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‘‘Within our mandate, the ECB is ready to do whatever it takes to preserve the EUR. And believe me, it will be enough.”
- Mario Draghi, July 2012
''We will keep at it until inflation is down to 2%. And our monetary policy tightening will be enough. It will be enough to restore price stability.''
- Jerome Powell, September 2022
The September Federal Open Market Committee (“FOMC”) meeting was hugely important and the implications of it will affect just about every person on Earth. The Federal Reserve hiked rates by another 0.75% - but as usual it was the fine print and footnotes that matter more.
For instance, did you notice the similarity of the two quotes at the start of this note? They date more than a decade apart but they essentially are the same message. Draghi, then the European Central Bank chair, and Federal Reserve chair Powell’s parting words at the press conference on Wednesday, have similar syntax and tone.
Draghi’s speech has been dubbed the “whatever it takes” speech. There, he said he would do whatever it took to stabilize the European sovereign debt market. His words alone had a profound effect on that market and “fixed” it almost immediately – without him ever having to buy a single bond.
Powell’s intent was to do the same – except his objective is to combat inflation. The most recent inflation reading came in at +8.3% [headline], the highest since March and before that, since 1982. The Fed has a very difficult job on their hands. They needed to stimulate the economy after the Covid shutdowns, but they pushed the engine too hard and for too long (along with other global factors contributing to higher prices) before they attempted to take off the extra power.
Now we are dealing with the ramifications.
Many of our clients are old enough to remember the last time this happened 40 years ago. Inflation in the late 70s and early 80s was this high. The Fed chair at the time, Paul Volcker, pushed rates as high as 17%!.
The parallels are important. Soon after Volcker hiked rates sharply in 1981, inflation rolled over. He then swiftly cut rates back down. However, he did so too soon and the inflation flame stoked back up. This occurred many times with Volcker cutting back too soon and having to reverse himself pushing rates back up. This meant that it took 3-4 years for inflation to finally have been squashed.
Powell understands this and will not want to fall into the same trap of cutting too soon. He will have to raise the real Fed Funds rates above 1% for a convincingly long period of time. A real Fed funds means the interest rate the Fed controls will have to be +1% AFTER accounting for inflation.
Today, the Fed Funds rate is 3.25% and “core” inflation is +6.3% so the real Fed Funds is currently -3.0%. We have a long way to go. Powell needs inflation to come down another 4% or to push up Fed Funds by that amount (or a combination thereof). And then leave it there for some time in order to not see inflation just flame back up.
We are getting into wonky territory here and I apologize but this needs to be understood as I noted this has a profound effect on all financial assets.
What does a real Fed Funds rate of 1% actually mean?
Long story not so short, it means financial conditions will get far tighter than they are today. It means getting a loan or approved for a credit card will become more difficult if you are a marginally-rated borrower. It means the money supply will contract – after growing by nearly 40% over the last two years!
What it really comes down to is that Powell needs to send the US economy into a recession. A recession is something all clients understand, including the ramifications. It means stocks go down, jobs get lost. Pain all around.
A recession, by definition, is deflationary. And he needs deflation in order to smash inflation. That is the only way to reduce inflation back to the 2% target. As Powell said in our opening quote, he will do whatever it takes to squash inflation.
When we enter a recession and prices come down, Powell will take interest rates back down – perhaps as low as zero again.
The implications of all this mean we continue to hold reduced exposure to risk assets and continue to focus on high quality investments. Yields today on investment grade bonds are comfortably above 4.50% for the first time in 15 years. Some investment grade bonds are paying upwards of 5.5%. A year ago we couldn’t even buy some junk rated debt for 5.5%.
Reduced exposure doesn’t mean no exposure. We will never make a binary call and ‘get out’ but can make adjustments around the margins including reducing duration (interest rate risk) or credit risk (risk of default). And we have reduced our tech exposure earlier this year and continue to be underweight as a defense mechanism against rising interest rates.
We will continue to keep our clients informed on our thinking on the markets and the ramifications for their portfolios. We appreciate the trust you place in us.
As always, if you have any questions or concerns, please do not hesitate to contact me.
Mark Asaro, CFA
Noble Wealth Management
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