The Federal Reserve, through a multi-decade series of shady practices, finds itself in a very disagreeable place. Policies of extreme market intervention have positioned the economy and financial markets for an epic bust.
Price inflation. Unemployment. Interest rates. Stock market valuations.
These metrics are presently situated in such a way that the “Powell put” will be impossible to successfully execute for the foreseeable future.
Price inflation is at a 40 year high. The unemployment rate is 3.8 percent, which is near its low. The 10-Year Treasury note is yielding 2.15 percent. While this key interest rate is certainly trending higher, it’s still near a historical low.
And for all the wild price swings and gnashing of teeth over the last two months, the S&P 500 has hardly slipped. In fact, as of market close on Thursday March 17 of 4,411, the S&P 500 is down only 7.83 percent from its all-time record close of 4,786 reached on January 3. It still has another 12.17 percent to fall before reaching official bear market territory.
Moreover, the ratio of total market capitalization over GDP is currently 185 percent. This is considered significantly overvalued.
By our estimation the S&P 500 has much, much further to fall in 2022. And given current price inflation, unemployment, and interest rates, the Powell put won’t likely be executed with the clockwork certainty that investors have grown accustom to over the last 35 years.
We posit that a 50 percent decline in the S&P 500 and an unemployment rate over 10 percent would be needed before the Fed can bailout Wall Street again. That, and massively higher interest rates will first be required to contain raging consumer price inflation.
Quite frankly, 25 basis point rate hikes to the federal funds rate won’t cut it. We’ll explain why in just a moment. But first, some context is in order…
When Alan Greenspan first executed the “Greenspan put” following the 1987 Black Monday crash, financial markets were well positioned for this centrally coordinated intervention. Interest rates, after peaking out in 1981, were still high. The yield on the 10-Year Treasury note was about 9 percent. There was plenty of room for borrowing costs to fall.
The unstated mechanics of the Greenspan put are extraordinarily simple. When the stock market drops by about 20 percent, the Fed intervenes by lowering the federal funds rate. This typically results in a real negative yield, and an abundance of cheap credit.
This tactic has a twofold effect of seen and observable market distortions. First, the burst of liquidity puts an elevated floor under how far the stock market falls. Thus, the put option effect. Second, the interest rate cuts inflate bond prices, as bond prices move inverse to interest rates.
As of the late 1980s, thanks to the Greenspan put, the Fed has been running an implicit program of countercyclical stock market monetary stimulus. Ben Bernanke then ratcheted up the Fed’s extreme market intervention via quantitative easing (QE) in the aftermath of the 2008-09 financial crisis. That’s when things really got nuts.
QE, remember, involves creating credit out of thin air and then loaning it to the Treasury. The Treasury then injects the fake money into the economy through government spending programs. QE can also involve bailing out the big banks by swapping the Fed’s fake money for toxic securities.
In short, U.S. financial markets have been rigged for at least three decades. The unintended consequences have infected every sector of the economy. And now, with the resulting effect of both massive asset price inflation and massive consumer price inflation, the next time the stock market cracks, it will be impossible to exercise the Powell put without also further inflating consumer prices.
The implications for buy and hold investors are bleak…
What is the Strike Price of the Powell Put?
The official CPI is currently 7.9 percent. When calculated using methodologies from the 1980s, the rate of inflation is double.
This week the Federal Open Market Committee (FOMC) hiked the federal funds rate by 25 basis points. The FOMC also promised to hike the federal funds rate six more times this year.
Some in the financial press reported this as “hawkish,” which is an absolute joke. But who knows? Maybe the Fed will get serious and hike by 50 basis points next time.
Regardless, it’s too little too late. Inflation is on the loose and the Powell put is seriously compromised.
According to the BofA Global Fund Manager Survey, the Fed put for the S&P 500 is now at 3,636. But what do they know?
As far as we can tell, participants in the FMS suffer from a serious lack of imagination. In fact, just a little abstract thinking tells another story.
For example, what if there’s a bear market yet consumer price inflation spikes to 10 percent (officially)? How could the Fed bailout Wall Street when consumer prices are inflating by double digits?
What if the economy contracts yet inflation rises…and the stagflation misery index – the unemployment rate plus the CPI – goes through the roof?
What then would be the strike price of the Powell put?
Scenarios like these have become increasingly likely.
Over the last two years, somewhere on the order of $6 trillion in fake money has been vomited into the U.S. economy. This is the primary reason for raging consumer price inflation. Despite what President Biden says, it’s not Vladimir Putin’s fault.
Here’s the point, the Fed will have to contain inflation before it puts a floor under the stock market and acts to further stimulate the economy. It can’t do both at the same time.
Any path that involves juicing the stock market or stimulating the economy before inflation is snuffed out would ensure that inflation continues to rage higher.
So how far will the S&P 500 fall – and unemployment and interest rates have to rise – before Powell can fire off the monetary bazookas?
Would 2,500 cut it? What about 2,000…or lower?
In reality, Powell or his successor will fire them off long before then…and the misery index will eat us alive.