Investors are Losing Faith in the Fed (and Rightly So)
When it comes to raising or lowering interest rates, the Federal Reserve is not in control. They only have the appearance of control.
External factors shape the Fed's course of action... and sometimes force a course of action whether they like it or not.
This is why persistent inflation pressures are a problem. Wall Street wants the Fed to cut interest rates. Fed Chair Jerome Powell also wants to cut interest rates. But because of persistent inflation pressures against the backdrop of a still-strong economy, the Fed has to hold off.
And if inflation pressures persist for long enough, they may even have to raise rates again.
Soft landings are rare — and incredibly hard to pull off — because the balancing act is so tricky.
If the Fed cuts interest rates prematurely, "sticky" inflation can become entrenched or even accelerate. If that happens, inflation expectations (the belief that prices will continue to rise) can become a self-fulfilling prophecy, at which point the inflation problem is worse than before.
If the Federal Reserve waits too long to cut, however — the current federal funds rate is at a 23-year high — the hidden stress effects of high rates can eat away at interest-rate-sensitive areas of the economy, creating the potential for a sudden sharp downturn in housing or manufacturing or autos and the like. If that happens, a hard-landing recession or even a financial crisis can materialize out of the blue.
There are no safe stances here: Whatever path the Fed chooses, including the path of doing nothing, has the potential to be a mistake.
The debt-and-deficits situation further complicates the picture.
Heavy debt issuance (via record budget deficits) increases the volume of net treasury supply: The government has to issue large quantities of newly minted U.S. Treasuries at auction on a monthly or quarterly basis to fund its ongoing spending needs.
If, at some point, net treasury supply exceeds demand by a large amount, interest rates at the long end of the curve can spike as bond prices suddenly fall (interest rates rise when bond prices decline).
Picture a shockingly low-demand U.S. Treasury auction creating a sudden interest rate spike in which the 10-year yield rockets to 6.0% or even (per JPMorgan CEO Jamie Dimon) as high as 8.0%.
When it comes to the path of short-term interest rates, then, the Fed has choices it can make — and yet the Fed is more like the conductor of a speeding freight train than an entity with real control. The conductor can throw levers, but a 20,000-ton freight train, barreling down a track, will do what it is going to do.
In brief this explains why we are so bearish on stocks. It is largely a function of nosebleed-level equity valuations coupled with extremely dangerous macroeconomic conditions.
As value investors like to say, "good things happen to cheap stocks," meaning that a stock that is cheap (in terms of valuation) can benefit from a wide array of upside surprises.
But the opposite also applies: "Bad things happen to expensive stocks," in the sense that an overvalued stock with irrational expectations built in can get the daylights hammered out of it for a slight misstep (witness ARM and SMCI in recent weeks).
At yesterday's post-meeting press conference, Fed Chair Powell tried to maintain an optimistic tone, but clearly hedged his bets.
Powell wants to get on with interest rate cuts... but the data is holding him back.
And Powell really, really wants to rule out an interest rate hike... but he can't rule one out entirely.
In this sense the inflation data is in control, rather than the Fed.
That in turn means factors like geopolitical impacts on the oil price or a sudden deterioration in the housing market could have more to say about whether the Fed cuts interest rates — or feels forced to hike them — than the Fed itself.
And historically expensive stocks, meanwhile, are still broadly priced for a probability space where everything is magical and wonderful, and everything works out perfectly.
This looks like a serious probability error.
Say the odds of things continuing to go perfectly are one out of six... whereas there are lots of ways for something bad to happen given the precarious nature of things: interest rate spike, rapid-onset hard landing, housing market implosion, metastasizing CRE crisis, the "trough of disillusionment" swallowing the AI narrative, et cetera.
In this sense, betting against equities (shorting them) is like siding with the five-out-six probability (83%) versus the one-out-of-six (17%).
The major indexes, meanwhile, are potentially setting up for new downtrends.
The Nasdaq 100 and the S&P 500 have both corrected below their respective 50-day moving averages and retraced toward 20-day moving average resistance, while also completing 20-day versus 50-day downside crosses (the orange and green lines, respectively, on the charts below).
Per the usual, price is a guide here: If the Nasdaq and S&P 500 resolve their current bear flag patterns by breaking below this week's lows, we will likely go short with a risk point above recent highs.
Until next time,
Justice Clark Litle Chief Research Officer, TradeSmith
TradeSmith is not registered as an investment adviser and operates under the publishers' exemption of the Investment Advisers Act of 1940. The investments and strategies discussed in TradeSmith's content do not constitute personalized investment advice. Any trading or investment decisions you take are in reliance on your own analysis and judgment and not in reliance on TradeSmith. There are risks inherent in investing and past investment performance is not indicative of future results.
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