- It’s nearly impossible to absorb financial news recently without a heavy dose of speculation about what the Federal Reserve is or isn’t going to do with short-term interest rates, what that means to markets, and blah blah blah. It’s as if we’re children looking to a temperamental parent’s emotional state to see how things will go. This makes us all forget the unexpected gift that started the year: there was extreme stock buying and a significant market run-up for the first six weeks of 2023.
We’re also forgetting our base thesis and expectation that the first half of this year wouldn't provide much growth from a market standpoint. Rather, we would have to be patient as the second half of the year would be more likely to provide a path to gains.
While there's nothing wrong with following the news, what investors need to realize that this is not your father's monetary policy at work. Focus must instead be on the M2 measure of money supply. We’ve said this before, but it bears repeating due to its importance, especially when market action makes people freak out. Throughout Covid, the money supply grew at an unprecedented clip:
From Scarce to Abundant
What do we mean by “your father’s monetary policy”? Let’s examine some history.
Prior to the 2008-09 financial crisis, the Fed implemented monetary policy in two general ways. One was buying Treasury securities from banks to add reserves to the banking system (i.e., loosening). The other was selling Treasuries to banks to drain reserves from the system (i.e., tightening).
Why would the Fed add or drain reserves?
So that banks would actively trade amongst each other on an overnight basis to meet regulatory requirements. By adding or draining reserves, the Fed could influence the interest rate banks would charge each other to comply with regulations. Thus, that interest rate was highly sensitive to Fed decisions. This system was called the “scarce reserve” model for monetary policy. It was in place during the late 1970s and early 1980s – a period often cited by recent media reports as comparable to today.
But then came the aforementioned financial crisis. The “scarce reserve” model was abandoned in favor of an “abundant reserve” policy in which the Fed flooded the banking system with more reserves than banks need. As a result, the Fed made those reserves valuable only by paying banks interest to hold them.
Now banks no longer scramble to acquire reserves to meet legal requirements based on their deposits – they only want deposits if the Fed pays them enough interest. This system is in place today and the Fed is paying financial institutions about 4.65% interest, which is likely to increase.
This means short-term rates are effectively set by government decree. The market-based process of banks trading reserves no longer exists. The result is investors are too focused on short-term interest rate edicts when they should instead look to the money supply (like we’ve been saying).
The M2 measure of money supply soared 40.4% from February 2020 through February 2022:
But in the last 10 months, it’s declined 2.3%:
We have never experienced the Fed trying to fight inflation under an “abundant reserve” regime. We've also never seen the M2 money supply grow so fast for so long and then decline so rapidly.
Thus, this isn’t your father’s monetary policy at work. There is no comparable history to guide us. Our current policy is different than anything in the first 200 years of America’s existence, and it’s created many disconnects.
Today, the futures market is pricing in three more short-term interest rate hikes of 25 basis points each. That forecast is perfectly reasonable. It’s also merely a guess on how the Fed’s edicts may change.
At Cornerstone, we’ll be focusing on the M2 money supply data for January 2023, which will be released tomorrow. It will reveal if the money supply continued to drop, which is what truly matters.
The unprecedented “abundant reserve” policy is why anything on the financial news right now is an educated guess, not a definitive solution. Semi-informed guesses are the best anyone can do because we don’t know the answer to a key question. That is, has the lifting of interest rates slowed the money supply, or do rates just happen to be higher? It matters because monetary policy hits the economy with long, variable lags.
So, there’s “mounting confusion about what lies ahead” as the investment landscape seems about as mixed and garbled as one could imagine, with conflicting data and fragmentation. Why? Well, it’s because of the disconnect emanating from different monetary policies. The gulf creates two extreme points of view – one bearish, one bullish.
The Bear Growl
Bears point to an inverted yield curve, hot housing components within the consumer price index (CPI), lower oil prices, negative manufacturing data, record household credits, and so on. The one-year CPI rise reflects this:
It’s widely understood that the consumer drives U.S. gross domestic product (GDP). To be sure, consumer spending was nothing short of “spectacular” last month. However, there is hard data implying another story.
Last month consumers poured money into new cars, travel, hospitality, entertainment, and most anything else. Retail sales reports showed consumers spending freely, despite ongoing inflation pressure. Every sales category had a month-over-month increase, led by a 7.2% surge in sales at food services and drinking establishments:
This caused consternation in the market as investors feared the data would convince the Fed it needs to push harder against inflation in an effort to “break” economic spending. The retail spending surge seemed to say, “Forget inflation. It’s full spending ahead. Life’s too short.”
Others may call it “whistling by the graveyard,” arguing that consumer behavior was corrupted with excessive stimulus and relief during the pandemic. In other words, there’s a prevailing feeling that when the “stuff” hits the fan, consumers will stop paying rent, let purchases be repossessed, and wait for another government bailout, leaving credit card issuers to deal with the mess.
This is a tongue-in-cheek exaggeration, of course. But there’s some hard data corroborating the sentiment. Specifically, the Federal Reserve Bank of New York’s household debt and credit report from Feb. 3, 2023, showed significant consumer debt increases from last quarter:
- Mortgage balances up $254 billion
- Credit card balances jumped $61 billion
- Home equity lines of credit rose $14 billion
Perhaps more importantly, the same report showed the current share of debt transitioning into delinquency increased for nearly all debt types.
The Bullish Stance
On the other hand, the bulls would point to their own supportive data. For example, the air is coming out of the housing bubble (see chart below) and typically lags other economic data by 6-12 months. Similarly, the spike in household debt will naturally relieve inflation as people realize they have less money and must live within their means.
The bulls also foresee reversals in markets and interest rate trends. They argue that since more than 58% of Americans own stocks in some form, when the market recovers there will be significantly more buying power available to pay debts.
Plus, bulls say anyone over age 60 can recall the mid-1980s, when new home buyers were overjoyed as mortgage rates dipped below 10% for the first time in a decade. Meanwhile, today's rates in the low to mid-7’s are treated like the plague because most new home buyers since 2008 have been living in a low-rate bubble created by quantitative easing.
The bullish crowd also considers the Fed’s 2% inflation target unrealistic. From 1960-2021, inflation fluctuated, averaging 3.8% annually (see chart below). During that time, the stock market managed to do just fine as household wealth grew, real estate appreciated, America prospered, and jobs were plentiful.
Where Does This Leave Us?
The two sides of the coin are quite different. Yet, the polarized debates on the economy, earnings, consumer health, price-to-earnings valuations, and more, will rage on because there is no consensus due to a monetary policy stance that lacks any historical context.
As we pointed out a few weeks ago, this situation will continue to foster ongoing volatility in the short- and intermediate-term until more data sheds light on economic conditions in the second half of the year. Like clockwork, the Big Money Index (BMI), which is a 25-day moving average of “big money” investor activity created by our friends at MAPsignals, began to dip from overbought territory as buying slowed and a new downward trend emerged:
So, the recent softer price action shouldn’t be a surprise as the market needed a breather to consolidate. But remember, we were given an unexpected cushion to start the year with the initial six-week run-up of the market that nobody saw coming (including us). See what we mean about forecasting the future being difficult?
That said, when you have good stocks in your portfolio, sitting tight during short-term volatility and market consolidation is a great plan of action. We were given a gift to start the year. Sometimes – like now – it pays to just show some patience.
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