Why the Fed is Trying to Starve Grandma
Hey, did you notice that the investment markets are down?
Like, a lot?
Stocks are down, bonds are down, crypto is down, everything is down except housing and prices for stuff.
In fact, this is the first time in over 50 years that both bonds and stocks are down this much at the same time.
You may also have noticed that a lot of this collapse coincides with the U.S. Federal Reserve Bank’s decision to raise interest rates and unwind its balance sheet.
I have written before about how the Fed’s rates affect the stock market, and I have also talked about the “taper tantrum” that could impact the markets.
Now, we’re seeing everything I wrote about before coming to pass, and retirement accounts everywhere are suffering as a result.
I’ve been getting a lot of questions about what interest rates mean for investors, how bad they can get, whether the Fed will trigger a recession (i.e., a “hard landing”), and what folks should be doing now.
So let’s dig in to why the Fed is crashing this party…
We’ll do some quick math to determine how bad it might get…
And let’s talk about what investors can do now to protect themselves and even profit.
Why the Fed Is Trying to Starve Grandma
Millions of retirees depend on their investment accounts to survive…
And on top of that, between legislative and corporate action (e.g., 401(k)s), millions more Americans have been prodded into investing their savings in the stock market in some form or fashion.
If the Fed is raising interest rates, this can have a direct negative impact on your and your family’s retirement investment account.
So it raises the question: Why would the Fed come after your retirement money?
Simple answer: Inflation.
Without a modicum of price stability, economies and their fiat currencies (that is, money not backed by anything) simply do not function correctly.
Now to combat inflation, the Fed is raising interest rates and unwinding the assets it bought to prop up the economy during the coronavirus pandemic.
I built a model predicting this inflation surge back in August 2021.
I said that CPI inflation would max out around 9.2% to 12.8% by August 2022, based simply on how much money was being “printed.”
Inflation just hit 8.26% in April.
Inflation, more or less, simply means that the prices of things people buy are going up. That means $1 in your pocket is able to buy less stuff. (As in, $1 bought you a certain amount of gas in 2020, but now $1 buys you substantially less gas in 2022.)
A little bit of inflation is supposedly good for the economy because it encourages spending, which spurs consumer demand.
But inflation that’s too high is bad for investors, in particular, because it makes the value of money earned in the future worth relatively less.
This is why tech stocks are down but boring stocks that are making money and paying dividends now, like $CVX, $K, and $LMT, have been doing well even during this downturn.
So everything the Fed is doing?
It’s to combat inflation at any cost.
There’s a Big Problem With This Plan, Though…
If you dig into the numbers, the Fed appears to be almost completely impotent when it comes to fighting this surge of inflation.
Let me explain…
Since the Fed raised central bank interest rates by 0.5% in early May, the most in 22 years, the stock market has been absolutely tanking.
Why? Interest rates indirectly determine the cost of debt in the U.S. economy.
So lending rates, loans, savings account returns, credit card debt, mortgages, government debt… All of this becomes more expensive as interest rates rise.
If companies can’t access cheap debt, that makes it harder for them to grow. If people can’t access cheap debt, that makes it harder for them to buy stuff (which inhibits corporate earnings growth, which is also a problem I mentioned earlier – notice how all of this stuff is interconnected?).
This is especially bad news for tech stocks and biotech stocks, which often depend on financing rather than profits for their growth.
Hence: a huge selloff in tech stocks and biotech stocks and pretty much every other kind of stock that’s trying to rapidly expand.
Now, in NORMAL CIRCUMSTANCES, discouraging people from taking on debt by making it more expensive slows inflation because it disincentivizes growth.
But that assumes that the inflation we’re seeing is a result of normal circumstances.
But we’re in the New Normal, baby.
$#!%’s gotten weird.
So right now, the market is “pricing in” (i.e., predicting) that interest rates will rise to 2.75%-3% by the end of 2022.
I find this figure… absurd.
(Which actually points to stocks perhaps being oversold at the moment.)
There are two reasons why I think the Fed will be relatively ineffectual in its fight against inflation…
Based on history, the Fed does not have much more room to increase rates.
Take a look at this chart:
Forgive me if the chart above looks like something my 1-year-old child would draw, but there’s no easy way to visualize the above.
Let me explain what you’re seeing…
The squiggly blue line in the upper chart is the indicator which shows the relative cost of debt in the U.S. over the last 40 years.
[The calculation is: (The Federal Funds Rate + The Market Yield on the 10 Year Treasury) / 100000 * The Total Federal Debt.]
What this gives us is a clear sense of how expensive debt can be before the market and economy “break” and the Fed needs to begin easing the money supply again.
You’ll notice that every time the blue line spikes and touches that upper red boundary, it preceded a recession, which are marked by red vertical columns.
If we zoom in to the last 20 years, you’ll see that this indicator peaked about 6 months before the tech bubble collapse in 2000, the great recession in 2008, and the Corona Crash in 2020.
Simply put: When the squiggly blue line touches the upper red line? It’s bad news, buckaroo.
Why is this the case?
As more and more debt has been floated in the economy, the relative cost of that debt has become more sensitive to fluctuations in interest rates.
This also means that the market and economy have been able to tolerate lower and lower strings of Fed rate hikes.
And this isn’t my opinion… You can see it clearly in the lower portion of the chart above, which shows the effective Fed Funds Rate.
Especially since the Bernanke era began… When the cost of debt becomes too much for the market to handle, the Fed shifts from “tightening” to “easing” the money supply, once again making money more accessible in the economy.
On top of that, the stock market has been able to handle lower and lower peak Fed rates before it breaks and the Fed shifts from tightening to easing again.
This, reader, is why I say that a peak Fed funds rate of 3% by year’s end is absurd.
It’s also why we might see an absurd situation where the Fed resumes quantitative easing even while it’s raising rates to stave off inflation.
The only way the market would be able to tolerate rates going so high is if the U.S. economy shed trillions of dollars worth of debt in the next few months.
Possible, but highly unlikely.
If the Fed raises rates to the point where the relative cost of debt goes above that upper red line, we’d be looking at a potential debt death cycle.
Forget inflation. Forget recessions.
Just as I explained in a previous blog post about how the supply chain crisis can cause inflation in the short term but deflation in the long term: If the market cannot tolerate the cost of debt, it’s deflation and an economic depression we’d need to worry about in such a scenario.
To sum it up, the Fed is trapped between two awful choices.
They can either break a 40-year trend and tighten money supply more than the economy or government can handle…
Or they can let inflation run its course and burn through the American economy like a wildfire through untamed brush.
My bet?
The Fed will stop tightening before everyone anticipates.
The wealth deteriorating effects of higher inflation can actually help a borrower cover their debt and pay it off more easily. That’s because debtors still owe the same amount of money, but there will be more money in the economy that people, companies, and the government can use to pay off their debt.
If the choice is between “high inflation” and “avoiding debt default,” the Fed is going to tolerate inflation running a little hot because inflation actually helps them avoid default.
So if that’s the case…
Do we know when the Fed tightening cycle will end?
The indicator’s equation I provided above lets us build a model and make an estimation.
Hypothetically, if the Fed raises rates 0.25% every quarter and the national debt goes up $300 billion per quarter…
Then the relative cost of debt will hit its ceiling after about 2 or 3 more rate hikes: 1.25% to 1.5%.
That means, in this scenario, the soonest we’d hit the end of the Fed tightening cycle is about six months to a year from now — late-2022 to mid-2023.
This is one reason why I think the market, especially high quality tech stocks, might be oversold right now…
This is also why I suspect the Fed will fail to combat inflation with monetary policy…
Or, rather, why I suspect that inflation will resolve on its own and the Fed will take credit for it.
With quantitative tightening and raising interest rates, the Fed is trying to “take the punchbowl away from the markets,” so to speak.
But that ignores the fact that, in this market, no one is drinking any punch!
Prices are high and going higher largely because companies can raise prices.
That’s it. That’s the reason for most of the inflation we’re seeing.
Some companies try to justify it. Some don’t.
The justifications include higher costs - for example, wages went up around 5% over the last year and producer prices went up 11%.
Businesses are encouraged to show stable and growing profit margins.
If their costs to compensate employees go up along with the cost to make stuff, then businesses will look for ways to cut costs or hike prices.
Even if the supply chain crisis ends, businesses will still use the figures above to justify price hikes.
And even if the justifications all go away, it doesn’t necessarily mean that prices will automatically go down.
People will either get used to paying higher prices, in which case the cost of living in the U.S. will stay high or go higher…
Or people won’t tolerate it, demand will evaporate, and businesses will lower prices again (which can spur a recession).
And the Fed? It doesn’t control any of this.
It can adjust monetary policy all it wants, but that ultimately doesn’t fully determine self-interested decisions being made by individuals and corporations.
Plus, the Fed’s policy changes take months to years to really have a true impact on business dynamics.
To sum it all up…
The Fed is in effect trying to put out a grease fire with water.
Hiking interest rates too fast might end up causing the problem to get worse or spread faster.
So What Can a Regular Investor Do Right Now?
The economy is full of mixed signals right now…
But most of them are beginning to point in a direction we might rightfully call “not good.”
Ultimately, my advice for investors in this situation is not all that different from what I suggested before this crash even began…
Invest in high quality assets for the long haul…
Invest in stocks that pay dividends…
Use dollar-cost averaging over time (as I explain here)...
Avoid putting too much or any money in the major indices right now (such as the S&P 500 and Nasdaq)…
Keep about 15% to 30% of your investment dollars in cash to take advantage of a deeper dip…
Set trailing stops for your more speculative investments…
Look for more attractive alternative investments.
On that last point…
I just invested $5,000 into I-Bonds, which are paying about 9.62% interest until October.
I just began investing in cryptocurrencies again for the first time since 2020–specifically cryptos that provide a development platform. But I’m only going in about $25 per week, because I don’t have total faith or certainty in the crypto markets long-term.
I also just bought a little bit of $QTEC, a fund that tracks the top 100 Nasdaq stocks, as well as a few smaller growth stocks such as the ones I recommend in the Finance Daddy Dollar Trader.
And I’ve still been putting $10 every day into $TDIV and $DTD–and I’m currently beating the market by doing it.
But for the most part?
I’m doing nothing.
I’m collecting dividends. I’m contributing cash to my retirement and investment accounts. And I’m waiting until mid-June to decide which stocks I want to buy more of.
There’s a quote about what to do in different market situations that I enjoy very much…
“There's a time to go long, a time to go short, and a time to go fishing.”
Meaning: there’s a time to buy, a time to sell, and a time to just ignore the markets.
From what I’m seeing, right now looks like a time avoid looking at your brokerage account for a while and “go fishing.”