The Tail that Wags the Dog

Dear Clients and Friends,

When it comes to cause and effect, the discipline of finance has little in common with physics or chemistry, where a single perturbation in a system has a unique and verifiable effect upon the outcome. Our markets have vague cause and effect relationships that typically work over long periods of time and produce results that are often difficult to predict. When it comes to the Federal Reserve and the effect it has on the market, there are multiple ways that their policy can guide the market, but in many ways, they are the “tail wagging the dog”. The more the Fed discusses their future design on policy, the more the market responds to that guidance prior to the Feds actions. As a father of four children, it would be like me discussing a new policy of weekly room cleaning starting soon; and an hour later finding that each child had already cleaned their rooms without me forcing them to do so.

Allow me to give this discussion some context. Prior to the Fed raising rates for the first time in 4 years, the market had moved the 30-year mortgage rate substantially higher off the Pandemic lows. In turn, both refinance and new loan origination has tumbled as of March and this all happened prior to the Fed taking concrete steps to slow borrowing. The gold standard forecasting tool for future economic conditions – The Yield Curve – flattened considerably in response to the Feds aggressive guidance, and according to most market historians a flat or inverted yield curve is a good predictor of recession within a few years of the flattening. In addition, the increase in energy prices and global uncertainty has only added to the volatility surrounding our markets. These forces are certainly working to slow a very hot market, and while not all are directly attributable to the Feds future actions, these forces may allow the Fed to act with less force in their fight against inflation.

Over a year ago, I wrote a few memos outlining the case for future inflation and the need for the Fed to take action, but in no way predicted that the current pressures that our economy faces. At this point, I see the market doing some heavy lifting for the Fed, as stated above. But the Fed will have to likely bring asset inflation down over the coming year through rate hikes and “aggressive” Fed Speak. Neither of these actions will be welcomed by certain sectors of our market. Regardless of what people say about current inflation, the fight to corral inflation will likely last some time. However, if the Fed is able to balance the inflationary pressures and keep economic growth intact, the ‘tail that wags the dog’ will have done something marvelous. I am rooting for Jay Powell and the Fed to do just that.

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