What Are The Markets Getting Wrong?

Authored by Michael Maharrey via SchiffGold.com,

We’ve talked about the recent selloff in gold. On the other side of the coin, the NASDAQ has made a string of 52-week highs. What is driving these market dynamics?

The Fed.

The markets generally believe that the Federal Reserve is finished hiking interest rates, or at least close enough to being done that a rate cut is on the horizon.

And they’re wrong.

In the short run, we may well see one more rate hike in June. The Fed has ratcheted up the hawkish talk. But in the long run, even if the central bank delivers another 25 or 50 basis points of hiking, the thinking is that the tightening cycle is 90% complete. That means more of the easy money drug will be coming soon.

Tech investors are anticipating that the next round of easy money will be just as good for tech stocks as the earlier rounds of quantitative easing.

The markets also seem to believe that inflation is going to come down. They expect the same Goldilocks environment that the tech stocks were operating under for the last decade or more. In other words, an accommodating Fed, cheap money, low interest rates and relatively low price inflation. That’s the environment these more speculative tech stocks need to justify their valuations. It’s not the earnings that will power them, nor the dividends. It’s the momentum of money chasing them. And that is a byproduct of monetary policy.

The markets are getting it partially right. The Federal Reserve is likely getting close to the end of the tightening cycle. They are also correct in thinking a recession is on the horizon — another reason the markets think the Fed will start cutting rates again sooner rather than later. But they are wrong to think this recession means a return to 2% inflation.

It doesn’t.

The next recession will likely be the catalyst for a dollar crisis and a resurgence in consumer prices.

Ultimately, we’re talking about stagflation with rising CPI coupled with and tanking economy. This is an outcome virtually nobody is prepared for.

The disconnect seems to be that Fed officials and economists in general think the looming recession will be relatively mild.

After the May FOMC meeting, Powell still insisted the Fed could get price inflation to the 2% target and bring the economy to a “soft landing.”

Blue Line Futures chief market strategist summed it up this way.

The tough pill to swallow is that the US economic data continues to come in line with expectations. It shows a greater outcome for a soft landing. At the same time, foreign economic data is coming out weaker than expected. That is why the dollar index is catching a bid right now.”

Bank of America chief US economist Michael Gapen also echoed this mainstream thinking.

In our view, rather than lean against a mild recession, the Fed would view it as an acceptable price for bringing inflation back down to target.”

The markets are buying into this line of thinking.

The question is why should anybody think the recession will be short or shallow?

If a bust is proportionate to a boom, we’re in for one heck of a bust.

The Federal Reserve and the US government pumped trillions of dollars of stimulus into the economy during the pandemic. This was on top of the trillions of dollars it pumped into the economy after the 2008 financial crisis. It held interest rates artificially low for well over a decade. This created all kinds of malinvestments and bubbles in the economy. In a nutshell, the Fed has screwed up everything that is a function of interest rates.

The economy and the markets are addicted to this easy money. That’s why the NASDAQ is getting a boost based on the anticipation of the next rate cut. The addict is looking forward to his next fix.

But over the last year, the Fed has pushed rates to the highest level since before the 2008 financial crisis. While it still hasn’t gotten price inflation anywhere near the 2% target, there is no way that this isn’t going to break things in an economy that depends on a low interest rate environment. We’ve already seen cracks in the system with the ongoing financial crisis. The Fed managed to paper over it with its bailout, but it’s only a matter of time before something else breaks.

When you take away the addict’s drug, the addict goes into withdrawal.

Right now, everything basically seems fine. Sure, we’re seeing some contraction in the economic data. The Leading Economic Indicators dropped for the 13th straight month. But the labor market is still strong (based on the cooked government data) and consumers are still spending (themselves into record levels of debt). Until there is a crisis, nobody is going to believe there’s going to be a crisis. It’s easy to believe that while there might be a recession, it’s going to be short and shallow.

In fact, that is exactly what everybody was saying in 2007.

It’s also important to remember that the 2008 financial crisis happened over a year after the Fed stopped raising interest rates. In fact, it was already cutting rates when the Great Recession kicked off. There is always a lag between changes in policy and the impacts of those changes. Since the Fed has gotten rates to over 5% and nothing bad has happened (if you consider three major bank failures nothing) people seem to believe that nothing bad is ever going to happen.

History tells us otherwise.