Hey There Income Hunter,
At last, we got the whole truth and nothing but the truth from Jerome Powell.
He stepped up to the mic on Friday and set the narrative for the foreseeable future with three words …
“Brace for pain.”
It was a moment right out of Rocky III when Mr. T was asked for his fight prediction and he only needed one word: Pain.
It was a courageous step and an essential step for the Fed because the narrative will now shift to “Powell means business.”
Although that will only stay the narrative until something breaks in the financial system. And that is still inevitable in a stagflation (low growth, high inflation) environment.
Today, we will take a look at the path forward and why interest rates will continue to be the signpost for how big a hit the economy will take in the months ahead.
It’s All About Interest Rates
Powell succeeded in removing the Fed put, meaning an imminent Fed pivot away from tightening.
Stocks are released from the “new bull market” narrative that was building and will now seek to find a bottom.
Stocks finding a bottom will coincide with bond yields finding a top. A truly hawkish Fed is bullish for bonds, meaning 10-year interest rates may peak lower than the nearly 3.50% to put in place in June.
The fact that US 10-year Treasury bonds ended up little changed on Friday while equity prices collapsed was a sign that Powell said all the right things:
I have said all along the Fed wants and needs inflation while keeping rates as low as possible for as long as possible …
They are finally in that happy place … for now.
Interest will remain the single most important signpost for a break in the financial system from here on out.
If 10-year rates remain below 3.5% while inflation stays above 4% the US markets can remain in balance as the system burns off its massive debt burden.
Credit Spreads
The all important credit spread signpost will tell us how low stock will go. The Fed BBB credit spread chart below illustrates spreads widening as the Fed has pushed interest rates higher.
Notice how the narrowed when the market narrative shifted to a Fed pivot away from tightening, which triggered a rally in stocks and bonds.
Well, now the narrative has reversed so we can expect spreads to widen back out as economic data continues to come in week and interest rates grind higher.
Here is how the process works:
- If interest rates sniff still higher inflation they may rise above 3.50%
- Credit spreads will rise to new high spreads indicating stress in the financial system
- Wider spreads will be a warning of new lows in stocks to follow
However, if the Fed regains its credibility as an inflation fighter, the financial system can maintain its current solid foundation and absorb the hit to the economy while debt is unwound.
The process will then be …
- Rates will remain below 3.5% and may even trend lower for a short time as slow growth and hopes of lower inflation brings in buyers
- Credit spreads will widen but not spike to new highs
- Stocks will consolidate near the lows as the market waits to where inflation will settle
Bring It Home
Bottom Line: Powell set the record straight for Fed policy.
What we need to remember is this: the government is now playing the vital role of market manipulator. We may see two extremes between the Fed and the government …
As the Fed tightens the government may keep spending, government spending is directly inflationary …
So, the Fed convinced the markets they will fight inflation, but that is only half the story…
The government will continue to spend to offset the impact of de-globalization, which means building infrastructure to become self-reliant.
Deficits will rise, tax receipts will fall and inflation will stay highly elevated. A hint on what it all means is …
We are getting close to a peak in the dollar and a bottom in commodity prices.
Stay tuned for a breakdown of sectors and trades to consider as the new Fed narrative vs new government narrative unfolds.
Have a great weekend and as always …
Live and Trade With Passion My Friend,
Griff