Economy Update – What’s Next for the FED?

It’s clear the G7 countries are entering a period of slow economic growth, and it is uncertain when growth will become negative due to nominal inflation overstating GDP data. The current financial disintermediation and weak banks are acting as a strong headwind for the economy in terms of credit creation. Additionally, China is accelerating, which may pull more countries along for the ride leading to some countries faring better than others for what is coming next in the Economy.

The equity market in Q1 of 2023 is probably confusing to anyone with a decent amount of common sense and knowledge of history. Given the number of problems in the world economy right now, one wouldn’t have expected such a strong rally for the first quarter of 2023. Although there are still some passive flows that are working and the bond yields have eased off since the US Federal Reserve (Fed) responded to the emerging banking crisis. The market took these actions as a signal the Fed was done hiking interest rates.

In reality, whether the Fed was done hiking or not by their own measures, they needed to step in and intervene when Silicon Valley Bank went under. This is because when there are structural failures in the financial system, there can be a domino effect that spreads to other markets, such as real estate and equities. Given the high degree of leverage in our current financial system, there is a real possibility that a banking failure could have serious consequences. While the current financial leverage is not as bad as it was in 2008, it is still quite high, and there has been a significant degree of speculation in the equity markets as a result of the free lockdown money distributed in 2020.

So in order to prevent a crisis, the Fed and the Federal Deposit Insurance Corporation (FDIC) intervened with Silicon Valley Bank. Now that there has been some fiscal relief and banks have guaranteed their deposits, the banking sector has some breathing room. This means that while they are not likely to give out more loans, nor will they give significantly fewer loans. To summarise the recent Fed and FDIC actions, at the margin, were stimulative for the economy and markets, though it was not quantitative easing.

Despite the short-term economic relief, the Fed will need to hike rates again, but not in this cycle. It is time for the Fed to observe the effects of their hiking and then act once new data becomes available. It is true that elevated interest rates make for tougher financial conditions as the cost of capital is increased, but this pain is likely going to be pushed onto the economy for as long as it can bare it, until something terribly important breaks.

Looking ahead, a ‘Soft landing’ is a fantasy, but a ‘Hard landing’ is not a certainty. There is still a lot of work to be done by the central banks. The FED has said it will keep rates higher for longer, but the bond market has priced in lower rates on yields, implying they believe the Fed will cut rates as soon as this year. However, the bond market has fractionalized interests from those who invest in it, and participants are responding to real-world events and data that becomes available to it. Nonetheless, the overall ‘mood’ of the bond market is that Jerome Powell will start cutting rates sooner than one year, despite stating otherwise.

After the Fed’s hiking actions, we can expect the “base effect” to kick in sometime this year, resulting in a decrease in year-over-year inflation and a likely softer labor report. It is probable market participants may view this data positively. Additionally, the “Passive-Bid” from popular ETFs such as Blackrock and Vanguard, along with pension funds, will continue to drive financial markets to higher prices to some extent.

This all creates a situation this year where the Fed will have an opportunity to declare victory on inflation even if it’s not at their target of 2% yet. This will provide the Fed with the means to backflip on its monetary policy and start easing financial conditions when they do break something in the economy. However, this may be the moment when the bond market loses confidence in the Fed and prices in much higher yields for bonds. This is what occurred in Japan following on from their ‘Lost Decade’ where they engaged in historically high levels of financial engineering that stagnated their economy considerably. Ultimately, the Bond market lost confidence in their central bank to manage an economy and demanded higher returns for holding their debt. A similar situation is brewing in the US economy if the Fed cannot reach its target inflation rate before causing severe economic damage.

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