There is no safety, as in times past when the Fed was draining money out of the economy and could just flip back to pumping money in, because the Fed is running the outflow pump fast and furious, and the Fed has no option for reversing the pump or even just stopping it this time around.
This time is different — very, very, VERY different, and I’ll tell you why!
Why the Fed MUST keep tightening as stocks crash
During the present stock dump, it’s important to remember that, for the first time in the lives of many investors, there is no Fed safety net under the stock market to arrest its fall, and here is why: The Fed will continue to tighten under inflation, regardless of what stock and bond markets do, because it has to. The Fed has a LEGAL MANDATE to control inflation. It is one of the Fed’s only two mandates — to 1) control inflation while 2) keeping the job market strong and tight.
It will be hard for the Fed to argue the job market is not strong and tight (even though it isn’t) when all the metrics the Fed traditionally uses before congress show employers just cannot find enough laborers and official headline unemployment is very low, making the job market really tight and beneficial to the wages of laborers. I have explained elsewhere why this is a false scenario, but it is the scenario the Fed has been presenting to congress for months now. Based on its own chosen metrics, the Fed doesn’t have much room to argue that it needs to tighten the job market more. However, the Fed’s other mandate has run WAY out of control and must legally be dealt with … unless congress were to grant it some special reprieve from that congressional mandate.
The Fed got away with not controlling inflation as is mandatory by telling congress that inflation was “transitory,” which was never remotely true. As my regular readers will recall, I spent the entirety of last year arguing against the Fed on that and against others who thought I was nuts, laying out heaps of evidence over many months as to WHY inflation was not transitory and would become scorching hot, as it has, and why that would kill the stock market. I believed that enough to bet my blog on it, saying I would stop writing on economics if inflation did not rise enough to force the Fed to tighten quickly and kill the stock market or eventually kill the market on its own, even if the Fed didn’t tighten, by raising business costs and deeply undercutting earnings and cutting demand for products by making them too expensive, thus suffocating the whole economy into stagflation.
We’re here. The Fed is tightening due to hot inflation as predicted, and stocks are crashing as bond vigilantes take control. (See “Why Inflation is Not Going to Give the Fed a Break” and “Stocks and Awe: The Federal Reserve Regime Change is Here!“)
We have come to the crux of the trap the Fed has set for itself. The Fed has fully given up the excuse it was using before congress for not dealing with inflation over the past half year. So, they cannot go back to saying that inflation is “transitory,” or congress will scoff in Powell’s face for flip flopping like a dying flounder by saying “It’s transitory. It’s not transitory, and that term wasn’t helpful. No, it is transitory after all.” He’d lose whatever credibility he has left. So, the Fed now has to fight inflation until they battle it down.
The last part of that sentence is what is important — until they battle it down. That means the stock market has no safety net because, even if the Fed battles intensely, it will take months to knock inflation back down to the ground with all the lack-of-labor-therefore-lack-of-production-plus-COVID-border-and-port-closures assuring that supply lines remain plugged as production remains down for months. In other words, the shortages are going to stay around longer than the stock market has left because the market is already falling hard. (And, yes, it will almost certainly see some good bear-market rallies along the way down. When has it not? Such as if the Fed comes out of its FOMC meeting this week sounding really dovish, but that rally, if it happens, will only last until the Feds next tapering step shoots bond yields back up again.)
How the Fed has trapped itself in an inferno
Yes, it’s true that the Fed LOVES zero interest rates, and the government just LOVES deficit spending; but the Fed no longer has the option of keeping rates at zero, and the government may not have the options of deficit spending. That is what is key to understanding why inflation WILL kill this stock market bull.
It is, however, also true that the Fed’s LOVE of zero rates for an entire decade and massive money printing have laid in a huge supply of money fuel to burn. It’s not just a tinder box; its is an entire house of cards filled with tinder soaked in fuel. The Fed has boxed into this inflation trap by laying in all the tinder and fuel necessary to keep inflation burning hot for some time, which will force it to attempt to suck the fuel back out very quickly — far quicker, as I recently pointed out in one of the articles referenced above, than we have ever seen before. This is going to be far more unsettling than previous rounds of Fed tightening so will run its course much sooner.
The trap they have lain for themselves was foreseeable for certain. That is why I said since early last year the Fed could be counted on staying with zero rates and massive money printing far too long, creating an inflationary fire tornado. (I’m sure you remember the illustration to the left.) That happens when inflation rises hot enough and long enough to create its own roaring updraft wherein inflation, itself, becomes the cause of further inflation. The Fed’s “transitory” narrative was proof that the Fed was going to do exactly that — wait to long to fight the fire. Throughout the whole “transitory” excuse period, in which the Fed was apparently hoping against all hope that inflation would just give it a lucky break so that it didn’t have to kill its dependent markets, the Fed kept adding fuel (of all the crazy things to do) to the fire to keep markets rising on the Fed fuel float. It did so because it knew markets and government finance were dependent on the Fed’s easing regime for their survival.
Now inflation has a raging flame the Fed cannot easily put out, so the Fed has switched to a tightening regime, which will have to become quantitative tightening (where the Fed actually sucks money out of the monetary system) in order to wrest inflation under control. Interest rate increases throttle money supply by reducing the velocity of money, but they don’t necessarily reduce the money supply. At least not directly. While they curb inflation, we will need to see overabundant money supply dwindle in order to stop high inflation. There is just way too much liquid fuel in the system.
Of course, the stock market is going to lend the Fed a hand there by becoming the new money incinerator to burn that fuel off as money that only existed in computer accounts gets written down rapidly. What was mistakenly thought of as wealth is going up in curls of smoke as I write. (I say mistakenly because this phantom wealth was all built on debt, making for easy stock buybacks and easy dividends, not on actual fundamental productivity and profits. I am not saying there was no productivity or profits, but I am saying those are NOT what was paying for all those massive stock buybacks over the past decade that pushed up stock prices into bubblicious heights.) Easy come, easy go.
Unlike times past, the new Fed tightening regime will also make it extremely difficult for the government to help out with its usual borrow-and-spend, stimulus-and-bailout programs because government bond rates are now going to soar precisely BECAUSE the Fed is relinquishing its total control over the treasury market by stepping away to fight inflation. (That is the big reveal — the key — that I laid out for all my readers when I made one of my earlier Patron Posts available for all: “The Big Blindspot that Will Bite Bonds and Stocks in the Butt.” Everything here is going according to scenario I’ve laid out.) The Fed is busy being a fire fighter, and that will make it hard to help the government out with more cheap credit. We have already seen that Biden failed to get his last borrow-and-spend package through because two moderate Dems were afraid of how it would fuel inflation by requiring more free money printing from the Fed. The move away from guaranteed low interest for the government makes that harder still. Inflation makes it almost impossible to move BACK TO low interest for the government.
I am sure the Fed and government will find a way to attempt to do something. They have to, but keep in mind how I declared the Fed was dead just ahead of the big crash in 2020 (from “Is the Fed Dead?” in June of 2019 to asking “How Dead is the Fed” in March to proclaiming it “positively most sincerely dead” in June of 2020. (By all of this I clarified along the way I meant it was dead in terms of its ability to save falling markets) The Fed proved dead in March of 2020, as I had predicted its next attempt at QE would be, when the market continued to fall even as the Fed pulled out stop after massive stop to try to arrest its fall with guarantee after guarantee of new money, lowered interest rates, etc. — all to no avail.
The market continued falling until the federal government stepped in to put its massive shoulder to the wheel alongside the Fed with gargantuan bailouts all over again. These went mostly to rich corporations (and, hence, bailed out their shareholders), which lacked the resiliency to deal with government-imposed shutdowns because they had spent all of their profits PLUS all of their credit on stock buybacks for the enrichment of those same shareholders.
Nobody cared because everyone wanted to be rescued … again, just as in the Great Recession. That is what this blog is all about — how we are trapped in an endless rinse and repeat Great Recession cycle just as I laid out at the very beginning of my blog days and have captured in my ebook, Downtime, which you see continually advertised in the right sidebar my site — not a great read, but funny along the way, and a clear encapsulation of the rinse-and-repeat bailout path the Fed has us all long because it solves things by throwing money at them so we don’t have to resolve the true faults that run throughout our economic structures. I have encapsulate those old writings like that to show how predictable this rinse-and-repeat cycle is. AND WE WILL DO IT AGAIN, if we try to rely on the Fed pumping the asset bubbles up with easy money, instead of correcting our economic flaws. And that is why that old stuff is worth the read. It’s not great literature, maybe not even good; but, at least, amusing; and, as you read it, you’ll see that, yes, here we are predictably where all of that said the Fed’s plans would take us and leave us.
So, just as in 2008-2009, we saw instant massive bailouts paid for by a huge increase in government debt. And that partnership with the government as the spender with the Federal Reserve as the press operator for the money printers that brrrrring along so fast you could not even see the money flying out, is what stopped the stock market from falling. That was the number-three big bust (the first being the dot-com bust, which the Fed solve by pumping up a housing bubble, the second being the housing-bubble bust) with bailouts repeating the cycle each time. Now we are going into number-four — the even more massive bust of the Everything Bubble the Fed pumped up after the 2020 collapse.
Those bailouts, which hasn’t taken us very far, but certainly took us very high, happened in a time when interest rates were low and inflation was hugging zero. This time is as altogether different as you could hope to find. It is different than all the previous times. We have not seen the Fed raise rates while already going into a recession, as we are now. Typically, the Fed raises rates in a hot economy until it takes us into recession. We have also never seen it raise rates to battle inflation after rates have been effectively at zero for years and after years of massive money printing.
Here is another key to understanding why this will be so bad: In 2020, the government was borrowing under the promise that the Fed would keep rates at zero because it could since there was essentially no inflation. This time, the government will be borrowing (if it attempts to do any bailouts) at a time when the Fed is raising rates to battle inflation, and the government’s borrowing will cause bond yields (and interest rates) to rise even faster than they already are. That will make it very tough in congress politically to step up for bailouts, knowing full well that will make inflation hotter and make the struggling masses angrier.
This is a mess — a spectacular mess — that the Fed and Feds have long laid in! So, this is going to get really ugly, really fast. (I’ll soon be writing a Patron Post about how ugly this will get. Those of you who support my writing at the $5 a month level or above will get the first look at that as my thanks for your solid support, but I’ll probably share it eventually or part of it with everyone.)
How the stock-bond pump-and-dump works
Now, you might have noticed bond yields have settled back down. Don’t be fooled by that! I already explained why that would happen months ago. While I explained it again recently, I know I always have critics who think my glass-eye realism (an old banker expression for someone who looks at the numbers with no emotion) is just pessimism, and they look to things like falling bond yields to say, “See, the trouble is already abating. You’ve seen it incorrectly.”
No, this is exactly what I said would happen. I’ve called it the seesaw relationship between stocks and bonds, but you can also think of it as an old-fashion pump handle where as the handle goes down, the plunger goes up, forcing water to flow. In this case we are pumping from one pool — the stock pool — into another — the bond pool.
It works like this: Bond prices go down as the Fed pushes down on the pump price handle by backing out of the treasury market (which forces yields to rise to attract additional buyers as the Fed ceases to be the buyer of first resort). The rising yields draw money flows from stocks into safer bonds with improving yields (lower prices) until the bond price handle finds a bottom (yields stop rising, prices stop going down). The money flow is being pumped from the stock pool into the bond pool. Then, as investors make bond purchases at those bottom prices, they are slowly lifting the bond-price handle back up with their increased demand for bonds (lowering yields). Then the Fed backs out of more bond-buying again in another step of tapering and pushes the bond-price handle back down for another pump, lifting bond yields on the other side of the fulcrum; thereby, pumping more money from the stock pool into the bond pool.
By that dynamic, bonds don’t just keep rising; however, every time they rise and lower, they are pumping money out of stocks and into bonds. It is that money flow that temporarily lowers bond yields again until the Fed takes its next step in backing further out of bond purchases, pushing down on the price handle. By the time the Fed is done, the flow of money from stocks is so continuous, it may continue to syphon money from stocks to bonds even when the Fed is done pumping. We call this fear. At that point, the money keeps flowing out under its own pressure.
That is how this particular money pump works, and you might have noticed the price pump is working really well right now!