VTI - Powell Delivers A Dire Warning For Stocks And Bonds

2023-10-20 08:25:00 ET

Summary

• Fed Chair Jerome Powell delivers a hawkish speech, warns of lower stock prices and higher interest rates going forward.
• Powell suggests recent increase in long-term yields is due to factors such as strength in the economy, unsustainable fiscal deficits, and changes in correlation between bonds and equities.
• Powell admits that the era of QE is over, signaling tough times ahead for stocks and bonds. Cash and short-term Treasury Bills may be attractive assets.

The New York Economic Club speech

The Fed Chair Jerome Powell delivered a direly hawkish speech for stock and bonds at the New York Economic Club on October 19th. Although the stock market ( SP500 ) and bonds ( TLT ) both fell slightly after the speech, the magnitude of the policy warning is far from being fully processed by the markets. In fact, lower stock prices and higher interest rates could be a secular trend going forward.

The most obvious "warnings"

The media has caught the most obvious "warnings" that are already known and mostly priced-in.

• When discussing the currently strong economy, despite the monetary policy tightening over the last 18 months, Powell stated that "the economy might be somewhat less susceptible to rate increases", mostly due to the fact that companies and homeowners have locked-in low fixed interest rates on their debt, and thus, are not affected by the recent increase in interest rates. Thus, Powell stated that "it might be that the rates have not been high enough for long enough" - and that's essentially the "higher-for-longer" message we already knew.
• When discussing the expected lags with which the monetary policy is expected to affect the economy, Powell acknowledged the Fed has slowed the pace of increase in interest rates "to give time monetary policy tightening to work". The implication is that the Fed is possibly done or nearly done with the current campaign of interest rate hikes to wait for the lagged effects, which is also priced by the market. The Federal Funds futures are pricing the possibility of another hike in January 2024 with only about a 35% chance.
• And yet, Powell acknowledges that "the evidence is that the policy is not too tight right now," in the context of discussing the neutral rate. This sends a conflicting message, if the current level of interest rates is not "sufficiently restrictive" then more interest rate hikes are required. This would be a negative surprise for markets - and likely caused a mild selloff in stocks and bonds.
• Powell acknowledges that the current inflationary pressures "are all happening in the context of very strong demand," which is fueled by the strong labor market, which is getting more in balance as labor supply is increasing - the prime age women participation rate is increasing due to work from home, and the immigration has increased. But Powell also acknowledges that the issue of "constrained supply" is adding to the inflationary pressures.

The dire warning (that most missed)

The dire warning happened in the context of discussing the recent increase in long-term yields.

Powell suggested that the recent increase in long-term yields is "not about higher inflation expectations and not about short-term policy moves" - it is mostly due to the increase in term premiums.

When trying to explain the increase in term premiums, Powell suggests the possibility of:

• "the "higher for longer" expectations due to strength in the economy,
• the unsustainable fiscal deficits,
• the QT, and
• the change in correlation between bonds and equities - supply shocks make bonds less attractive hedge to equities and thus the term premium has to increase.

Further, Powell acknowledges that "higher bond yields tighten financial conditions." However, this is not due to the expectations about "us (Fed) doing more" - there could be structural longer-term factors, specifically 1) the correlation between stocks and bonds, and 2) unsustainable fiscal deficit.

Yet, Powell acknowledges that he doesn't know for sure the reasons behind raising the term premium, and thus, the Fed will "let it play out and watch it," which is "at margin reducing the impetus to continue to rise rates." This reinforces the message that the Fed is likely to pause the interest rate hiking cycle, which should be positive for the market.

Yet, Powell also acknowledges that "the pandemic inflation" could be the structural problem and that the "perfect storm of disinflation" over the last 20 years is now over because the supply shocks will keep the inflationary pressures high going forward.

Powell continues and acknowledges that "the effect of lower bound was a big problem" for monetary policy during the secular stagnation over the last 20 years. Essentially when interest rates are near 0% in normal times, how do you cut and stimulate the economy in bad times?

Did you catch the warning?

Here is what Powell did not say - during the last 20 years of disinflation, the zero bound problem was solved with the QE - balance sheet expansion or money printing to stimulate demand.

But now that the neutral rate has risen and due to the fact that we will likely continue to face inflationary pressures due to supply shocks, the nominal policy interest rate is not going back to the 0% level. Thus, there will not be the need anymore for the QE to stimulate the economy going forward. The "zero-bound" problem no more.

That's the dire warning for the over-inflated stock market - which is still hoping for the Fed to turn on the printing press in a forthcoming recession. The QE is not going to happen again even in a recession as the neutral rate has risen. Thus, the valuation multiples have to sharply correct to below 15x for S&P 500 PE ratio, and it's currently near 20.

Additionally, Powell says that the QT is one of the reasons for higher term premiums. The fiscal deficit problem is not going away, thus the supply of Treasury bonds will keep increasing. The demand for Treasuries is not going to improve as the foreign buyers are not going to participate due to de-globalization.

The only variable that could reduce the term premiums by increasing the demand for Treasuries is the resumption of QE - monetizing debt. But QE is not going to happen as the neutral rate has increased. Thus, long-term interest rates are likely to continue to rise.

So that's the dire warning: no more QE - that's bad for stocks and bonds.

Powell actually admits this when he mentions "the break in correlation between stocks and bonds", which he says is a structural factor causing higher term premiums. The correlation should be negative, when the stock market goes down you should be able to hedge by buying bonds, as interest rates decrease. This is not happening anymore; bonds and stocks are going down together. Why? No more QE. That's the warning in plain sight.

Implications

Tough times are ahead for stocks and bonds. Where to hide? Some say gold ( GLD ) could be the solution. Yet, gold also benefits from QE as the U.S. Dollar depreciates. Gold could possibly move based on the strict safe heaven attraction. Yet, gold does not pay any interest or dividends. Thus, speculation in gold for capital gains is also risky.

In this "higher for longer" short-term interest rate environment the most attractive asset is cash, or Treasury Bills, up to 12 months in maturity.

Alternatively, tactical trading strategies and investing in hedge funds or CTAs that play the cycle from the long and short side is also appropriate.

For further details see: