Since the Fed started its brave modern monetary theory experiment during the dotcom bust, it kept feeding the narrative that the solution to every problem was to print even more money and buy up more assets. This worked well during financial crises -- through the 2000s and 2010s. One clear trend was that every time the Fed started to tighten or even hint at tightening, the market would throw a tantrum and the Fed would only be able to raise rates by a few percentage points before something would snap. The Fed then would need to reverse policy and print even more than what it did before.
The economy, like an old car, kept breaking down. But, instead of fixing it once and for all, the Fed kept trying to tape it and glue it together. After every fix the car would move, but lag the previous move. Now the car is too old to throw away -- or, rather, the debt bubble is too big to burst -- so after Covid lockdowns, the Fed came in with a truckload of duct tape, and printed $5 trillion in a few months to support the economy, hoping inflation would not be an issue.
Why? Because it was never an issue over the past decade.
The Millennials and Gen-Xers, even, all they have ever seen is more and more liquidity thrown in a system at a time of deflation and lower rates. Even though we had Japan as a case study in front of us, those books were used as bed stands rather than a crystal ball into the future. This system is built on so much debt not only in the U.S., but for the rest of the world as well, that it cannot sustain a small move higher in rates. Today we have 30-year fixed mortgages doubling in months from 3% to over 6%. We have gasoline prices close to $6 per gallon at the pump, and inflation averaging around 8%-10% year-over-year. Raw materials along with supply chain issues post-Covid created a world that saw a massive jump in input prices. These prices have been passed onto the consumer as there is no way the companies can eat all of this.
Inflation we are seeing today is similar to one that was seen by our parents in the 1970s. The irony is none of us have ever traded those markets, only read about them. When everything goes down, there is no place to hide but in cash. Financial advisers have built their careers pushing the "60-40" portfolio, only because their timeline went back to 2000 to convince investors of its benefits. In stagflation or hyperinflation markets, both bonds and equities go down, there is no hedge.
Today as Fed tapers liquidity out of the market, this is seeing bonds fall as 10-year yields rise to 3.4%- and 2-year yields exploded to 3.2%. The 30-year vs. the 2-year has inverted once again, which means the bond market is far from healthy. It has been showing stress since the start of this year. The Russian war on Ukraine exacerbated problems, but many started before the invasion. Credit markets have seen widening spreads and we know rates are moving in one direction. The worry is that the economy is all connected and if bonds collapse, it means yields squeeze and when yields squeeze means rates and mortgage rates squeeze. The housing market is bread and butter of the consumer. Today given where mortgage rates have rallied, the same house would need to fall by 30% just for that consumer to afford the same mortgage, or pay a much higher mortgage but with the same wage growth. This is causing weakness in the housing market. Is that the next domino to go? May housing starts fell 14.4% vs. the 1.8% decline estimated -- and vs. a 5.5% rise in the prior month (revised up from negative 0.2%); building permits are down 7% vs. a 2.5% decline estimated -- and vs. a drop of 3.2% in the prior month. It is all connected. We may not be as leveraged as in 2007, but still the U.S. consumer is unable to spend to support these prices.
If the credit market dries up and there is no more lending together with a housing crisis, mixed with a bond market that has no marginal buyer, this can cause all sorts of complications. Investors keep quoting the markets are down 20%, surely the Fed will come to rescue it now. But they too easily forget that the market rallied 200% or more since the Covid lows. The Fed that had said inflation was transitory is the same Fed that today is saying it sees no chance of a recession. Truth be told, the Fed does not know, it just hopes as it has no other tools than to ease rates or print more. But for that to happen, inflation has to come down to 2%, otherwise we will have an economy in recession perennially.
The everything bubble as this cycle was labelled also means when liquidity goes, everything falls. The only difference this time is that there is no more Fed put that the market has gotten used to. At least not until they choke off demand to get inflation back in control, or until something snaps and they have no choice.
