The Federal Reserve starts its two-day meeting to discuss what they will do what we all know they will do: raise the target Fed Funds rate by 75 basis points.
Investors everywhere examine the inflation, debt markets, and past statements on monetary policy. Economists debate the issue. Ultimately, it’s a game theory problem, and the solution investors have voted for is higher rates.
Going into this meeting, we see there is an 82% chance of a 75 basis point increase in rates and an 18% chance of a 100 basis point increase. In our experience, we see the Fed do what is reflected in market prices, so we expect the 75 bps.
With inflation out of control, investors are finally demanding higher rates as compensation for the loss in purchasing power. We can only say, “took’em long enough.” At the same time, we still think the Fed is behind the curve. After this rate increase, the effective Fed Funds rate will fluctuate between 3.00% and 3.25%. But look where 1-year Treasuries are trading, 4.05%. This tells us the market is doing the heavy lifting for the Fed, and they are following its lead. As another data point, 3-month T-Bills yield 3.37%.
Rising rates will continue to put pressure on equity prices. Higher rates mean the intrinsic value of cash flows is lower. The math is straightforward. Technically, stock prices are discounting higher rates (and a slower US economy). Our interpretation is that the S&P500 is heading down to $3,400 level.
Market pundits are fighting the trend as they are quick to say the bear market is over every time there is a bounce in stock prices. But we do not think they are being realistic. Stock prices got way too high because of a $5 trillion spending binge by the Federal government and the money printing that temporarily covered up the cost. We are now seeing the cost through higher prices.
This is the US story. The European economy and politics are not on US investors’ radar screen. They are having massive demonstrations on a daily all over the continent. It has been going on for months, and none of it shows up on the nightly news. The EU is bankrupting farmers by telling them they can no longer use fertilizer. Is this incompetence, or is there something more nefarious at play?
Europe’s economy is in a full-blown implosion. The causes are many, but the big ones are negative interest rates bankrupting pension funds, and retired persons. It hammered anyone who was a saver as well. They underwent money printing that exceeded that which we experienced in the US. So they have all the fuel they need for super high inflation.
Energy policy is another reason for their economic implosion. The EU pressured all their member states to shut down their nuke plants and stop developing domestic sources of oil and gas. But they did not say, “stop using oil and gas.” They simply decided to depend on Russia for their energy. That has turned out to be a really dumb idea.
If and when stock prices get down to the $3,400 level, it is important to recognize that this just takes prices back to 2020 levels, just before the lockdowns took place. Said another way, it is just taking back the C19 bubble premium.
We hope people reduce their risk by reducing exposure or hedging with options strategies on index ETFs. This is no time to be complacent.
