The Economy is "Running Into A Wall" Now
Stagflation Fears Will Cause Volatility Until March
Excerpted from Sunday January 30th GoldFix Weekly Report: Next week companies will resume stock buy-back programs. This, now that the Fed is done, should underpin any strength we get for the next few months. Volatility, to the extent we get it, will be an expression of doubts on that.
To the extent we have continued volatility like last week, we feel it will be largely a manifestation of the increasing fear that the Fed is on the horns of a dilemma. Raising rates is increasingly looking like a policy error. Not raising rates is very seriously looking like an inflation problem.
The Fed just cannot afford to have to abandon rate hikes at this time. They must quell inflation. BUT: the fed must also be able to ease rates in the near future to keep pace with China. Recall last week:
Zerohedge has written on this repeatedly since the yield curve started its journey to flat in November:
Between now and when the Government actually does something, markets are going to do what they do. Traders are going to make things look emotional. Either the Fed solves the problem, the markets solve the problem (forcing the Fed hand), or politics dictates a bad solution. But for now, it is worth looking briefly at what we mean by some of this.
Bearish Flattening Says An Error is Coming
We frequently talk of Bond yields as if they are on a see-saw. Here’s a little more of that concept for your reading “pleasure”. The following chart depicts the difference in yields between the shorter term bond market and the longer term bond market. What matters almost as much in this chart as the actual level is the direction of the arrow.
This particular chart takes the 10 year bond yield and subtracts the 2 year yield from it. The difference is the value on the chart.
In general stocks go up when the yield difference is rising. Stocks go down when the difference is dropping. Upwardly sloping is good for stocks. Downwardly sloping is bad. But there are other factors not shown that determine how bad they are and why they are bad. That’s where our see-saw comes back in.
A downward sloping line ( 2 year dropping relative to 10 year) as we currently have combined with a "see-saw effect" ( right side dropping with left side raising and fulcrum stable) is indicative of the market not liking what the fed may be doing next.
Inverted Yield Curve Depicted
In the current environment the bond market is telling us that when the Fed raises rates as they have stated they likely will, will be like cutting off oxygen to a winded sprinter. It will be slowing down an economy that is gasping for air.
Conversely, if the fed doesn’t raise rates, it will be propping up the economy, but also seriously risks a re-ignition of major inflationary pressures. Like our sprinter getting that amphetamine shot and possibly running into a wall. It happens. Economies juiced on easy money eventually hit a wall of diminishing returns as too much future potential is discounted in current stock prices. This happens even if the long bond yield is kept artificially low as many think they are now. We discussed this in our comment on duration risk in 'Growth Stocks More Vulnerable From Here' Goldman Sachs two weeks ago.
Inflation is Bad...
Taken with other asset prices, particularly stocks, the Bond market term-structure is pretty reliable, and frequently answers the question on the inserted chart above: "Why Are Stocks Doing What They Are Doing?"
Right now the curve has been chronically getting flatter. Our see-saw is almost completely flat. It has gotten that way by the short term bond yields going up AND the long term bond yields going down. The fulcrum is essentially unchanged. This is a “bear- flattening”.
In plain English: The market thinks short term rates will go up to stop inflation. The market simultaneously thinks that raising those short term rates will risk a major recession down the road. So long-term rates drop. What is done now may have to be undone very soon afterwards. This is stagflation risk personified.
The only way out of it should it manifest, is to either cause a massive recession (asphyxiate the out of breath runner) like Volker did in 1980 and reboot things after a crash. The other extreme is ignite inflation ( kill the runner with amphetamines) like Nixon and Carter did between 1972 and 1980, before Volker/Reagan and then reboot after a crash. Note that an error usually leads to painful cures.
Market seriously thinks the Fed is messing up if it hikes now
Right now the markets as a whole are saying 3 things:
Bonus: If the bond curve inverts (see-saw up on short end more) then SHTF.
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