Onboarding Lesson 2: Higher for Longer

Good morning and welcome back!

Last week we covered the Silent Tax known as Inflation, and why it’s been devastating to so many family budgets and investment portfolios.

This week we’re going to talk about the Fed’s response to inflation, known as Higher for Longer and where they are in the cycle and what it means for you.

Also, check out my thoughts on a legend calling it quits over here. When a giant in the game throws in the towel, that can be a big market tell. One of my favorite strategies over the last 30 years of managing money has been to PAIN TRADE great traders/investors when they run into trouble.

Typically, they are ‘right’ in the trade, just early and get shaken out due to timing, risk constraints, or other external factors. This provides us an opportunity to enter the same trade without the sunk costs and steep losses. This way, we can be less emotional around the risk/reward calculus and capture the trade’s upside without the pain they’ve already gone thru.

And now, let’s talk Higher for Longer.

Key Lesson: Higher for Longer.

Higher for Longer is the Fed's mantra over the past year. The Fed has raised interest rates higher, and it intends to keep them there longer than most market participants expected (not yours truly, but most of the CNBC Bubblevision talking heads and others).

As we discussed above, the longer rates stay high, the more suffocating it is for the economy and borrowers. People, firms and governments not only need to borrow money, but they need to refinance loans they've already taken out. Refinancing at 5.5% is a lot tougher and costs more (money is more expensive as we showed in the mortgage example above) than refinancing at 2%. These added borrowing costs will put many firms out of business, and may even topple political parties or governments (Sri Lanka, Argentina, etc.).

Originally, investors thought the Fed would be cutting interest rates this year. That estimate got bumped to next year as inflation proved more sticky and the economy more resilient than people expected. Now we've gone from 50-100 basis points (100 Basis Points or 'Bips' is equal to 1%) expected by June 2024 to 50 Bips by September 2024. So they keep pushing out the time until we expect cuts and have cut back on the size of the expected cuts. Thats "higher for longer" in a nutshell.

Time for A360 Insider Baseball Secret #2. The Fed is just making an educated guess. They don't really know anything and they are rarely correct with the timing or direction of their policy decisions. For instance, they waited far too long after the Pandemic this time to raise interest rates and kept stating publicly (along with the Biden Admin) that inflation was "transitory" (ie, it would magically disappear in short order). Of course it wasn't transitory, and we saw the worst bout of inflation most of us have seen in our lifetimes.

The takeaway here is No one really knows. The Federal Reserve is just 12 relatively smart, relatively old guys sitting in a room trying to guess about the most complex organism on Earth (the market). We'd be better much better off turning their jobs over to an AI and letting them implement the AI with limited veto power.

If history is any guide, the Fed won't be cutting 50 bps next year to fine tune a 'soft landing' (an engineered slow down of the economy that avoids a painful recession and lands the economic ‘plane’ without damage). They'll be doing emergency 100 basis point cuts and printing money again to avoid a banking collapse or other economic seizure when they realize the economy has stalled.

Now that we’ve given an intro to ‘Higher for Longer’ and why market participants are obsessed with that notion, let’s consider what is likely to happen. 

Part II. What is Likely to Happen:

• The Fed will blink at some point.

• They are caught between a rock and a hard place.

The Fed has raised rates higher and faster than any time in history to deal with the massive inflation we’ve seen over the last 2 years. The thought on everyone’s mind is when will they stop? And when will they begin to cut interest rates?

It’s likely the Fed is done raising rates. While they still might do one more hike, most of the heavy lifting has been done. But just because they are done raising, doesn’t mean they will begin cutting anytime soon.

Nor do cuts necessarily serve as the panacea or ‘all clear’ signal to invest in markets despite what you hear on TV. If you look at history, some of the biggest drawdowns in market history occur when the Fed starts cutting rates aggressively which is somewhat counterintuitive.

But think about why this might make sense. If they are cutting, it means rates are too high and liquidity is too tight and the economy is suffocating.

If they start cutting, that sends a message to us that the Fed is now more afraid of recession than it is of inflation.

Therefore, the timing and size of a cut may mean the Fed has made a policy mistake by keeping rates too high for too long.

Regardless, you can expect a knee-jerk bounce when the Fed starts to cut rates or telegraphs that it will begin to do so (remember, the market is a discounting mechanism meaning it prices based on the future rather than the current reality).

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I believe the 1st and 2nd Quarter of 2024 will be the bottoming of the economy. It’s likely that we will be in an undeniable recession by that point.

The 2ndQ of 2024 should see a bottoming and while the news will remain bearish (the news always lasts longer than the actual economic reality….both on the bull side and bear side), the economy and markets will start preparing for a run into the Presidential election.

Historically, the Fed doesn't want to be super tight into an election nor be the determining factor whether or not an incumbent gets re-elected. Because they don't want to be the scapegoat for a loss of one party or candidate, they typically give the economy a little juice or at least back off tightening. This can be done by buying treasury bonds to lower the yield, rolling over their balance sheet, cutting rates or injecting liquidity by other measures.

But there is one thing you have to remember if controlling inflation is the Fed’s number one goal, 'Bidenomics' (as if that is a real cohesive economic policy and not just a mish-mash of nonsense), has made the Fed's job tougher at every turn.

The Fed wants inflation and prices to cool down. They've tightened higher and quicker than almost anytime in history to deal with the explosion in inflation. Rather than coordinate with the Fed, the Biden Admin has been pushing massive fiscal stimulus (budget spending) at every turn. The Inflation Reduction Act, Build Back Better, and other bills taken together are trillions of dollars in additional new spending.

By firehosing money into the economy, the Biden Administration is directly counteracting the actions of the Fed. This is making the Fed go 'higher for longer' since prices have not come down (dirty secret - inflation is not coming down....prices are just rising at a slower rate).

Disinflation is what we have now. It's a fancy economist term that means the rate of inflation is not going up as much. So inflation was running at 10%, now it's only running at 3%. So eggs went from $3 to $10, and now they're only going up to $10.30 this year instead of doubling again. Deflation would bring them down to $8 (or God willing, back to $3)).

I'll let you do the math. Somehow inflation was only running at 10%, but the price of many things doubled. That would be 100% inflation. Here's the other ugly dirty, secret. Nearly all of the official government numbers are bogus. The only question is, how bogus.

Sites like ShadowStats or TruFlation give a better estimation of the actual inflation numbers but still don’t capture the true levels of pain because of fancy economist concepts like replacement, elasticity and other measures which don't give a fully accurate view of the world.

Either way, all you have to know for now is that the rate of inflation is lessening, but it's still going up a bit too fast. The Fed wants a 2% inflation rate. We're closer to 4%.

The big question is, does the Fed declare victory closer to 3% and offer some peace treaty on rates or do they jam inflation back into the box and take it down to 2% or lower (frankly, it's almost impossible to arrive at a target number, you'd have to put us in a recession and see some serious deflation before we'd hopefully arrive back at the 2% number). 

Back to the point. The Biden Administration is working directly contra to the interests of the Fed by producing a large amount of fiscal stimulus, including the massive budget deficits we’ve seen over the last 3 years.

That means the Fed has to stay 'higher for longer' (higher interest rates for a longer period of time).

Here's the problem with that...there's a clock running.

Besides the desired effect of tightening liquidity and monetary conditions (less money floating around, asset prices tend to get hurt as its harder to borrow, invest, etc), it means money is more expensive. And since we live in an economy that has been built on debt and free money (at least for the past 25 years), there are a lot of skeletons floating around.

The other reasons the Fed has a clock ticking on its ‘higher for longer’ interest rate strategy boils down to three key reasons.

1. If rates stay high for too long, the economy will suffocate. With the insane amount of sovereign (government) debt we currently have and large deficits every year (we spend way more than we take in tax revenues), these debts and deficits need to be financed (the Treasury needs to sell more bonds to investors to finance (provide money for) the government.

   
   Here's the problem. Short term rates are now 5.5% and long term rates 4.75% approximately. It's now twice as expensive to finance our annual deficits and debt that is coming due. The government sold most of its original debt at a rate of anywhere from 1% to 2.5%.  Rates have now doubled so it will cost twice as much to sell new debt. For example, next year we have to issue approx. $10 Trillion in debt. At 2% that costs us $200B a year in interest expense alone (the principal $10T has to be paid back or refinanced at some point in the future).

   
   At 4.5%, that debt will cost $450B, or $250B more than last time. That $450B is a large and growing number that eats up a good chunk of our existing budget and also makes our deficit next year even larger. That's the definition of a 'debt spiral'.

2. Bank Balance Sheets - Bank balance sheets are a big concern as well. Banks loaded their balance sheets with 10 year Treasuries back when the 10 Year was trading at 2% or less. Now that the 10 Year is yielding 4.75%, that means the price of the bond has dropped by nearly 50% (remember, bond prices and yields move inverse to each other). If bank balance sheet losses were at least $600B in March, that means they must be much worse right now as the bonds have continued to go down in value since then. And they will continue to worsen as the 10 Year yield goes higher. At 5% or higher, it's gonna be a mess. That could be the 'break' the Fed is waiting for to stop raising or start cutting or injecting liquidity. 

3. The third reason is more nuanced. The Fed is a non-partisan body. They are considered 'independent' and don’t want to be involved in politics. Keeping rates high in an election year pre-election is bad for the economy and therefore bad for the incumbent President. Therefore, historically the Fed tends to back off any tightening campaign during a presidential election cycle and even occasionally is known to juice the economy (inject extra liquidity/money).

Federal Reserve Chairman Jay Powell is also said to be aware that the risks of a mistake are high but views the bigger danger as not doing enough rather than doing too much. And he is said to believe that he and his colleagues must ignore the political calendar in their decision-making.

Either way, the clock is ticking. The Fed needs prices and inflation to come down fast and everything Team Biden is doing is working against that.

So where do we go from here?

The Fed has already tightened harder and faster than most expected.

Not that long ago, market predictions were for the Fed to cut 100 basis points (1%) in 2023. That got pushed back recently to 2024. And now in recent weeks, they've predicted the Fed will only cut 50 basis points in 2024. That's a huge shift. If true, interest rates will stay high throughout the election.

If inflation is the only focus of the Fed, it's probably the right move. So many bad things can happen if inflation re-ignites and becomes 'entrenched'.  It creates a vicious cycle of more inflation that becomes that much harder to combat in the future.

However, the Fed also has to balance other factors - like unemployment, insolvent banks, overleveraged companies and individuals. So keeping rates high enough and money tight enough to tame inflation is easier said than done.

Eventually, the Fed will give up its battle against inflation. Keep reading to find out why.

The Fed is Caught Between a Rock and a Hard Place

By Summer of next year, the Fed is going to have to choose between inflation or growth.

In a highly leveraged (too much debt) world, high interest rates are a killer. In the last 15 years we’ve added trillions in debt to personal, corporate and government balance sheets.

That debt has to be repaid or rolled over (refinanced) at higher rates right now. If rates stay high enough for too long, many of the companies that thought they could refinance at low rates will not be able to pay back their debt and will go bankrupt.

The same goes for some governments around the world, and plenty of consumers also facing higher mortgages, credit cards and auto loans. As companies go out of business, unemployment goes up and forced sellers enter the real estate marketplace driving real estate prices lower. This becomes a vicious cycle that eventually produces deflation (the decline in overall prices). Deflation makes debt even tougher to pay back (money shrinks, debts stay the same or go higher).

The Fed is also deathly afraid of deflation because they know there is too much debt in the system. They will want to avoid that scenario at all costs. Right now there is a real risk of a ‘debt spiral’. Higher rates means it becomes more expensive to finance our annual deficits and total debt. We pay more in interest (think of a credit card with higher minimum payments) and those additional interest payments means our deficits get bigger.

A debt spiral is a situation where a borrower takes on new debt to pay off existing debt, creating a cycle of borrowing that becomes increasingly difficult to break. As debts mount, the cost of servicing them—paying interest and principal—rises, often outpacing the borrower's income. This can lead to higher interest rates as lenders perceive greater risk. If the borrower can't reduce or manage the growing debt, they may end up in default, which can exacerbate financial difficulties. This downward spiral can affect individuals, businesses, and even governments, leading to severe economic consequences.

However, right now, inflation is the current problem. To avoid deflation, the Fed will eventually have to cut and inject liquidity (print more dollars). They may have to do the same if the 10 Year Treasury bond starts trading at 5.5% or higher which would choke off economic growth.

Either way they move, inflation will come back as more dollars are put into the system.

In other words, there is no easy solution. The Fed will have to choose between some inflation, or deflation. Deflation destroys high leverage economies like ours. Therefore if the choice is between inflation and deflation, the Fed will choose inflation every time. The trick is going to be timing when the Fed makes that pivot.

As long as rates remain high, we can expect a brutal recession at some point. Not this garden variety subtle recession/stagflation that we are seeing now. Once the recession hits and becomes obvious, the Fed will eventually have to cut rates and add liquidity even if inflation has not reached their target 2% level. This will set off an additional round of asset inflation that will be good for investors and those with savings, and harsh for the middle and lower class who can barely afford gas and groceries as things currently stand.

Each time the economy almost collapses, the Fed is forced to make bigger and bigger moves in order to stave off deflation/collapse, and that produces other bubbles that are destructive in the long run as well.

After the tech bubble burst, they cut rates to zero and kicked off the Housing Bubble that became the Great Financial Crisis of 2008.

In order to stave off the GFC, they had to inject trillions and bail out the banks. The total numbers then we’re smaller than what they did in 2020 with the Covid Pandemic.

If the Fed keeps rates too high for too long, the amount of money they will have to inject to kickstart the economy and/or keep rates low will be even bigger than the GFC or Covid Pandemic.

At some point soon, it becomes unsustainable.

Next letter we’ll dive into the 10 Year Treasury Bond and I’ll give some advice on how to position yourself for the coming turbulence. 

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