talking straight, and her intelligence was correct.
When US president Joe Biden said his top economic priority was getting inflation down, my inner cynic muttered: “yeah, course it is mate.” It turns out what he was saying might actually, believe it or not, be true.
The Federal Reserve’s primary mandate is to keep inflation down. It might be that chief, Jerome Powell, is taking this mandate at face value. All that stuff about his hero being Paul Volcker might even be true too.
Lower asset prices help the cause.
Back in 2008, and for many years since, everyone in Policymakerland was worried about deflation, and every effort went into staving it off. So we got QE, ZIRP (zero interest rate policy) and all the rest of it. We got very used to it. It went on for so long, it became normalised. The idea that they would ever do anything else seemed far-fetched.
But, no, in Policymakerland they are genuinely worried about inflation, and so asset prices are not going to be defended. Au contraire. They want them to fall.
Bear markets mean financial conditions tighten. Tighter financial conditions mean lower money velocity and lower inflation, according to modern definitions at least.
The Fed is talking tough, and it might be that talking tough does a lot of the job for them – and they might not have to actually act as tough as they talk.
If they can get stock prices down a bit, house prices down a bit, and a lot more caution around the place, with just a bit of jawboning, then the need for higher rates will diminish, and the western world might not actually implode.
Falling crypto markets help the cause too. There won’t be that particular thorn in the Federal side exposing the shortcomings of fiat money.
Tighter conditions will put some upward pressure on unemployment, which means the upward pressure on wages will go away too, and that will help reduce inflation.
If this has to happen sometime, that time is now, in the second year of an election cycle. Come 2023, the priority will shift to getting the economic conditions in place to win the next election. Part of this of course is lower inflation, but they will want the correction in the past and asset prices moving back up again.
OK. So if you buy this theory - how far do stocks fall?
How low can the S&P 500 go?
Currently we are at 3,970 on the S&P 500, having been as high as 4,800, and over the last couple of days the bulls appear to have regained control of the tape. The low was 3,800 - off about 20% from the highs. Another 10% or 15% would take us to the low 3,000s.
While we could bounce a little here, I’m inclined to think we haven’t yet seen the lows. Best-case scenario, I’m going to say 3,600 – that’s the post Corona-panic high. Worst case? Down around 3,000 at the 2019 highs. Most likely, I’m going to guess somewhere in the middle at 3,400 – the 2020 pre-lockdown highs. Remember these are just guesses.
But the bottom line is this: the “print-money-and-protect-asset-prices-at-all-costs” narrative has gone. It’s history.
The issue is no longer deflation, by their definition. Now it’s about inflation. They’ve been able to ignore it for years by crooked measures, ignoring asset prices and all the rest of it. They can’t any longer. That’s what they are now fighting.
As they say, “don’t fight the Fed”.
It won’t be the case forever. Elections have to be won. But it seems the case for now.
Psychologically, we might need some despair and maximum pessimism before the bear market can be deemed over. There still seems to be too much optimism about. We need to be at that point of perception that the bear market is entrenched and we are never going to get out of it, before it can end. We haven’t reached that point yet.
Everything bubbles on the way up, everything pops on the way down.
It might be, by the way, that UK stocks – small and large – turn out to be a very good place to hide. (I’m not saying the UK economy – stocks markets and economies are different beasts).
My reasoning? A presentation by fund manager Gervais Williams that I saw at the UK Investor Show last weekend. UK stocks have been rubbish for 20 years, but in the inflation of the 1970s they were one of the best global places to park capital. Fingers crossed the same thing happens this time around.
This article first appeared at Moneyweek.
Don't fight the Fed