Lag Effects and the Kamikazi Fed

Kamakazi Fed

One of the things that I periodically do with my trainer are exercises that focus on getting my heart rate to 80% of its maximum after starting at 75%. It’s done to stress the heart and to see how quickly it can recover. I have used an exercise bike and versa climber to facilitate this, as these pictures show.

Lag Effect Gary Carmell Exercise

versa climber Lag Gary Carmell Exercise September 2022

I try to go as fast as I can until my heart rate gets to the 80% threshold and then, hopefully, in a relatively short period of time, will come back down to 75% so I can do another set. All of that sounds good on paper but what usually happens is that it takes a little time before my heart rate starts elevating. And while I’m looking at the monitor showing my rate at 75% or 76%, my body is feeling a level of fatigue and energy depletion that correlates with a higher heart rate. In other words, I tend to feel more fatigued far beyond what I would normally feel at reaching 80% over a more gradual buildup via different exercises. This feeling becomes validated after I stop and see how my heart rate continues to climb. As this picture shows, it recently went to 88%. 

Gary Carmell Heart Rate 88% Lag

The point of me bringing this up is that these exercises work with a lag as there’s no immediate impact on my measured heart rate. By the time I reach my target, I’m fatigued, and after I stop, my heart rate continues to accelerate far beyond the target. Like many of my insights, they come in a flash, and this one hit me while I was working out. I knew it had some kind of relevance, but what was it? And then the aha moment occurred, and I realized that it has parallels with monetary policy.

Jerome Powell and the Federal Reserve are clearly on a kamikaze mission to crash the economy and the financial markets. It’s that simple. Unfortunately, the two indicators he’s laser-focused on, inflation and the job market, are backward-looking or coincidental at best. Inflation is unquestionably coming down with oil prices having dropped quite significantly, copper crashing, lumber has dropped significantly, and gas prices well off of their highs

Monetary policy, like my heart rate exercises, works with a lag. The Fed has raised interest rates very dramatically in a short period of time and is now starting to shrink its balance sheet. Add to this the incredible strength of the dollar, which is starting to hurt countries that are not energy independent and have to purchase commodities in dollars and adds to their inflationary pressures. You have countries like Japan that may start to try to strengthen their currency by selling dollars and dollar-denominated assets like U.S. Treasuries. Look how yields have shot up, particularly late last week, after Japan’s central bank announced it was intervening to help prop up the yen.

Treasury Yield 10 Years (TNX) 3.7110 September 2022

And overseas, particularly in Great Britain, interest rates exploded higher after the government announced tax cuts and more spending, which fueled even more fears of runaway inflation.

5) UK Bond Yields Go Wild After Tax Move September 23, 2022

All of this carnage is happening with the full effects of tighter monetary policy not yet being felt. I don’t see how we don’t enter a recession with the Federal Reserve seeking to crush demand. This is corroborated by the Leading Economic Indicators (LEI), which show slowing growth at best and recessionary conditions as a more probable path.

US leading indicator falls for sixth consecutive month in August

Conference Board US Leading Index MoM 2016 - 2022

This is from the Conference Board, which produces the LEI.

“Economic activity will continue slowing more broadly throughout the U.S. economy and is likely to contract,” said Ataman Ozyildirim, senior economics director at the Conference Board in Washington. “A major driver of this slowdown has been the Fed’s rapid tightening of monetary policy to counter inflationary pressures. The Conference Board projects a recession in the coming quarters.”

Even the Fed’s own projections show slowing growth, higher unemployment, and higher inflation versus its June forecast. 

FOMC Economic projections June - September 2022 - 2024

What is interesting is that the Fed’s forecasts show inflation getting back down to its 2% target level in 2024. So it looks like we’re in for some real pain leading to rates peaking by early 2023 and then, according to the Fed’s forecasts, coming down again in 2023 through 2025 and beyond to its estimate of a 2.50% neutral rate. 

Implied Fed Funds Target Rate

Here is another way of charting the Fed’s core PCE forecast, along with Wells Fargo’s.

Core PCE Inflation Forecast September 23, 2022

If history is any guide, then it looks like inflation is close to its peak and should be dropping materially over the next six to 12 months.

Historical Headline CPI Comparison Headline YoY CPI as it heads into the peak CPI in each period

Now let’s look at some indicators suggesting inflation should be coming down.

Shortages are easing, which should lessen inflation pressure.

Chart 37_ Product Shortages & Core Goods CPI Inflation

 Kansas City Fed Manufacturing Supplier Delivery Times September 22, 2022 2005 - 2023

The Kamikaze Fed is reinforcing investors’ beliefs that they are going to cause economic pain which is manifesting itself in an increasingly inverted yield curve, which tends to correctly foreshadow recessions.

US 10yr - 2yr Government Bond Spread (bps) September 21, 2022

US 30yr - 5 yr Government Bond Spread (bps) 1999 - 2023 Sept 21, 2022

Powell clearly has his sights set on bringing down housing prices. He feels that leeches should be applied to the patient to create bloodletting so that it can be positioned to become healthy again. Let’s get the patient very sick so that it can become healthy in the long run.

Powell clearly has his sights set on bringing down housing prices. He feels that leeches should be applied to the patient to create bloodletting so that it can be positioned to become healthy again. Let’s get the patient very sick so that it can become healthy in the long run.Click To Tweet

Fed's Fowell_ US housing market headed for 'correction' September 21, 2022

This is what Powell said during his press conference last week after announcing that the Fed had raised interest rates by another 0.75%.

“There was a big imbalance … housing prices were going up at an unsustainably fast level,” Powell said at a news conference following the Fed’s decision to raise its policy rate by another 75 basis points. “For the longer term what we need is supply and demand to get better aligned so housing prices go up at a reasonable level, at a reasonable pace and people can afford houses again. We probably in the housing market have to go through a correction to get back to that place.”

The bloodletting has already begun as mortgage rates have shot up as a result of much higher Treasury yields.

Optimal Blue 30 yr Conforming Fixed Rate Sept 21, 2022 2017 - 2022

And because the Fed is no longer buying mortgage-backed securities and may even begin to sell some of its holdings, mortgage investors are demanding a higher premium to own mortgages. And this is compounded by concerns that an economic contraction will lead to more defaults and potential losses for home lenders. One can see from this chart that the premium of the 30-year mortgage over 10-year Treasuries is approaching levels last seen during the Great Recession. This is also contributing to rapidly higher mortgage rates. The difference in this cycle, however, is that loan quality is vastly superior to what it was during the subprime crisis, so mortgages may offer a compelling value for those willing to wade into those turbulent waters.

30-Year Fixed Rate Mortgage Average in the United States-Market Yield on US Treasury securities at 10 Year Constant Maturity 2002 - 2022

The combination of much higher mortgage rates and home prices that have appreciated quite significantly over the last 10 years has led to the monthly payment for the median home to reach historically high levels since the 1980s.

US Typical Mortgage Payments for a median existing home 1980 - 2024

Shelter costs are a big driver of inflation, as this chart shows.

Gimme Shelter Housing Accounts for an increasing share of overall inflation 2021 - 2022 September 23, 2022

And while our rents are growing, the rate of growth is decelerating. And with a large pipeline of units scheduled to be delivered over the next few years, we would expect rents to be less of a driver for inflation starting in the next six months or so.

CPI y_y_ average of utility costs, gasoline, food at home, and electricity 1941 - 2022

And what goes up eventually does come down. China has been slowing down rapidly, and, given what a massive commodity consumer it is, this should be a source of diminishing inflationary pressures.

The Chinese Economy is Facing Deflationary Pressures 2010 - 2022

One can see that demand for gasoline and distillates has been trailing the 2020-21 averages, which is interesting because that period included the worst impact of Covid.

US gasoline demand US distillate demand September 22, 2023

Shipping costs, while still materially higher than pre-Covid, are now dropping dramatically and far off their peak.

WCI Shanghai to Los Angeles Co 9_26_19 - 9_22_22

The outlook for corporate profit margins is very weak based on the historical relationship between two surveys and PPI trade services, which is a proxy for corporate martins.

The Philly Fed and Empire State Agree on the Margin Story 2011 - 2024

Finally, from a jobs perspective, Bank of America is projecting job losses in 2023.

Finally, from a jobs perspective, Bank of America is projecting job losses in 2023.

In summary, the Fed is hell-bent on crashing its plane into a ship that is already having mechanical problems and in increasingly rough seas, which raises the chance of it sinking or becoming severely impaired. This is the situation before the Fed crashes its plane into it, which is virtually certain to render it severely impaired. It will then have to come to the rescue to save the ship through heroic and aggressive repairs. 

Buckle up!

Kamakazi Fed





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