One question I have been getting asked a lot lately, usually by older, more experienced investors, is “How does this all end?” They are referring to 0% rates, years and years of QE, surging asset prices, etc. And my response is always the same: “It will end the way it always ends: The Fed will kill it.”
What I mean is that eventually, the Fed will remove accommodation and it will hike rates to the point where it chokes off economic growth, just like it did in 1999/2000, 2005/2006, and 2018. The question, of course, is when the Fed accomplishes that goal, and over the past week or so the bond market has implied it might be sooner than people think. And it’s been a familiar and reliable indicator that’s signaled this mild uptick in future Fed policy: The 10s-2s yield spread.
The 10s-2s yield spread has declined more than 10 basis points over the past week, down from the recent highs of 120 basis points. There’s only one reason that’s happened, and it’s because the market is pricing in the greater possibility the Fed has to aggressively hike rates to combat inflation. Put more plainly, the longer inflation stays high, the greater the chance we eventually get to a point where the Fed 1) Needs to quickly accelerate the tapering of QE and 2) Has to quickly raise rates to combat inflation. And as crazy as it might seem for those of us who study markets, there are a lot of people working on Wall Street and in banks that have never seen a 50-basispoint rise in rates at a Fed meeting. That used to be not uncommon at all!
Now, this isn’t about tapering, at least not directly. But if the Fed decides to taper at a faster rate than $15B per month, then markets will rightly assume the first rate hike could come a month or two after tapering ends. In the case of tapering of $30B/month, tapering would end in March/April, which means our first rate hike could be June, six months earlier than expected. And if inflation is still very hot, there’s no reason that first rate hike can’t be 50 basis points!
Now, to be 100% crystal, I do not think that’s what’s going to happen. The very mild flattening in the curve is not a reason to reduce equity exposure. But the 10 basis-point dip in 10s-2s is a reminder that eventually rates will rise to a level that kills the expansion, and the longer inflation stays elevated the greater the chance the Fed has made a policy mistake by letting inflation run too hot, and it will have to correct it, and that only happens one way: Through violent rate hikes that will cause significant market volatility.
Again, it’s premature to worry about that right now. For now, the facts say that rates rising to a level to hurt the economy are still a long way off (so stocks have more room to run). But over the coming months we’ll continue to watch the yield curve closely, and if it flattens further and signals that the market is becoming very worried about large Fed rate hikes in 2022, we will tell you loudly and clearly, because that will absolutely be a risk-off event.
A couple follow up questions I have been getting...
Follow-Up Question 1.
Up till now your tone had been mostly that the medium- and long-term outlook for stocks is positive. Doesn't this contradict that? Has your outlook changed for stocks in the medium and long term? Or is it dependent upon the inflation data. Meaning: if inflation continues to be stubbornly high then the outlook has changed?
Answer: No, this doesn't represent a change in my positive medium-term outlook. Instead, I just wanted to take the opportunity to point out that 1) Watching the yield curve is still important and 2) It will tell us when this is going to end, so you can count on me to keep an eye on it.
You’re right about inflation. If it stays this high (or keeps going) that will change the Fed’s tapering schedule and rate hike process. But we’re still a ways off from that and it’s not a guarantee to happen. Inflation could well recede in early 2022, and if so then “How This Ends” is likely years away.
Follow-Up Question 2.
Can you address what is more important to the "end of the rally." What will carry the most weight as a catalyst for the "end": tapering, rate hikes or the withdraw of liquidity via balance sheet reduction? The markets reacted to tapering and rate hike but did not truly rollover until Q4, 2018 - the most famous auto-pilot rate increase quote and continued balance sheet runoff. It seems like the markets were able to deal with the rate increases and tapering but the liquidity withdraw was the real issue?
Answer: To your point, if past is prologue, then tapering of QE shouldn’t be an issue for markets. After all, tapering QE still means adding QE each month, we’re just adding less. Similarly, with the Fed funds rate at 0% and considering it’s unlikely to be above 1% until well into 2023, rates by themselves will have to go much higher to trigger a loss of economic momentum (Fed funds got to 2.25% - 2.50% before it was “Too Much” for stocks).
But to your point, balance sheet reduction is, in my view, essentially like “additional” rate hikes. So, if we see the Fed still concerned about inflation in late 2022/2023, we could easily see a situation where the Fed is raising rates and letting the balance sheet decline, and at that point I’d expect the clock would be “ticking” on when they got too tight.
Now, please don’t take that late 2022/early 2023 as a hard prediction. I’ll have to see what happens with inflation over the coming quarters. But my only point is that this is not like last time, where inflation was very low and that gave the Fed plenty of leeway to not reduce the balance sheet and to gradually hike rates. This time, inflation is very elevated so unless it falls very steeply, something I think is unlikely, then we are looking at a more aggressive tightening cycle this time around, so we’ll need to watch it carefully next year (which of course I will do).
And remember – the one fact pertaining to all conditions is that they will change.
Let me know if you have any questions or comments.
Kurt S. Altrichter, CRPS®
Fiduciary Advisor | President