October 2022 Insights

The only thing worse than a hostile monetary policy is a Federal Reserve that does not know what it is doing. The markets are dealing with both.

As inflation hit a 40-year high in January 2022, Federal Reserve Chairman Jerome Powell said the Fed “decided to keep the target range for federal funds rate at 0 to ¼ percent.” In that same press conference Mr. Powell referred to inflation as a “high class” problem. Now, after high inflation has caused a rout in the currency, commodity, stock, and bond markets, Mr. Powell has found religion and wants everyone to know that low, stable inflation is the “bedrock” of the economy.

For well over a year, Chairman Powell has repeatedly said that the Fed is “guided by our mandate,” one of which is stable prices. As the Fed ignored inflation and did not begin to raise interest rates until the Consumer Price Index (CPI) was 7.5 percent – a 40-year high – markets are sending a message to the Powell-Fed that those type of statements are not credible.

Consequently, markets have lost confidence in the Fed and are acting accordingly.

September saw the S&P 500 index fell 9.3 percent, the yield on the 10-year U.S. Treasury Note rose 68 basis points (0.68%) to 3.83 percent (it was 2.60 percent on August 1, 2022), and a barrel of oil fell from just over $88 to roughly $79.70.

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Following a 9.1 percent gain in the month of July, the S&P 500 index fell 5.8 percent in the last four days of August following Federal Reserve Chairman Jerome Powell’s speech at Jackson Hole, WY. For the month of August, the S&P declined 4.2 percent.

 While we have been especially critical of the Powell-led Fed previously stating that “people who speculate on a radical, untested theory that has a damaging effect on the markets and the economy should not be in charge of monetary policy,” apparently, we were not harsh enough. To be blunt, the Powell-Fed has embarrassed itself.

 The same people who ignored rising inflation and kept interest rates at zero until inflation hit nearly 8 percent are now lecturing us about the importance of low inflation. Powell, who four weeks ago said “now that [interest rates] are at neutral” – the theoretical level that is neither accommodative nor restrictive – recently did a 180-degree turn saying “another unusually large increase [in rates] could be appropriate at our next meeting.” 

After the 1008 point decline in the Dow Jones Industrial Average on August 26, 2022, the day Powell gave his speech, Minneapolis Fed President Neel Kashkari said he was “happy.”

The yield on the 10-year Treasury Note rose from 2.60 percent in early August to nearly 3.25 percent at month end. Oil, meanwhile, was trading at roughly $87 a barrel, down from the mid-$90s in July.

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After falling more than 20 percent in the first half of the year due to a massive policy mistake by the Federal Reserve and exacerbated by questionable domestic energy policy and the Russia/Ukraine war, the S&P 500 index rallied more than 9 percent in July following months of persistent weakness.

The interest rate on 10-year U.S. Treasury Notes fell to 2.67 percent from roughly 3.50 percent in mid-June, and a barrel of oil fell almost $10 in the past four weeks

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The Federal Reserve has made an enormous mistake and the stock, bond, currency, and commodity markets are paying the price. Moreover, the Fed is the problem, and they do not know it.

In August 2020, the Fed reached a conclusion centered on the assumption that inflation was too low. The Fed then changed monetary policy based on an untested theory – flexible average inflation targeting – with a goal of increasing inflation “moderately above 2 percent.”

The Consumer Price Index (CPI) hit nearly 8 percent before that Fed actually raised interest rates – its “primary tool for adjusting monetary policy.”

As former Federal Reserve Chairman Ben Bernanke wrote, “the Federal Reserve’s objectives – its dual mandate, set by Congress – are to promote a high level of employment, and low, stable inflation” (Emphasis added). The Fed failed catastrophically in one-half of its two mandates.

In June, Fed Chair Jerome Powell told the Senate Banking Committee that the Fed needs “compelling evidence” that inflation is falling before interest rate hikes slow after ignoring “compelling evidence” that inflation was well-above its 2 percent target.

The markets have lost confidence in the Fed. As a result, the S&P 500 index lost 8.3 percent in June and has had its worst start to the year in decades.

Few markets have been spared. The yield on 10-year Treasury securities have risen from 1.52 percent at year-end to roughly 3 percent after hitting nearly 3.5 percent in mid-June. High yield (“junk”) bonds have soared to 8.88 percent from 4.35 percent at year-end. These massive rates of change suggest that the people in charge of monetary policy should no longer be making decisions.

A barrel of oil was trading around $105 at month-end from roughly $125 four weeks ago, however, oil is still up more than 40 percent year-over-year. Copper is down more than 20 percent, cotton dropped nearly 30 percent, and natural gas fell 16 percent in a matter of weeks as the global economy slowed.

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The S&P 500 index eked out a gain of 0.22 points in May following a brutal 7-week selloff primarily due to the massive mistake by the Federal Reserve that let the inflation genie out of the bottle. As a result, the Fed has done enormous damage to its credibility and reputation, and markets reacted accordingly.

While we have written extensively about Federal Reserve mistakes in the past, the Fed compounded its mistake by increasing interest rates only 25 basis points (0.25%) in March, and continued to purchase bonds despite inflation running at a 40-year high. Moreover, less than one week following the March Federal Open Market Committee (FOMC) meeting, Fed Chairman Jerome Powell emphasized the need to raise interest rates “expeditiously,” seemingly unaware of the fact that the Fed could have done so the previous week, not to mention months earlier.

The significant gap between what the Fed said they would do and what they did has caused confidence to evaporate.

To be clear, the Russia war with Ukraine has added to price pressures including substantially higher oil and gas, wheat, and fertilizer prices. And U.S. policy regarding domestic fossil fuel production has essentially created a self-inflicted oil embargo. Nevertheless, the Consumer Price Index was 7 percent in December, before the Russia/Ukraine war, and roughly 8 percent before the Fed raised interest rates.

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The markets were under a great deal of pressure in April as high inflation, a significant rise in interest rates, continued geopolitical turmoil between Russia and Ukraine, and a Federal Reserve with a credibility problem weighed on stocks and bonds.

The S&P 500 index fell 8.79 percent in April and the yield on the 10-year Treasury security rose from 2.32 percent to 2.89 percent as the Consumer Price Index (CPI) increased 8.5 percent year-over-year. Moreover, the high yield bond index saw interest rates rise from 5.46 percent to 6.84 percent over a four-week period. The rate of change and lack of confidence in the Fed is causing leverage to be unwound, and investor sentiment has turned decidedly more bearish.

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The month of March saw big swings in stocks, bonds, and commodities as the Russia/Ukraine war entered its second month, inflation rose to roughly a 40-year high, and the Federal Reserve signaled a significant change forthcoming in monetary policy.

The S&P 500 fell 5.26 percent in January, 3.00 percent in February, and 4.57 percent between March 1 and March 14, 2022, before gaining nearly 11 percent over an eleven-day period to finish down 4.9 percent in the first quarter.

A barrel of West Texas Intermediate crude oil rose as high as $130 in March as President Biden announced a ban on Russian imports of oil, although technically it does not go into effect for a few more weeks. In fact, a tanker carrying 680,000 barrels of oil left Taman, Russia on March 22, 2022 for New Orleans, LA. After April 22, 2022, the U.S. will no longer allow oil imports from Russia.

Nevertheless, in an effort to reduce gasoline prices at the pump, President Biden announced a plan to release 1 million barrels of oil per day from the strategic petroleum reserve. Oil ended March near $100 a barrel.

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The S&P 500 index fell 3.1 percent in February as the Russian invasion of Ukraine added to the growing list of uncertainties affecting markets. Oil spiked to more than $105 a barrel, while wheat jumped to its highest level since 2008 as Russia and Ukraine account for roughly 30 percent of all wheat exports. Prices for corn, iron ore, sunflower seeds, barley, among others produced in Russia and Ukraine rose in tandem.

This is happening at a time when inflation has been increasing for more than a year while the Federal Reserve has failed to act. We consider this reckless behavior. As recently as January 26, 2022, Federal Reserve Chairman Jerome Powell referred to “the relatively high-class problems” that come with the economic recovery, including “high inflation.” Inflation is running at a 40-year high, and real hourly earnings (meaning adjusted for inflation) have declined for 10 consecutive months.

The Fed has lost touch with reality. One day Fed Chairman Powell states inflation is a high-class problem, while another day he claims the Fed understands “that high inflation imposes significant hardship, especially on those least able to meet the higher costs of essentials like food.”

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In our early December piece, we wrote “Of greater concern is whether the Fed is making another mistake.” And specifically, “any perceived mistake could result in a significant reduction in risk assets” as “hedge funds are exceptionally good at crowding the exits.” That is exactly how the year began.

A rough start to the year got even worse following a press conference by President Joe Biden whereby the S&P 500 index dropped 6.8 percent over the following three days. That is not a political statement – it is a fact. It is quite clear that the markets did not like his comments that suggested a “minor incursion” by Russia into Ukraine would be tolerated, and that the 2022 elections might not be legitimate.

The S&P 500 index declined 5.25 percent in January having been down more than 11 percent only a week before. The bond market sensing a major mistake by the Federal Reserve regarding inflation saw the 10-year U.S. Treasury yield rise from 1.35 percent on December 3, 2021, to 1.87 percent on January 18, 2022. The nearly 40 percent increase in interest rates over a seven-week period was a catalyst for a selloff in the U.S. equity markets, with the NASDAQ Composite falling more than 15 percent at one point in January.

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