I am a fan of Formula 1 (F1) racing. I was first exposed to it in high school through some friends of mine who are huge car heads. One of them would invite my friends and me over at six am to watch it on his TV. At the time, waking up so early to watch an event that didn’t have my full interest was a bit much. Fast forward a couple of years, my interest in F1 peaked again with much more enthusiasm. A race location was recently announced to take place in Las Vegas 2023. Immediately I began looking at hotels and how much tickets could cost out of curiosity since it is a bit ways away. I have never been and was not sure what prices would look like that far out. I wanted to have an idea of how much an experience like that would cost me so I can budget for it if it’s reasonable or wait another year instead. I’m like the Federal reserve, looking years out to see how macro trends are forming and adjusting my course now so I’m positioned best down the road.
Today there are things that the Fed is doing that nudge the equilibrium of the market in different directions, but there are also the external forces that nudge the equilibrium out of balance – and as 2022 goes on, we will see who of the two is the stronger force. It is important to keep in mind that the Fed cannot control the market through its actions but rather adjust the environment in which market participants engage. Just like how I might look a couple of years out to book a trip and gauge my way to an ideal experience, the Fed must consider a multitude of variables and outcomes and maintain this equilibrium.
So far this year Jerome Powell has been trying to convey that growth is very strong, the labor market is tight, and household bank accounts are still plush. All signs pointing to having the U.S. economy chug back to healthier levels – but – it was not that long ago we thought there would only be a handful of interest rate increases. To most of our surprise, the market has been somewhat resilient as the Fed has put out more and more data that allows them to justify them being more aggressive. Central banks need to tighten, but not so much that real rates end up destroying the debt-based global economy. Powell has mentioned in the past that the labor market is ‘hot’, but the constrained supply of workers that is unable to meet demand creates a significant amount of drag for potential long-run GDP growth:
Low labor force participation rate + constraint of available labor = lackluster potential for economic growth
This in turn drags down the real interest rate (inflation-adjusted) at which our economy can function. Powell is preparing Wall Street for a less accommodative monetary policy, because as real rates trend lower the more difficult the private sector will find it to access credit and begin to see how ‘default alive’ they are (as I have mentioned in past articles Quality is King). Therefore, earnings will most likely slow and as we have already begun to see with the NASDAQ – adjust for more realistic valuations.
There is a reason central banks keep an eye on the growth of labor supply: as birth rates decline and the aging population phase-out of the labor force – a higher number of savers there tend to exist (these structural factors I will mention again later). Why does this matter? Well, it is the job of these central banks to maintain this equilibrium because their monetary policy is meant to promote economic growth, employment, and price stability. So that’s why lower real yields are desirable for borrowers of credit because they can use leverage to boost earnings, and therefore, growth.
And as mentioned by Brainard, they are in favor of being aggressive (through more interest rate increases and rapid reduction of the balance sheet) to get inflation down. But that is because according to Powell, the labor market is ‘hot’.
The rise and fall of real interest rates determine how cheap or expensive borrowers can access new credit. The long-term trend of interest rates has pointed downwards thanks to changes in demographics and productivity (structural factors referenced earlier). These macro drivers of growth have been behind these trends more than the monetary policy decisions made by central banks. So, while it is understandable that hawkishness from the Fed can hurt the markets in the near term, in the long run, the macro-environment balances out more suitable for growth. When the Fed does raise rates, companies that are ‘default alive’ will outperform businesses with weaker balance sheets. It is important to keep this bigger picture in mind and not be overly fixated on what movements the Fed is taking. Understanding the balance between these two forces will make you a wiser investor.
– Kenneth Wolin
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