The Dividend Cafe - The Fed's Pickle

Episode Date: September 22, 2023

Today's Post - https://bahnsen.co/3EPBStR Actually, the inspiration for this week’s Dividend Cafe is not “why markets were down this week or this month” – but rather something more substantial and thematic. There are some “whys” that are more important than “whats” right now and big picture, I felt certain macroeconomic themes we are watching were worth a whole Dividend Cafe. That verbiage makes it sound kind of boring, but really, I am just under-selling the excitement of what lies ahead for those who jump into this Dividend Cafe … You will not want to miss the drama and fun. Off we go Links mentioned in this episode: TheDCToday.com DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, weekly market commentary focused on dividends in your portfolio and dividends in your understanding of economic life. Hello and welcome to this week's Dividend Cafe. We are digging into various distresses in the financial system this week. I have a caveat I want to provide as we get started here. I think, let's see, the Dow is down as I'm recording. We're in the middle of the day Friday. The Dow is down about 600 points on the week. That's 1.7%. That's not exactly the kind of thing that should make me ever go, hey, we need to change what we wanted to do at Dividend Cafe because of a 1.7% drawdown over five days. The NASDAQ is down 3.3% on the week. That's a lot worse. And it's down 7.5% since it's high in July. So a couple of months at 7.5%, that's a little more substantial. But you know, this isn't the type of stuff that should ever cause me to say I need to do a special bulletin on. Those things are normal and expected.

And that's part of the dynamic of being an equity investor, obviously. But the reason I wanted to kind of avoid certain evergreen themes and some of the other topics that I had in my potential docket to write about and talk about today and go this direction is that to me, there is something behind why certain things are happening that I want to unpack with you right now. And I do believe, just to kind of set the table a little, we should be really clear about what is happening. It isn't just that there's equity volatility, and it isn't that that equity volatility is severe, which it's not. It's not that the equity volatility is no big deal. It's that we're talking about bond market volatility. That is much more of a story.

And for reasons I've talked about in the past, the bond market never gets the attention the stock market does. And yet I think right now it's important to understand where the chicken is and where the egg is. You had a 10-year yield in April that had gotten all the way down to 3.3%. Now, in fairness, first of all, that's about five months ago. Second of all, it wasn't at 3.3 for very long. It had come quite a bit down to get there.

But I mean, we did stay in the mid threes and the mid high threes for quite some time. And it was where it was. And now we're talking about it as I'm talking, being a whisker short of four and a half percent. I mean, that's a dramatic move. And even if over five months that doesn't grab your attention, it's 38 basis points that have been added to the 10 year yield just this month. And so you have seen upward pressure on the yields of longer term bonds. And I think that there's some

significance in what's going on here. And I want to walk you through it. So effectively, if I can just kind of review what has transpired in terms of this particular period of market flatattishness.

I hope I'm well on record. I know I am. I have the tape. I have the writing. I do believe we're in the midst of what is very likely to be historically a prolonged period of directionlessness or flattishness in market indexes. And I think that historically has been the case after a really substantial bull market that you generally will have a period after a bear market of not reverting to a big upward trend or continuing a downward trend, but just sort of bouncing. And the upward bound and downward and, you know, the floor and the ceiling, if you will, could be where they are. But my point is that it stays in a reasonably tight range. And, you know, when something I'm making up a number, but let's say that range is going to be

plus or minus 8 percent. When things are plus 8, it feels like that's a really good market. When things are plus or minus 8, it feels really bad. But my point was from beginning point to end point. So when am I kind of starting this? It's more or less at the end of 2021. All right. You had that bull market from 2009, 2021. We had the COVID interruption for about a month. Market indices resumed an upward trend. And then after the election of 2020 and the vaccine and energy reopening and the market, excuse me, the world reopening society, 2021 became this kind of blow off top. Shiny objects got ridiculously overpriced. The overall market did quite well. And you were still in a zero bound for the Fed.

You had a lot of earnings recovery, had a lot of economic recovery. And so it was things like energy and value doing well, but also growth and tech doing well. And then we go into 2022. And so what I'm going to suggest here is that there's five phases I want to walk you through real quickly. And I mean that real quickly.

More or less, the first phase was markets realizing in early 2022 that the economy was weakening, that it wasn't looking at this robust period of strength. And that, you know, we needed to first just sort of clean the house a little bit. And so shiny objects got taken to the woodshed first. And so very early in the cycle, you kind of had a mercy killing of shiny objects. And that this was surrounded by a period of economic skepticism, like, OK, we may be facing some economic challenges. The second phase then is by mid-2022. Now the Fed gets very involved. It's very clear that the Fed was going to tighten more than expected.

It led to a market sell-off. It led to the assumption that the Fed would induce a recession. The likelihood it would induce a recession. Earnings revisions start coming down. Expectations for growth start going negative, etc. Permabears, who had predicted 20 of the last two recessions, started calling for a recession in spades. And non-perma bears also just said, look, the odds, the statistical probability here is that you get a recession.

And so that had to get priced into markets. By late 2022, an interesting thing happened is that markets began to price in the idea that the Fed may be near the end of their tightening. It was certainly my view at the time, market factors were largely positive near the end of 2022 in terms of pricing out a little bit. Like, OK, on the other side of whatever may happen with the economy, whatever may happen with rate policy, we see a more positive thing and markets began to try to look forward and be more optimistic on how that may play out. I think that a lot of that deal with market actors, investors who have seen it before, discounting the next steps sooner than later and trying to get in front of the way it all may unfold. That was sort of the third level of market activity.

Then number four is that into 2023, the recession discussion itself changed. That now of a sudden instead of a will we or won't we, it began a we will, but how bad, excuse me, I'm saying it backwards. It became a will we or won't we discussion as if the possibility of not having one was, you know, a necessary option where previously the discussion was largely we're going to have one, but how bad will it be? bad will it be? You follow me? And I think that by mid 2023, just a few months ago, the odds were now more in favor of no recession than even like a mild recession, let alone a more severe one. Okay. And prior to that, your debate was really binary between mild and severe. And then all of a sudden you added this, well, or not at all. And markets began to price in this kind of scenario or outcome by which a Fed ended up reversing tightening, claiming victory over inflation, which, as you know, I most

certainly think they should do move on past yesterday's battle and also avoiding a recession. Pretty good scenario that was getting priced into both bond and stock markets. But then now this fifth phase is where I think we are now over the last couple months, which is one of which markets have begun to say, wait a second, what if we do avoid recession, but the Fed just stays tight for a long time, valuations aren't getting a better boost. Risk-free rates stay high.

Risk assets valuations have to come down. Liquidity stays tight. Bond markets beat equity markets to starting to price in this scenario. And stock markets have been catching up a little bit. But that's more or less where we are, is a financial market, stock and bond, financial markets that have gone from fearing recession to being excited that there is right now no recession,

to now wondering if we get a market problem in a non-recessionary scenario. And so this is all within 18 to 24 months. These kind of five steps have sort of played out. You know, this week, Chairman Powell, as the Fed came out and announced they're pausing, not raising, you know, they doesn't see them cutting anytime soon. They really want to, you know, make sure that inflation stays in the rear view mirror, that kind of thing. He talked about how difficult getting to the neutral rate has been, that the neutral rate seems to be higher than it's been before.

And the neutral rate is this sort of poorly defined term that has a lot of circularity in it, which is the rate at which if you're above it you're restricting economic activity and if you're below it you're stimulating economic activity and I always think it's a difficult thing philosophically to talk about a concept that you don't know what it is you're going for until you can define it with with hindsight well hindsight. Well now we know that X was the neutral rate because a little bit more than X this happened and a little below X this didn't happen and it's constantly changing. I think it's all predicated on a view that I have come to believe is deeply flawed which

is that trying to stimulate economic activity or restrict economic activity with the cost of capital is foolishness. That most of our significant problems we have come not from the cost of capital, but from just general confidence and insolvency to begin with. I mean, real severe moments. You know, someone came and said,

okay, well, Lehman Brothers seems to have an $80 billion hole in their balance sheet. And we're going to go ahead and lower the cost of capital so you can do business with Lehman. Because at 4 percent, you don't want to, but maybe 2 percent you will if you believe it to be an insolvent entity. I mean, it's just absurd. And we've seen this in all significant financial crises over the years or balance sheet recessions that the cost of capital is somewhat ineffectual at stimulating activity when the solvency of counterparties is really what might be the issue. And I think when someone loses a job, they don't say, well, if my credit card rate

was a little lower, I would go ahead and take this family vacation. But because the credit card rate's higher, I'm not going to. Their issue is employment. So wages, profits, solvency, net worth, balance sheet, asset values, these things are all real. The cost of capital is an input, but it is not the defining input of economic activity. And that's, I think, the flaw of a sort of divine view of monetary interventions. Anyways, to move on with this, the Fed doesn't know what the neutral rate is, and the market is now realizing that. And they believe they need to alter economic activity with policy tools. But I don't think the Fed has been understanding why markets do not see it that way. And so you get a sort of confused

project, confused objectives, and then certainly a very mixed and essentially confused response. Now, I want to give full credit to my very dear friend, who's one of the most brilliant people I know, Rene Ananout at Corbu, who, his theory about what the fire and the ointment is, is that productivity is either higher now or the Fed sees productivity going higher. And that leads to, it requires us to have a higher neutral rate assumption that you can if you're getting more from less you're going to need a higher rate to to restrict economic activity. And if it's true and if it's sustainable then you need a higher Fed funds rate for some time. And that would then lead to more capital coming in the U.S. It would lead to a stronger U.S US. It would lead to a stronger US dollar and certainly lead to a capex boom.

There's kind of a virtuous cycle there because that chain of events leads to a capex boom, but a lot of that chain of events is somewhat caused by a capex boom, and that's somewhat my view. So I agree entirely with Renee about that. I think the question is whether or not one believes that the Fed will actually allow this higher rate environment to take is happening in the market right now on the long end of the curve, without talking about quantitative tightening, which all focus and media discussion and most people you just talk to around the street is on the Fed funds rate. And I understand it. I think

part of it is just simpler. It's shorter. It's more definable. It's more understandable. Quantitative easing, quantitative tightening, and more complicated concepts. But quantitative easing, tightening, let's basically call it the policy tool of what the Fed does with their balance sheet. And the Fed funds rate, the policy tool of what the Fed does with the short-term interest rate, the policy rate used to influence the cost of capital. These are two different policy tools. They're obviously intertwined, but they're different levers that the Fed can pull in one direction or the other. And you can say, OK, well, look, the Fed right now has a trillion dollars less treasuries on their balance sheet than they did a little over a year ago when

they began quantitative tightening. on their balance sheet than they did a little over a year ago when they began quantitative tightening. And households have a little more than a trillion dollars additional on their balance sheets than they did a year and a half ago. So it's kind of even-steven. All that's happened is a trillion came off the Feds, a little more than a trillion went on households, and it's washed. But the difference is that the Fed is a non-economic buyer of treasuries. Not only do they not care what the difference is that the Fed is a non-economic buyer of treasuries. Not only do they not care what the yield is, the whole point is the fact that the yield

may be lower is to them a good thing. They're not buying for their own account so that they can collect good income, where households are buying for that reason. They're economic buyers. So you didn't do an apples to apples, let's trade out a Fed position in treasuries with a household position in treasuries. And it could be the private sector. It could be banks. It could be foreign investors for some degree, although that gets more complicated because you have a currency issue.

But my point is that the apples to oranges is that you can't get a trillion off the Fed and a trillion on the household without the yield being higher. And that's what's happened on the longer end of the curve, is households had no interest in buying 2% 10 years, but they apparently do have interest in buying 4% 10 years, 4.5% 10 years, or what have you. And so I think that what we have to answer is whether or not the Fed is, to some degree, a politicized entity. Are they a totally independent body from the Treasury or not? Or is the accord between the Fed and Treasury that's clearly been a part of American economic life for 15 years or longer, is that still in play? Because one thing I do know, and I want to

get to a bottom line summary of exactly what the tension is, so you can really clearly understand my point of view on this. Fundamentally, is the Fed's role more to accommodate what its economic policy objectives are, or is it to accommodate governmental policy objectives? And this is the tension, especially back to like Rene's thesis about productivity, you know, which I think is very potent stuff. Fiscal policy, 32 trillion of debt, requires accommodative monetary policy. High productivity suggests that the Fed may want tighter monetary policy, higher rates. If the Fed were, what can you do to remedy this?

Fiscal policy, let's say, could raise taxes. That then requires less Fed accommodation, in theory. The more revenue coming in, less need for borrowing, less sensitivity to cost of capital. But then you lose the productivity. Higher taxes, lower productivity. I promise you, I'm right about that. So the very thing that could cause the Fed to want to do more restrictive monetary policy reverses if the fiscal changes. But if the fiscal doesn't, then the Fed is stuck in that pickle.

I'm going to read from Dividend Cafe so that I state it for the podcast, state it for the video with the clarity that I think my written word afforded it. The pickle of our day for the Fed, which is really where markets are sort of jumbled right now. Fiscal policy needs more accommodative monetary policy, but high productivity calls for less accommodative monetary policy. And a fiscal policy is changed to be in line with less accommodative monetary policy, then lower productivity results and calls for more accommodative monetary policy. It's a tangled web all started by the doubling down of economic intervention with experimental policy tools. So right now, do I think markets are responding to government shutdown threats and so forth? I don't. I put all this in Dividend Cafe today. The average, we've had 20 of them, 20 in my lifetime. I'm only 49 years old, believe it or not. believe it or not. I know you thought I was a lot younger, but of those 20, the market has essentially been up the vast majority of times since 1980. The market's been up 11 out of 14 times of those 20. The average length of one of the shutdowns was eight

days. They're not generally market sensitive events. But, you know, you also could argue you haven't had one before that coincided with Fed tightening or higher for longer thesis with a UAW strike. There are with Chinese economic slowdown weighing on global growth. There's plenty of macro things that could all factor in together here. But I think really what we're dealing with is markets that are having to deal with the reality of the Fed's pickle, that they can talk about being higher for longer. And my thesis is they can't stay higher for longer because of fiscal policy and that the

productivity boom is threatened if fiscal policy gets in line with more accommodative monetary budget cuts, tax increases. And if fiscal doesn't go that way, which it most certainly is not, then the Fed will not have a choice but to Japanify itself the other way. And that is therefore the very tricky thing for both bond yields and ultimately equity valuations. That's a lot to chew on. I very much welcome your questions. I've tried to be as clear as I can. They're somewhat complicated topics, but I hope I pulled off what I intended to by simply laying out this dilemma. Generally, when I don't know if I pulled it off on podcast or video, I say, well, I think I do

better in the written word, so try that. But maybe the written word won't help either. There's a few other nuggets there at divinitycafe.com. Please check it out. And we'll come back to you next week, either with more elaboration on this topic or moving on to something different. But I do welcome your questions at thebonsongroup.com. I wish you a very good weekend. And I thank you, as always, for listening, reading, watching The Dividend Cafe. Thank you. or investment opportunities referenced herein will be profitable. Past performance is not indicative of current or future performance and is not a guarantee. The investment opportunities referenced herein may not be suitable for all investors. All data and information referenced herein are from sources believed to be reliable.

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