The Fed Pause

The Fed hiking cycle appears to be coming to an end at the May FOMC meeting, with Fed governors coming out last week to reiterate market pricing of a 25 bps rate hike in May, but also saying that they see a pause afterwards.  So let's make the assumption that the last hike of this cycle is in May. 

Fed Funds Rate (1999-2023)

Here is the SPX after the last rate hike and first cut in 2000-2001.

Obviously when you do this kind of analysis, the timing of the last Fed hike and first Fed cut in each business cycle is a huge variable.  In 2000, the Fed was about on target with the last rate hike, and the first rate cut, not hiking too late, and not cutting too early/too late.  Remember, the final rate hike in May 2000 happened near the peak of a massive internet bubble, so there was going to be a lot of pain once the Fed had gotten through with its rate hikes.  Despite being at bubble levels, you still had a brief grace period for the SPX after the last rate hike, as it chopped around in a range for a few months, grinding a bit higher before going on a massive downtrend into the first rate cut, which was only good for a 1 month rally, and then further weakness afterwards.  This is typically what you would expect from an average Fed cycle.  

Here is the SPX after the last rate hike and first cut in 2006-2007. 

This time, the Fed was slow to hike rates in 2004 to 2006, going just 25 bps at a time, nurturing a huge housing bubble, which gathered a momentum of its own, keeping the economy resilient for several months after the last rate hike in June 2006.  This is probably the most unusual Fed cycle in recent history, as the economy was able to brush off the higher interest rates and an inverted yield curve for over a year, before finally succumbing to the dual pressure of high rates and a popping of a massive real estate bubble.  The lags of monetary policy were longer than usual as the reflexivity of the real estate mania took a life of its own and credit kept booming despite the higher rates, as the momentum dragged economic growth higher for longer than most business cycles.  Thus, you had a huge rally after the last rate hike, one that lasted a year.  When the economy started to weaken and you got early signs of things breaking in the summer of 2007, the Fed came in with a rate cut which was good for about a 1 month rally, but that was just a bull trap into a massive downtrend.  

Here is the SPX after the last rate hike and first cut in 2018-2019. 

In this cycle, you had a Fed that just got bullied by the stock market.  When Powell made his final rate hike in December 2018, the economy was steady, but growth was slowing.  There were no obvious signs of a recession coming, yet Powell pivoted in January 2019 because....... the stock market went down.  This is where Powell cemented his reputation as a caver, as a folder.  In this case, the stock market was already down over 10% from the highs when the Fed made its last rate hike, and was helped immensely by Powell's pivot, because you had a Fed that was promising easier money when the economy wasn't even that weak.  It was the best situation imaginable for stocks and you had a relentless rally all the way to the first rate cut, which was unnecessary but Powell did it just to keep his promise, even though the economy was strengthening again by the time he made that call.  What happens when the Fed cuts rates when the economy is not weak?  You get a rally, although it was choppy due to overblown trade war fears at the time, once people realized that was a nothingburger, it was off to the races for 6 months, blasting through all time highs and going up relentlessly for 13%.  

Once again, the Fed is faced with a decision on what to do after its final rate hike, which is most likely in May.  The Fed is laying the groundwork for a long pause at above 5% Fed funds rate.  Its one thing to pause at a restrictive level of rates when the economy is slowing and there are no signs of a recession, its whole another thing to pause when the economy is slowing but there are signs of recession in manufacturing and commercial real estate, as well as tech, with layoff announcements accumulating.  

Let's not forget that this economy has a much slower natural growth rate now versus 2000 or 2007, when the demographics was younger, as the baby boomers were in their prime working years, as well as faster population growth.  Productivity growth was also greater at that time.  Global growth was also much higher because China was booming in the 2000s.  So the baseline growth rate is much lower now, which makes a 5% FFR much more restrictive than 5% in 2007 or 2000.  Let's not forget the long period of zero or near zero rates from 2008 to 2021, which incentivized corporations and investors to pile on low interest rate debt to leverage capital for higher returns.  That's not so feasible when short term rates go from 0% to 5%.  So you can absolutely bet that investment will be drastically reduced at these level of rates, especially as the massive distortions created by $6 trillion of fiscal stimulus is no longer there pumping everything higher. 

People talk about today like it is the 1970s, just because that was the last time you had high inflation.  But today couldn't be more different than the 1970s.  Just the overall debt levels in the US and global economy are on a whole another stratosphere than back then.  Less debt = higher tolerance for high interest rates.  More debt = lower tolerance for high interest rates.  The natural growth rate of the economy was much higher.  The population much younger.  No savings glut keeping interest rates down.  There was almost no offshoring to put downward pressure on wages.  Just a totally different world now.  

The Fed hiked so late in this business cycle that its putting the most pressure on the economy when its naturally slowing from the lack of pentup demand for goods and too much inventory(the inventory de-stocking cycle) and the popping of the everything bubble.  The Fed should have been hiking a year earlier, in spring 2021, and that would have been able to slowly bring down the economy with monetary tightening.  Instead, they have back loaded rate hikes and jammed it in over a year, while the business cycle is on the downtrend.  

Compared to May 2000, June 2006, and December 2018, this is the weakest the economy has been when the Fed made its last rate hike.  And its also the most inverted yield curve, mainly because these rates are unsustainable in the long run for this high debt, slow growth economy.  And why are rates so high?  As a reaction to a one time global fiscal stimulus bonanza that caused massive inflation.  An inflation wave that many are extrapolating out into the next several years, just because that's what people do.  With the coming debt ceiling fight and the Republicans' desire not to help Biden in 2024, you can bet on McCarthy not playing ball, looking for either a budget freeze or sequestration for FY 2024.  And don't forget the student debt moratorium gets lifted at the end of August, which will be a drag on consumption later this year.  Plus all the credit tightening and lag effects of higher rates going to work to slow down loan growth and investment.  

The equity market is trading in its own reality, with huge stock buybacks providing the demand as investors increase their cash holdings. 

Those big buybacks will be difficult to maintain when earnings are dropping hard, as I expect in the 2nd half of the year.  Its going to be interesting to see how the stock market trades when the buyback bid is much weaker than it has been for the last few years. 

The coming weakness will really test Powell's mettle to see if he is willing to torpedo the economy and cause a deep recession to try to be the next Volcker.  Powell is quite nonchalant now and seems as if the things will be fine just keeping rates above 5%, but the economy is already noticeably slowing (rising jobless claims, fewer job openings, very weak ISMs, weak demand for diesel/trucking/shipping, and weakening retail sales).  I doubt Powell will be able to hold off on rate cuts as long as he wants.  The economy will be too weak for him to just sit and do nothing.  The market will force a cut, as it usually does when the economy enters a full blown recession.  My guesstimate for that to happen is 3 to 6 months from now (July-October).  Timing when the worm turns is always difficult, which is why I am leaving dry powder available just in case the bulls go overboard.  

I am mostly on the sidelines when it comes to playing the stock index.  The second half of April, after tax reporting season, is usually a bullish time of the year for the stock market, as you get buybacks coming back after the blackout period during earnings season.  I don't expect anything too bad from Q1 earnings, it will be a different story for Q2 and Q3.  For now, its not likely you'll see any big bombs being dropped this season, so you could get a relief rally.  Positioning is not that favorable for bulls, so I would only expect a small rally.  The SPX could grind a bit higher from here, although fundamentals are too weak, and its already up over 350 points from the March lows so I doubt you see any big rallies from here.  Thinking SPX 4200-4220 is as high as it can go before hitting a wall of reality, and even that might be tough to reach.  

I will start layering into short positions if the SPX gets closer to 4200.  The top of this rally should come in early May, around the time the Fed officially signals that they are on pause after their last rate hike, which will probably be front run by eager beaver longs who don't want to miss a Fed "pivot" rally.  A Fed pivot is only bullish when they are pivoting while stocks are down big, and/or the economic conditions are not so weak.  You have neither in the current situation.  It will make for a messy 2nd half of the year.