Make no mistake about it. There is no need to guess. The Fed today turned the interest rate environment around, turned the tables, and not even a war in Europe could stop them.
We are now about to walk a tightrope between lowering our inflation rate and throwing the American economy into a recession. There are three key issues to watch: the rate of the Fed’s hikes, 25 basis points to start, the speed of their hikes, and finally the amount by which they cut their balance sheet and in what fashion. The latter includes roll-offs, outright sells, and where on the yield curve that any selling might take place. The Fed’s moves here will be major signals that we all should be watching.
The recession consideration is not without merit, in my view. Rising interest rates can have all kinds of collateral damage. There are linked to the cost of borrowing for the government and corporations. This also encompasses stock buybacks, the cost of mergers & acquisitions, mortgage rates, real estate values, and the price of leverage. The Fed doesn’t seem to be overly concerned though. They should be.
“In my view, the probability of a recession within the next year is not particularly elevated. All signs are that this is a strong economy, one that will be able to flourish, not to say withstand, but certainly flourish, in the face of less accommodative monetary policy.”
– Fed Chairman, Jerome Powell
One major issue here is the amount of inflation that has to be confronted. We are nowhere near, nowhere close to the Fed’s desired level. The Consumer Price Index (CPI) is up 7.9% over last year. The Producer Price Index is even worse. It is up 10.0% in the last 12 months. This brings our rate of inflation, which I calculate as the average of the two indexes, to 8.95%. The Fed would have to move heaven and hell to get that number down to a 2.0% level anytime soon. Moving too quickly will spark wildfires, in my opinion. I hope the people at the Fed grasp this point.
In the fixed-income world, the Fed’s latest move has prompted a reaction. We used to have a “yield curve.” Now it is more accurate to call it a “yield line.” The three-year Treasury now yields just 20 basis points more than the two-year Treasury. From there, things get quirky. There is just a 1-basis point differential between the three-year Treasury and the five-year Treasury. In fact, this morning, the five-year Treasury now yields more than the ten-year Treasury. So much for the value of duration and length of maturity risk.
I point out that the U.S. “yield curve” has inverted before each recession since 1955. A bond market inversion has signaled a recession that follows it, lasting between six and 24 months, according to historical data. This comes from a 2018 report issued by the staff at the Federal Reserve Bank of San Francisco.
Take heed!
Another unknown is what Putin might do next in Ukraine as he bombs museums, hospitals, maternity hospitals, and apartment buildings. Any further rise in hostilities or any incursions into other countries could send safe haven assets significantly higher and throw equities into a tailspin. In part, all of the markets remain subject to the atrocities that have come, and may come. Add this to the possibility of a Russian bond default and the uncertainty principle rises significantly.
Carefully selected funds, with yields that are more than our inflation rates, continue to be my investment of first choice. Most of the funds that I like pay monthly, and so, as long as the dividends are paid each month, “Here’s money,” regardless of what the markets have done. While past performance never guarantees future results, I think this is a prudent investment strategy in an ever-riskier world. Income and cash flows may not lead to spectacular gains, but Grant’s first 10 Rules, “Preservation of Capital” is more important now than ever. Nothing wrong with solid and stodgy when the world is flashing signs of “topsy turvy” in giant neon letters.
Original Source: Author
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