Yesterday, we watched the tape, wondering which way investors would take the news.
In the morning, the latest inflation numbers had investors’ attention. They showed prices coming down a little.
And in the afternoon, the Fed raised rates by 50 basis points (one-half of a percentage point)…and said it would continue to raise rates until they were at more than 5%. From CNBC:
‘The Federal Reserve will hike interest rates to as high as 5.1% in 2023 before the central bank ends its fight against runaway inflation, according to its median forecast released Wednesday.
‘The expected “terminal rate” of 5.1% is equivalent to a target range of 5%-5.25%. The forecast is higher than the 4.6% projected by the Fed in September.’
What to make of it?
A new era
At first, the inflation data looked like good news — as long as you didn’t pry into the numbers. But a 5% Fed Funds rate was not good news. No matter how you look at it, consumers, government, and businesses are going to pay more to borrow money. And for people who owe, jointly and severally, US$91 trillion, any increase in interest charges is a bummer.
Our hypothesis is that although the new era began more than two years ago — when the 10-year T-bond hit its all-time high — we are still in the ‘hinge’ period, swinging between old and new…hope and desperation…inflation and deflation. Some prices go up. Others go down. People are confused. And the financial news is mostly noise.
But one thing is sure: this new era won’t be like the old 1982–20 era. More likely, it will be the opposite.
Already, the 10-year Treasury yield is nearly six times what it was back in 2020. Where it goes from here, no one knows, but a lot of investors are betting that softening inflation numbers will allow the Fed to soften up too. Inflation could settle into a 4–6% range…they believe, with a Fed Funds rate right in the middle. With no further threat of interest rate hikes, stocks could go up. They are hoping for a repeat of the last 20 years, but with the backdrop of higher inflation and interest rates.
How likely is that?
A record month
We don’t know, but our guess is that there are too many jagged edges sticking out; like trying to make a pet of a porcupine, it will be hard to get comfortable with it.
The federal government is the biggest debtor in the world. As rates rise, so do its costs, while its income goes down. Higher rates reduce economic activity…lowering US tax receipts. And they make it more expensive for the feds to roll over existing debt or borrow more.
Yesterday, we looked at a record monthly deficit for the US Treasury — US$249 billion. That was almost half the money the feds spent. The Office of Management & Budget is still predicting a deficit of US$1.3 trillion for 2023. But it will almost certainly be far worse.
The bigger the deficit, the more the feds must borrow. And the more they borrow, the more they push up interest rates for themselves and everyone else. If lenders thought inflation was anchored at around 5%, they would insist on an interest rate of around 8%, giving them a real yield of 3%. Few stocks or bonds could compete with an 8% yield on a ‘risk-free’ Treasury note. Zombie corporations, unable to roll over their debt, would go broke, and bad debt should be erased.
A cross to bear
In The Wall Street Journal yesterday, for example, was an update on WeWork. Two years ago, we warned that the business model of WeWork was, well, unworkable. But now we see that the financial strategy was unworkable too:
‘WeWork, saddled with expensive long-term leases and more than $3 billion of debt, recorded a negative cash flow of around $4.3 billion between July 2020 and September of this year.’
WeWork’s stock is down more than 70% this year. Its bonds trade at about 50 cents on the dollar. And if a recession is coming, how many renters are going to want WeWork’s fancy desks?
We don’t know that either. But there are thousands of WeWorks, each with its own cross to bear. Too much debt. Too little cash flow. And no way to survive a recession.
Yes, in this hinge period, it’s not inflation that investors have to fear; it is deflation. People always make mistakes. The Fed makes the mistakes worse by dangling cheap credit in front of them…leading them to borrow too much. But markets correct mistakes by crashing prices, bankrupting overstretched companies, and wiping out unpayable debt. That ‘correction’ is not over; it is just getting started.
For The Daily Reckoning Australia