Federal Reserve playing chicken with financial markets

The game of chicken, learned by most teenagers, provides a reasonable description of current financial market conditions.  The Federal Reserve is playing chicken with financial markets.

Usually the game of chicken determines a winner by whoever "blinks" first.  In this case, there can be no winner, at least long-term.  In order for the Fed to win, it must crash markets.  In order for markets to win, they must call the Fed's bluff.  The twist in this game of chicken is that the American people lose regardless.

If the Fed "wins," inflation presumably comes back under control, but market values destroy the retirement assets and jobs of many.  If markets win, inflation continues to destroy the standard of living of all.

Obviously, this game involves a third party who never intended to play: American citizens.

Where Do We Stand Now?

Another rate hike of 0.75% this week by the Federal Reserve.  The dollar, because of higher interest rates, is strong against other currencies, but financial assets are weakening.

Everything was down (red) this week and seriously so!  Since the closing prices of July 26 (the day before the first of three rate increases), all tracked securities are negative and becoming increasingly so.  Markets reluctantly believe that Powell means what he says.  

Hit hardest was TLT, the 20-year Treasury Bond ETF (bond prices move inversely to interest rates).  Suffering the least (although not by much) was GLD, considered a hedge against inflation.  (That is not unusual at this stage of an inflation battle because of the strengthening of the dollar versus other currencies.)

Do Markets Fully Believe Powell?

When Powell began hiking rates, he had little credibility.  As the rate hikes continued, credibility improved, but still does not reflect his promises.  Markets seem to believe what he has done, but not what he has promised.

This presents a danger, because markets do not value based on history but on expectations.  As yet, they do not believe Powell's promise to stop inflation!

My opinion derives from prior fights against inflation.  The table below summarizes these:

From this information, if the Fed is truly as serious as Powell claims, they have just begun the rate increases!  In all instances above, the real rate of interest (defined as the interest rate minus the inflation rate) had to go positive in order to stop inflation.  In most cases, a real rate of at least 3% was required.  Assuming inflation is 8 or 9% today, that means the Fed would have to raise interest rates to 11 or 12%!  If so, this battle (and the market casualties associated with it) has just begun!

If markets truly believed Powell, they would be at much lower levels than they are.  That they are not suggests Powell is still incredible in his claims/threats.  Stocks could easily be 50% (or more) lower than current levels if markets suddenly believed Powell.

Current market valuations reflect Fed actions, not Fed intentions.  They are pricing what has already happened, but not what was promised.  If markets truly believed Powell, they would adjust before his promised rate hikes and likely drop another 50% in value!

Markets are anticipatory in valuations.  Prices are determined by expectations, not history.  Powell's promises and current market values are inconsistent with one another.  Does Powell blink?  Will market participants eventually believe him?  These are the critical but unknowable questions.

Each rate hike boosts Powell's credibility.  He does not have to get to his promised stopping point for market valuations to reflect his implied level of interest rates.  But he has to get to this level to control inflation!

At some point, markets believe or disbelieve Powell.  If they believe him, look for at least another 50% down from current valuations.  If they disbelieve him, look for stagnant or slightly declining valuations from here.

Each rate hike influences more investors to believe in Powell's seriousness.  Another one or two increases could cause markets to crash.  Or they could crash before the next scheduled Fed meeting if markets assessed his promises/threats to be real.

More believe in Powell's sincerity than before his July 27 rate hike.  And more believers have come on board with subsequent rate increases.  Market performance this week suggests a large swing in the fear that Powell is serious.  Market sentiment shifts in herd-like movements, suggesting that major valuation changes could occur prior to the next scheduled Fed meeting.

Markets are likely to continue to decline for two reasons:

  • More people see the losses in their personal portfolios and want to stop the pain.
  • More investors decide that Powell's fight is credible.

We lived through several years of "panic buying."  We are near or already in a period of "panic selling."

Until now, markets appeared to be reacting rather than anticipating.  If markets finally agree with the Fed's stated intentions, they could drop another 50% or more from these levels before the next meeting.  It is easy to see a selling panic happening!

Is Powell for real?  I don't know!  I know there is something strange regarding his recent behavior (as mentioned in a prior post).  Michael Snyder ends his recent piece with this:

[W]e are eventually headed for a meltdown of epic proportions.

But instead of working to prevent a historic crisis, the Federal Reserve is actually encouraging one.

The American people deserve some answers, because there is something about all of this that really stinks.

Perhaps there is more going on than is obvious.  However, that subject is a different post.

Monty Pelerin blogs at Economicnoise.com.

Image: Public Domain Pictures via Pixabay.

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