Bullish investors had a good month in February 2024. The bears, not so much.
Markets in the US rallied in February, with all major indices hitting record highs. The Nasdaq, S&P 500, and Dow Jones all reached new all-time highs, while the Russell 2000 achieved a new 52-week high. Every industry sector saw gains, with Consumer Discretionary leading the pack (+8.7%), followed by Industrials, Basic Materials, and Technology. Notably, NVIDIA stock surged over 28% in February, adding nearly $2 trillion to its market cap.
Inflation data is still hotter than nearly everyone’s expectation. As a result, the Federal Reserve’s monetary policy stance might concern some people, but the market certainly does not care. Market expectations for a rate cut shifted from March to June are starting to look less likely. The Fed emphasized its data-driven approach, stating it wouldn’t consider lowering rates until inflation shows a sustained decline towards their 2% target. We do not think this is bad like everyone else because there is no need for the Fed to cut rates unless the economy is rolling over, unemployment begins to rise, and/or there is a problem in the banking sector.
To summarize, we think the economy, as measured by GDP and unemployment, is doing just fine. Therefore, there is no reason to cut rates. In our view, that would be unnecessary and probably reignite the flames of inflation, making most people worse off.
Our only concern is that we think people are getting too exuberant. As a result, they are tossing caution to the wind as they jump on board the bull. Situations like this typically end badly, and we suspect that will be the case here as well. When that beatdown occurs is unknown and very difficult to predict as bubbles go on longer than most people think. That said, our gut suggests it is closer than the crowd thinks.
The big rally in stocks has caught many people by surprise. We, however, have not. As we have discussed on these pages and in our videos, we think monetary policy is still loose. Many think that raising short-term interest rates makes money more tight. We disagree; we think the Fed took its foot off the accelerator, attempting to put the economy into coast mode.
History suggests that the YTM on 10 US Treasuries typically trades near the nominal GDP growth rate. When this is the case, investors earn a pretax real rate of return that is about equal to real GDP growth. When this is the case, savers participate in the growth of the economy, as they should. Savings are a virtue and good for everyone in society, as entrepreneurs use those savings to build and grow businesses and wealth. As you can see in the chart above, nominal GDP is still above the YTM on 10-year Treasuries. Ergo, monetary policy is not tight.
Some argue that monetary policy is tighter than most realize because the Fed is shrinking its balance sheet, thus reducing high-powered money, which affects the stock of bank deposits and bank lending.
We can see from the chart above that the Fed is on course to reduce the quantity of assets on the balance sheet systematically. There is talk that they might sell all their mortgage-backed securities and buy short-term US Treasury notes and T-Bills with the proceeds. It’s interesting to see if that happens. Having pushed the price of mortgage-backed securities up too high, thus suppressing home borrowing costs and therefore causing housing price inflation, an unwind of this manipulation is likely to have negative consequences. Market intervention by the Fed and any government causes problems as they force people to do things they otherwise would not do. The pain comes with the unwinding.
There is something else that is taking place, which is funding the Fed’s balance sheet reduction and the US federal government’s deficit. Most people do not know it, but issuing government debt increases the money supply. The only difference between a US Treasury security and a Federal Reserve Note is that the Treasury pays interest, and the FRN does not. The Fed freely exchanges the two when they buy treasures for FRNs. However, private financial institutions like banks and brokers can do the same through the repo market. They sell the securities and agree to buy them back at a predetermined price in exchange for FRNs. They then spend the FRNs as they wish. When they want their bonds back, they unwind the REPO transaction, and they are back to where they started. This phenomenon is making the Fed’s job of bringing inflation down more difficult. With the federal government in no mood to cut spending, we should expect inflation to continue.
Finally, there is one last point we have made. Higher interest rates are putting more cash in the hands of savers. Interest payments are running at a $1.2 trillion annual clip and rising as rates rise and deficits rise. There, investors take their interest payment and buy more bonds or stock. It is rather interesting how government debt creates the cash for the private sector to purchase the government debt.
Data Source: NASDAQ & Federal Reserve
