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Posted May 06, 2022

Sean Ring

By Sean Ring

The Pop and Drop Stock Market Continues

  • On Wednesday, the Nasdaq was up about 3% on the Fed rate hike news.
  • On Thursday, the Nasdaq fell 5% as the reality of hiking set in.
  • This volatility is not indicative of a healthy market.

Happy Friday!

I hope you grab a nice bottle of vino tonight and enjoy it.

But before you do that, grab a nice cup of your favorite coffee.

In todays Rude, I will parse the stock market moves over the last two days.

If youre sitting there with your hands in the air, wondering whats going on, youre not alone.

I imagine almost everyone whos seeing the tape action over the last two days is thinking, What are they doing?

Believe me; sometimes, I used to do that on my trading desk!

Before I get to it, let me warn you: no one definitively knows why the markets go up and down.

But we can take pieces of evidence and put them together in a way that tells us a sensible story.

Thats inductive reasoning for you, and since the market is so fluid, its the right way to go.

Now lets start

Big Rate Hikes Arent Happening, Thank Heavens!

Again, let me reiterate my belief the Fed must hike rates to normal levels.

But how Powell accomplishes this matters more than the accomplishment itself.

Hiking by 75bps in a single meeting always seemed stupid to me.

Its like a point guard who got the ball stolen from him immediately fouling the guy who stole the ball.

Its an unthinking play making up for a mistake.

Yes, the Fed finally cottoned on to the fact that its very late to the inflation party.

But hiking so quickly will throw the economy into a tailspin.

Let me explain what theyre trying to do, using the Bank of Englands easy-to-follow flow chart.

Credit: Bank of England

    1. The Fed raises the Fed Funds target band.
    2. As a result, market rates like mortgage rates should rise as well.
    3. A higher rate reduces asset prices, as the cash flows are discounted at a higher rate.
    4. Expectations and confidence are hit as the punch bowl is taken away.
    5. The dollar should strengthen, as higher rates make people deposit more into dollar accounts.
    6. Domestic demand and net external demand (exports minus imports), which make up total demand, should fall as expectations are reduced, and exporters goods are more expensive for overseas buyers.
    7. Imports become cheaper as the dollar increases in value.
    8. As a result of the above, inflation is reduced.

Of course, its more complicated in reality, and the moves dont always go as planned.

But its important to note that the Bank of England, Englands central bank, believes it takes between 9 and 12 months to get from point 1 to point 6.

And then it takes another 9 - 12 months to get from lowered demand to lower inflation.

In all, one rate move needs 18 to 24 months to work its magic.

But the Fed - and very different central bank - believes it can ratchet the economy up or down at will.

This has never proven to be the case without dire consequences.

In fact, the last time the Fed hiked so quickly was the year 2000.

And we all know what happened to tech stocks then.

The Markets Get Excited

With all this said, why did the markets rally so hard on Wednesday?

Yes, the Fed hiked rates by 0.50%, or 50 basis points (bps).

The markets then furiously rallied.

Jay Powell mentioned the following:

A 75-basis-point increase is not something that the committee is actively considering I think expectations are that well start to see inflation, you know, flattening out.

Ok, so 75-bp hikes are off the table.

Thats great.

But I think the market got overly excited about it.

But not only is the Fed hiking rates, but its also going to start its asset tapering.

Source: Capital Economics

Remember, the Fed currently holds an enormous amount of US Treasury securities.

From The Balance:

As the nation's central bank, the Federal Reserve is in charge of the country's credit. It doesn't have a financial reason to own Treasury notes. So why does it?

The Federal Reserve actually tripled its holdings between 2007 and 2014. The Fed had to fight the 2008 financial crisis, so it ramped up open market operations by purchasing bank-owned mortgage-backed securities. The Fed began adding U.S. Treasurys in 2009. It owned $1.6 trillion, by 2011, maxing out at $2.5 trillion in 2014.

This quantitative easing (QE) stimulated the economy by keeping interest rates low and infusing liquidity into the capital markets. It gave businesses continued access to low-cost borrowing for operations and expansion.

The Fed purchased Treasurys from its member banks, using credit that it created out of thin air. It had the same effect as printing money. By keeping interest rates low, the Fed helped the government avoid the high-interest-rate penalty it would incur for excessive debt.

But right now, the Fed holds nearly $5 trillion in US debt.

As the Fed sells or merely lets the bonds roll off (mature), its only going to put more pressure on the markets.

 

But in another meeting note, the Fed said it would only let $47.5 billion roll off at a time and then increase this amount to $95 billion after three months.

The market was expecting $95 billion straightaway.

This is hawkish, but not as hawkish as the market expected.

Right now, Ill say Chair Powell shouldve copped it in 2018 and continued hiking rates then.

But President Trump and he got a case of the shivers.

Were paying for it now.

The Morning After

The market woke up in a grumpy mood yesterday, as it realized the Fed ruling out 75-bp hikes wasnt all that.

From the Journal:

The stock market took its biggest U-turn since the early days of the pandemic Thursday, with the Dow Jones Industrial Average posting its largest decline this year just 24 hours after its largest gain since 2020.

This cant be healthy.

Heres the market from Tuesday to yesterday:

Credit: The Wall Street Journal

The market looks about as stable as Amber Heard.

Heres the bigger picture:

Lets see what happens today.

I cant see the chart changing materially, but you never know.

Wrap Up

The market popped, then it dropped.

Powell soothed the markets initially by promising not to hike 75 bps and scale back the bond selling.

But the market woke up Thursday feeling like itd been had.

So the sell-off was nasty, especially for the tech stocks.

Good friend and Rude reader Hung-Wah WhatsApped me this tweet:

Credit: Twitter

How high does the Fed go this time?

Will Powells Volcker mask stay on?

Or will he chicken out again?

In the meantime, have a wonderful weekend!

All the best,

Sean

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