Cheap Lawn Chair

People are underestimating the recession that is ongoing.  The base case I see from most forecasters is that the economy is either in a shallow recession now or will enter a shallow recession later this year or in early 2023.  Almost all deep recessions start as shallow recessions.  During most recessions, the Fed is either ready to cut or already cutting rates during this part of the business cycle.  Here we are, they are still raising rates and doing QT.  Post bubble.  Increasing the odds of the recession becoming a deep and painful one.  

You can toss out the last 13 years of price data, that's almost a different world.  Breadth thrusts, new highs vs new lows, and other data mined statistics from a sample that covers mostly just a raging bull market lead to obvious conclusions that don't tell you much about the current regime.  You have to think 1973, 2001, 2008, to get a sense of what kind of market we're in.  

But unlike those time periods, the profit margins are even higher.  Profit margins can only go up so much before it sucks the living life out of the real economy, turning workers into voluntary slaves who toil for their corporate masters with no alternatives due to the oligopoly based "capitalist" system.   This system prevents new competition from forming, allowing for extreme pricing power, feeding into the inflation dynamics which are already well embedded by populist fiscal and easy monetary policy.  

Antitrust legislation is toothless, and corporations are taking on rent seeking attributes, due to their pricing power, and shedding their product supplying attributes.  The thing about rent seeking is that there either needs to be more renters (population growth) or renters need to have increasing incomes to keep feeding the beast of economic growth.  If they don't, consumption decreases and corporate revenues follow.  

Inflation is one way to keep feeding the beast, but that invites another set of problems as investors will eventually balk at receiving deeply negative real interest rates if the government keeps going with its inflationary policies.  The inflation will feed on itself as investors look for alternatives to government bonds and look to store wealth in real assets like real estate, gold, commodities, and even stocks.  Governments will eventually realize that all that stimulus and money printing has long term consequences, the main one being a lack of trust in their currency.  The weaker currency feeds the inflation cycle until you get an Argentina situation or a voluntary depression from halting money supply increases in order to regain trust in the currency.  Bad choices come from bad policies.  Bad choices lead to bad outcomes. 

Let's not forget that the overall growth profile for the US, as well as for most of the big economies (EU, China, Japan, etc.) is totally different than 2001 or 2008.  Organic growth is much lower, so the dependence of monetary and fiscal stimulus is much greater.  Without it, things get ugly.  Its something that I hear very little of amongst economists who are arrogant beyond belief despite poor track records.  Trend growth is near zero, and what little growth that shows up in the GDP and other econ. data is from inflation being underreported, which shows up as real GDP growth.  Most of the real GDP growth now is really just inflation in disguise.  

So what does that have to do with the current market?  You have to look at the big picture to more accurately forecast what's likely to happen.  In an organically low growth global economy, Fed funds rates over 2% are restrictive, not neutral.  Its not about the real interest rates.  The neutral rate for the economy is negative real interest rates, and QE!  That's hard for lots of investors to wrap their heads around, especially over the last 20 years when inflation has been relatively low.  Fed funds rates have spent most of the time at zero (with QE ongoing).  And the brief moments above zero were mostly spent under 2%, and if it did go over 2% (briefly in late 2018 to mid 2019, and now), it caused an economic slowdown and things started to break (repo in 2019).  

The neutral rate for the US economy is probably around 1% doing light QE, just enough to sop up about 1/3 of new issuance, while the neutral rate for the EU is probably around -0.5%.   The very concept of a neutral rate is an interest rate that is common, that maintains the economy at a desired growth rate, not too high, not too low.  That's not 2.5%.  A 2.5% Fed funds rate and QT over an extended time period will significantly slowdown the global economy, to levels much lower than the Fed's long term desired growth rate. That's not neutral.  That's restrictive.  

Soon many will find out as the Fed tries to take Fed funds rate above 3% how damaging it is to the economy and that's when you start getting very loud noise from the Street demanding a dovish pivot.  Hoping for a dovish pivot and demanding one are 2 very different things.  Hoping for a dovish pivot happens when stocks are going up.  Demanding a dovish pivot happens when stocks are going down.  Eventually, the Fed will fold like a cheap lawn chair.  It is what they do.  Hawk talk is cheap when stocks are going up.  Neel Kashkari can act like a tough guy on inflation and dismiss the bond market's message when stocks are ripping higher.  Give me the same talk when stocks are going down in savage selloffs.  You will hear crickets. 

We are still in the hoping for a dovish pivot stage of the rate cycle.  This is the fairly benign phase.  When the market starts getting agitated seeing that growth is really weakening, they will have a temper tantrum, looking to induce a Fed pivot.  And usually when the Fed tries to deny what the market wants, the market throws an even bigger fit and eventually gets rewarded by the Fed with dovish language and future rate cuts. 

I still see a lot of denial on TV and social media about this rally, dismissing it as a mere short term bear market rally.  They are probably right in the long term, but it makes it tougher to time a short entry when there are so many market skeptics.  This skepticism tends to extend these type of counter trend rallies.  Finally starting on Wednesday, there were the first signs of more call buying and a bit less hedging in puts but nothing excessive considering the big rally on Wednesday.  You can sense that retail is getting bulled up, but would like to also see institutions follow.

Speculation is making a comeback, a small echo of the 2021 crypto/tech/EV mania that excited retail traders like it was 2000.  Its getting closer to that exquisite moment where you can enter a position with a very skewed risk/reward proposition. The two things holding me back is the futures positioning data and downtrend in 10 year yields.  We'll find out more when the commitment of traders report comes out today.  It should show a large reduction in speculator short positions.  If it doesn't, that's a warning sign that its still too early to short.  

Short term, the market looks overbought, and we still have the big monthly data event which is the CPI next Wednesday.  So it would not be surprising to see some consolidation and pullback from such a big up move going into that number next week.