What’s Really Forcing the Fed's Hand and How It Could Impact Your Portfolio
One would assume central bank would have learned from their mistakes in 2021.
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The much talked about Jackson Hole Fed meeting came and went, with a twist as always. The central bank did not disappoint as Fed Chair Powell surprised the market by flip-flopping once again, turning dovish and leaving the door open to a rate cut in September when in reality the U.S. economic data do not warrant one.
Just a few weeks prior to this briefing, the Fed minutes showed that the balance of risk suggested that further data points were needed to change their monetary stance. The Fed has a dual mandate: labor market stability and keeping price inflation close to their 2% target. It seems the big downward employment revisions for May from 144,000 to 19,000 and for June from 147,000 down to 14,000 — a combined cut of 258,000 jobs — spooked the Fed as they pay more credence to a weaker labor market than rising inflation. However, the unemployment rate is ticking close to 4.2%, at all-time lows, hardly meriting a rate cut.
The picture is much better understood when looking at initial claims and continuing claims. The initial jobless claims are not picking up as companies are not laying off their workers, but the continuing claims are elevated, implying that it is harder for those that are unemployed or for new graduates to find a job. That is the real issue.
We know that some companies are trying to protect their margins by laying off workers and replacing them with AI for the menial tasks. But this is not something the Fed can salvage by just cutting rates. There is a secular shift happening in the workplace whereby entry-level analyst or clerical jobs are being usurped by AI at a fraction of the cost. The unemployed have to diversify into a whole new skill set, which is harder to do in a short time frame.
Meanwhile, the most recent CPI and PPI readings suggest that every metric regarding the prices paid and received are ticking higher after spending months stabilizing. Even the forward-looking inflationary measures suggest a higher implied rate.
One would assume that the Fed would have learned from their mistakes in 2021 when they discounted the power of inflation via an increasing money supply base. But a bigger issue is the refinancing of about $1.6 trillion-$1.7 trillion in debt that needs lower rates. If rates do not come down, the U.S. interest expense alone will be unmanageable and curtail any fiscal spending plans whatsoever, ones that the U.S. desperately needs to grow its GDP or at least sustain it. With U.S. national debt north to $37 trillion and climbing, the Fed and the Treasury, it seems, have just one avenue, inflate it away.
Last fall when the Fed cut rates prematurely by 100 basis points, the bond market vigilantes retaliated with yields rallying by 100 bps. It remains to be seen how the bond market will react if the Fed does cut in September, but judging by the way the 2/10 year spreads are trading with the curve steepening, it suggests something is afoot.
Will we be talking about universal basic income or more quantitative easing to save the U.S. economy at a time when inflation is sticky at 3%? Investors have not seen it yet, but this a whole new investment environment, one of stagflation, a cycle that benefits neither equities or bonds, but hard assets. Today investors are less than 3% allocated to assets like gold and precious metals. It could be time for a portfolio makeover.
