During their respective tenures as Fed Chair, both Bernanke and Yellen said that economic expansions don’t die of old age (historically), the Fed tends to murder them — attempting to slow inflation by raising interest rates (tighter money … slower economic activity …  higher unemployment … slower economic activity …).

With this in mind, the Fed has now clearly telegraphed an end of emergency policies.  It’s likely to be a very gradual process, but nonetheless, it’s a distinct change in the direction of monetary policy.  And it is inflation, which is running hotter than was anticipated by the Fed, that is at the core of their decision to pivot.

But don’t expect this pivot to end the economic expansion anytime soon, nor end the bull market for stocks/asset prices.  Unlike the history referenced by the two former Fed chairs, this time, the Fed will be moving rates from the ultra-low level of zero.  And, interest rates adjusted-for-inflation remain deeply negative. 

Negative real rates mean that monetary policy, even as the Fed begins to raise rates, will continue to promote spending, not saving, for quite some time. 

This dynamic will continue to push money out of the bond market (an almost certain negative return asset class from this point) and into higher risk, higher returning asset classes.  Higher asset prices will continue to support new, higher record household net worth, which will fuel even more consumption, which will result in higher corporate earnings, which means higher asset prices (and so the cycle goes). 

Of course, it’s all a recipe for higher inflation.  And with that, we should expect the Fed, once again, to ultimately murder the economic expansion, with a far more aggressive interest rate tightening cycle than is now being anticipated.  But given that they are starting from such an ultra-easy level on monetary policy, the economic expansion and asset price boom has plenty of time to continue.  Returns will be there.  The question is, how much return will be there after adjusting for inflation? 

This is why it’s important to take the Fed’s cue, to pursue higher risk/higher return investments in this environment, as cash and asset class returns are already being eroded by inflation that is running at a near double-digit annual pace (annualizing the past four months).
 

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As we've discussed, the Fed spends a lot of time manipulating the expectations of consumers and businesses, as part of their policy making.

They talk a lot, in attempt to manufacture stability in markets, and the path they would like to see, for the economy and for interest rates.  

Sometimes it works.  Last year, at the peak of pandemic and economic uncertainty, they managed to stabilize the treasury market by vowing to backstop the troubled corporate bond market.  Within months of the announcement, even crippled airline companies were able to sell billions of dollars of bonds.  All told, the Fed only had to buy $14 billion worth of corporate bonds – a tiny fraction of the total market.  It was the threat, that they would do "whatever it takes" that returned stability, not just to the corporate bond market, but to the treasury market and to all global markets (stocks, bonds, commodities … everything).  

Now they are trying to navigate the end of emergency policies.  And they are, once again, talking a lot.  As we know, the Fed chair had a highly anticipated prepared speech this morning, where he was due to telegraph a beginning of the end of QE.

He did, but with a healthy dose of expectation manipulation.  First, before Powell gave his speech, they rolled out Fed President after Fed President for interviews with financial media.  Their job was to confirm the market expectation that the Fed sees the economy in good shape, inflation as possibly a higher risk than the previously projected, and, indeed, that it was time to start winding down the QE program.  Perfect. 

So what did the most important Fed official say, the Chair?  He reigned it all back in.  He gave us five reasons that inflation wasn't going to run hot.  

With that, the interest rate market finished lower on the day.  And that was a victory for Powell and company.  After all, they want to remove accommodation on their schedule.  They don't want to see a run up in market interest rates, which would put them in a position where they would be forced to unwind emergency policies faster, and begin lift-off of the Fed Funds rate earlier.

Jay Powell will make a prepared speech tomorrow at the annual Kansas City Fed global economic symposium.  This event, typically hosted in Jackson Hole (but online this year), has a history of gathering the world's most powerful central bankers.  And there is a history of major policy signalling.  

In 2010, Bernanke telegraphed QE2 in his Jackson Hole Speech.  Two years later, he telegraphed QE3 at the event.  In 2014, Mario Draghi (head of the European Central Bank) telegraphed aggressive action from the ECB to battle deflationary pressures — a bond buying program was formally announced just days later. 

Interestingly, the Kansas City Fed moved the event to Jackson Hole, back in 1982, in effort to convince Paul Volcker to attend – the Fed Chair and a fly fishing enthusiast.  Volcker was, at the time, aggressively battling high inflation with very aggressive interest rate hikes. 

Of course, we enter this Jackson Hole meeting with the most dangerous inflation we've seen since the Volcker era. 

And remember, just last week Powell talked specifically about Volcker in a town hall meeting.  He admiringly called him "the most distinguished public servant, in economies, in [Powell's] lifetime."  And he admires him because of his courage to take on the unpopular, but necessary path of beating what Powell calls The Great Inflation.

Volcker beat double-digit inflation with short-term interest rates that approached 20% — and in doing so, he took the economy into recession.  But he also set the stage for a long and very good period of development for the U.S. economy. 

Now, we already know the Fed has pivoted, over the past month, in acknowledgement of the aggressive inflation already baked into the economy.  On that note, I suspect we'll see Powell, once again, bring up the Volcker era in his prepared speech on Friday.  If he does, the markets may have to recalibrate for a Fed that is beginning to see a higher risk (than previously) that they may have to become inflation fighters in the near future. 

Sticking with the theme we've discussed the past two days, rates continue to rise on optimism about the economic recovery.  And that's being fueled by optimism about the pandemic outlook (with the expectation of widespread global vaccine mandates, following the FDA's approval of Pfizer's vaccine).

So, U.S. 10 year yields are now 10 basis points higher than prior to the FDA announcement on Tuesday.  And as we discussed on Tuesday, we should expect the world to follow the lead of the FDA, with regulator approvals and subsequent widespread vaccine mandates.  With that, yields globally are on the move. 

Today, German yields had the biggest one day move since March.  Italian yields (one of the weak spots in Europe) jumped by nine basis points, the biggest move since late February.  What's in common now, with that late February – early March period?  Congress was about to put a stamp of approval on the $1.9 trillion Biden spending package.  Today, they are about to put a stamp of approval on another $4.5 trillion in government spending.  

In anticipation of the $1.9 trillion, the U.S. ten year yield rose from 1% to 1.75% in forty days, earlier this year.  The difference then:  The Fed was not only concerned about rising rates, there were reports that they might consider taking additional action to force down longer-term market interest rates (through another iteration of "operation twist"). 

This time around, the Fed is actually talking UP rates.  

We talked yesterday about the FDA vaccine approval as another November 9th, 2020-like moment,  where markets interpret it as new hope that the pandemic will end. 

And that — combined with even more extravagant government spending coming down the pike, and a Fed that has prepared markets for an end of emergency policies — is a recipe for the beginning of the end of ultra-low rates.  And it all is reflective of a sustained economic recovery. 

Indeed, rates were on the move today, trading up to 1.30%.  And no surprise, when we look across the stock market, small cap and value stocks have been the outperformers the past two days on this formula of "pandemic escape" and sustained economic recovery. 

After all, coming out of recession, small caps tend to follow the path of interest rates (climbing rates, suggests more optimism about the outlook).  With that, as interest rates (the 10-year yield) rose from as low as 31 basis points, last year, to as high as 1.78% this year, small cap value stocks soared.  Conversely, as you can see in the chart below, as we've seen a decline back to 1.13% on the ten-year over the past few months, small caps have fallen, diverging from the performance of larger cap growth stocks (and the broader market).