No Retreat, No Surrender

My kids went back to school this week, and despite the 90 plus degree temps outside, summer is officially over for them. However, for the stock market, the summer season doesn’t really end until post-Labor Day. That means that we are likely to see at least another week of benign, low volume market action.

Once Wall Street officially gets back to work next month, many questions will need to be answered. But perhaps the most important one is how long will the Federal Reserve remain supportive of the rapid rise in prices—both asset prices and consumer prices, and how can they extricate themselves from market interventionist practices. If the disastrous withdrawal from Afghanistan shows how hard it is to leave a fragile country without consequences, the Fed should take some notes.

Since 2008, the Federal Reserve has engaged in unprecedented actions to support markets in both fragile times and robust times. Afghanistan may have been a 20-year war, but the Fed has been fighting its own 13-year war. Back in 2018, newly appointed Fed Chair, Jerome Powell, began an attempt to withdraw troops from the market, attempting to let the market stand on its own two feet. A sharp sell off in February of that year, followed by an even steeper fall between October and December, told Chairman Powell that withdrawal without consequences was not possible. Beginning in January 2019, he let the market know that they would be coming back to the rescue. That mission turned into a full-scale invasion in February 2021 with the onset of the Covid crisis. Now, more deeply involved than ever before, the question again is laid on his desk: can this market stand on its own?

I always believe that actions lie less frequently than words. While all in charge seem to remind us that we are in a strong economic environment, as remarkable as that seems given the massive disruption over the past 18 months, their actions do little to ensure us that it is the case. If the economy is as strong as they indicate, would it need this much support. If the economy is as strong as they indicate, are negative real interest rates required. For context, currently the inflation adjusted interest rates on the 5-year US Treasury Note sits at a dismal -1.66% and the 10-year Note hovers near -1.0%. These mark levels not seen since the Fed began its war on deflationary markets back at the end of 2008. In fact, in January of 2009 real rates on the 5-year Note were nearly 3 percentage points higher than they are today. Certainly, the Fed believes the market is better off today than it was at the depths of the Financial Crisis. But perhaps their actions imply something else altogether.

Today, at the Jackson Hole symposium, Chair Powell indicated that they could begin tapering bond purchases by the end of this year. However, could as any good lawyer will tell you can also imply may not. The market’s action today, gaining nearly a full percent on the S&P 500, seems to interpret his words as anything but hawkish. While the backdrop of the Afghan withdrawal makes for a nice comparison to the Fed’s conundrum, I don’t see their future response to be withdrawal at all. Americans may not be happy with the humiliation of retreat halfway across the world, but the reality of retreat by the Fed from financial markets would lead to greater political ramifications at home.

Personally, I don’t see the Fed ever truly exiting this battlefield. However, this doesn’t mean I believe the Fed will win the war. If the adage on the battlefield is that the enemy always, “gets a vote,” the same applies here. The Fed fights many enemies and the one they’ve not considered for some time is inflation. Our current negative rates are as much a factor of low nominal rates as it is a function of rising inflation. The Fed ultimately faces two potential outcomes deflation or inflation. Neither outcome is beneficial. But the former comes with immediate political ramifications, while the latter may not arise until everyone involved is no longer in office. In Washington, kicking the can down the road seems to always be the path to bet on.

Thanks for reading,

Zach and Dave

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