MARKETS OUT OF WHACK: Why This Time IS Different!

MARKETS OUT OF WHACK: Why This Time IS Different!

The word “unprecedented” has been overused since the onset of COVID-19 in the U.S., but from time to time, it’s the only word that can accurately describe what’s happening in the global financial markets. Right now, the sheer volume and magnitude of market dislocations are truly unprecedented.

It’s hard to invest if you’re just trying to make sense of it all. There’s no denying that American businesses are under tremendous pressure due to supply chain disruptions, sticky inflation, labor and tech component shortages, geopolitical tensions, and a host of other top-of-mind issues.

Amid this effectively stagflationary backdrop, common sense would dictate that the stock market should respond by lowering valuation multiples while analysts should mark down corporate earnings estimates. Somehow, neither of these has taken place; there’s neither optimism nor pessimism but a jaded cynicism that all dips will be bought because there’s nowhere else to hide.

No one’s hiding in government bonds nowadays. Bond yields are up thanks to relentless central bank intervention, but this means that bond prices are down to the lowest levels seen in years. Even so, the usual knock-on effects of high bond yields fail to exist in 2022.

Under normal market conditions, there’s a rotation out of stocks and into bonds – the traditional “flight to safety” that characterized your parents’ and grandparents’ markets. Today’s investors – at least the handful of hedge funds that effectively control 80% of stock price moves – are shockingly indifferent, though, and there’s no flight or gradual migration out of stocks.

The oddsmakers are betting that the benchmark federal funds rate will break above 4% and the 10-year U.S. Treasury yield – already at multi-year highs – will break out of its longstanding range and march higher:

The equities market assuredly can’t tolerate a vertical move in bond yields, but so far, investors are largely indifferent. They’re also ignoring warning signals like FedEx’s CEO calling for a recession and the housing market accelerating its downfall as homebuilder sentiment falls for the ninth consecutive month.

This time is “different,” but not in a good way, and even the professionals are dumbfounded, not to mention the retail traders who have no basis of comparison for this level of disequilibrium. 2-year Treasury yields are higher than 10-year Treasury yields and inflation is high, but gold isn’t moving – this truly is an upside-down reality we’re living in.

Much of this has to do with the one asset that so many people neglect to monitor: the U.S. dollar. It’s counterintuitive to call the dollar “strong” when inflation is so high, but the greenback is currently the cleanest shirt in a hamper full of dirty clothes – it’s not actually good, but it’s better than the alternatives at the moment.

The dollar’s strength won’t last forever, and gold will return to its rightful place above $2,000 soon enough. We will see this happen, but what we won’t see is a return to pre-COVID and pre-war conditions: low inflation, the Fed having your back, and cooperation between nations that allows for easy access to fossil fuels and other essential commodities.

We now have the great divergence: the economy and markets don’t predictably respond to the Fed’s moves like they did from 2009 through 2020, and traders can’t rely on the good old backstop we know as the “Fed put.” Powell will gladly accept a recession to clamp down inflation, so we’re all dollar watchers now whether we like it or not.

In the words of Federal Reserve official Richard Clarida, “Until inflation comes down a lot, the Fed is really a single mandate central bank.” We’ve come to the end of a multi-decade low-interest-rate environment, and Jerome Powell’s doing his best imitation of Paul Volcker’s – a poor imitation that’s not convincing anyone.

Powell praised Volcker not long ago, saying “he had the courage to do what he thought was the right thing.” It’s true that Volcker had to turn the world upside-down with 15% interest rates to do what needed to be done, but that was then, and this is now. Politics being what they are, Powell can’t possibly do in 2022 what the Fed did in 1981.

We’ll all just have to learn to live with irrationality for a while and respond accordingly. Just take comfort in the fact that hard assets have survived and gained value despite – and perhaps because of – the government’s policy errors throughout the decades.