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The Fed Annoys. The Outlook Remains.

From the Maven Letter: January 26, 2022
By Gwen Preston

Well that was a week. And then today was a day.

Stocks are all over the place. Friday was a big ol’ drop. Monday looked the same until about an hour before the close, when dip buyers rushed in and turned an almost 4% loss into a halfpercent gain for the S&P 500.

Someone I follow on Twitter looked for previous times the markets have bounced that much in a day. Since 1977, the S&P 500 has only recovered from an intraday loss of more than 3.98% three times.

Jim Bianco followed that look-back with this comment:

We all know why the volatility: the Fed. I’ve talked at length about why the start of a rate hike cycle is having such repercussions. In short: higher rates challenge companies that are addicted to cheap debt and the bond market is losing a huge and price-insensitive buyer (the Fed) who may soon even become a seller. Together, those forces could mean significantly higher debt service costs, which would threaten profits, and profits are the most important and consistent correlation with rising share prices.

On a more arm-wavey level, the Fed’s shift from ultra support to inflation-fighting tightening is being taken as 3 a reason to question some of the things that happened in the last few years. High spec tech stocks flew to the moon, cryptos rose unabated, and new IPOs were assumed incredible until proven otherwise. Rate hikes are acting as a reason to remember reality, a world where profitless tech companies have to actually start to work and IPOs are bought only with hesitation until they make good on some promises.

For context, I think it’s important to realize that this shift is not brand new. A good chunk of the crypto and meme stocks that made the biggest moves in 2020 peaked in February last year and have declined since. And since it was retail traders who powered those gains, retail traders have not done particularly well over the last year.

A down year isn’t the kind of backdrop to fuel a renewed surge into speculative stocks. Add in fundamental changes in the forces powering markets and lots of traders may twice about jumping back into the same game.

That said…it is also very hard to let go of a game that worked so well. A great example is the slide following the dot-com bubble. Investors wanted the party to start up again, wanted their accounts to show the numbers they had showed so recently. Those desires drove three rallies of more than 40% in the 2.5-year selloff from the Nasdaq peak to its bottom in late 2002.

I got this chart and thought from Joe Weisenthal, a writer from Bloomberg who adds a note on what he’s watching at the end of my morning Bloomberg news brief. After listing the reasons traders should now shy away from the high spec stocks that soared in accommodative times, he posted this chart as a reminder that letting go is easier said than done: “A lot of the believers who bought into the story of the last two years may not capitulate anytime soon.”

All that to say: even though there may be fundamental rationale for investors to change behaviours, I don’t have conviction it will happen. The buy-the-dip mentality remains strong, despite being tested of late, and rate hikes aren’t here quite yet.

That last statement hit home today. Today’s Fed meeting was an absolute nothingburger, yet one that the market hated.

The Fed held rates firm (no surprise there) and confirmed that it is reducing its bond buying program faster than initially planned (also no surprise). Other than that, the statement said nothing.

Then Powell started on his post-meeting news conference. Asked about when the Fed might start selling bonds, he said they’d created a plan – first they would reduce how much of the proceeds from maturing notes they reinvested before actively selling anything – but then said the committee hadn’t yet discussed a timeline for such actions or a target size for the balance sheet.

He confirmed they plan to raise in March but didn’t give an amount. And since this was not a Dot Plot meeting, we didn’t get any insight into how the members’ thoughts on the speed of hikes had progressed.

There was nothing new. Nothing. And yet gold did this.

The first drop (from $1845 to $1830) happened before the news. Then you can see that gold actually gained on the statement…before tanking as soon as Powell started talking at 2:30 EST.

Broad markets were just as flummoxed.

The QQQ (a good proxy for the Nasdaq), the Dow Jones Industrial Average, and the S&P 500 all rose gently up to 2:00, jumped on the statement, and tanked as soon as Powell started talking. Why?

Perhaps because Powell at one point said “there is plenty of room to raise rates.” (Rates are currently at zero, while inflation is 7%, unemployment is below 4%, and the economy looks pretty good. Saying there is plenty of room to raise rates is stating the blatantly obvious.)

Because Powell said he wouldn’t rule out back-to-back rate hikes. (The market has already priced in several back-to-back hikes. They are clearly coming.)

Because Powell didn’t take inflation seriously enough – expectation had been building that, faced with CPI at 7%, the Fed might move more aggressively, ending QE now rather than in March and giving clearer signals on hikes. (The most ironic and yet most likely answer.)

The last point is, I think, the one that matters. By doing nothing, the Fed tried to walk the balance of not surprising markets while still seeming to act…but, with markets having accepted that hikes are coming and that the Fed not only has to stop buying bonds but at some point soon has to start shedding them, by doing nothing the Fed fell behind and ignored reality.

As I’ve written, traders were forced to accept reality over the last few weeks. To now have the Fed sidestep that same challenge is annoying and worrying.

The worry now is that the Fed, which was already lagging behind inflation, could end up having to push a bunch of tightening measures later this year as catch up. Tightening has to happen. The Fed could have laid out a clear plan for that, subject of course to changing conditions. Instead, they kicked the can another few months, which could make it harder to thread the needle (between fighting inflation and not hurting the economy) later this year.

There’s also a simple credibility issue. The only reason to not lay out a clear tightening plan is that the FOMC is still hoping inflation will just go away, something they said loudly in the fall they no longer believed will happen.

So which is it? Dunno. Mohamed El-Erian did a nice job summarizing this outlook; click here to jump over to his article.

So has my outlook changed?


Gold is still set to rise alongside rates. Today’s meeting almost served as a setback – the market was primed for a plan to raise rates and start shrinking the balance sheet and when the Fed instead stuck its head in the sand the markets got a bit annoyed.

But nothing has changed. Today’s correction in gold was annoying, especially after three strong weeks, but it actually fits the bill. Right now, the Fed is still supportive. The central bank is still buying $20 billion of Treasuries and $10 billion in mortgage-backed securities a month and rates are still zero.

That will change in March. Gold might gain ahead of that change or it might wait until it happens.

As for the overall markets, I think there’s a roughly 20% chance the markets tank in a serious way in the next year. If nothing else, Powell made clear today that he will not spring surprises, which means the market should be prepared for a series of hikes (it was prepared to hear just such a plan today).

Investors don’t want the broad bull market to end. And the start of a tightening cycle does not a reason make. Sure, things are different. Sure, debt service costs will rise and cut into profits, but that’s many months down the line.

And yes, if the markets do crash then mining stocks – from explorers to producers and from gold and silver to copper and iron ore – will crash alongside. But the hypervigilant Fed would deploy a safety net asap and gold would respond first, which means I think if the 20%-odds crash happened then gold stocks would not fall dramatically, perhaps 30%, and would likely rebound sharply after.

That is not a possibility that I will try to position around. I’m already in gold and will stay there, regardless of the risk of a broad market crash. The risk is greater for base metal and uranium stocks…but the fundamentals for copper, uranium, silver, nickel, and met coal are just very strong, enough to also come out the other side of a crash quickly.

If warning signs across the broad markets get worse, I may change this stance. But for now: I’m in and sticking in.

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