Notes From Underground

Last week the FOMC raised rates by 50 basis points, which seemed like the most likely outcome (although interest rate markets had assigned a slight probability of 75 basis point increase). The statement was nothing if not vague about the FED‘s plans, yet the last sentence left the central bank room for flexibility: “The Committee’s assessments will take into account a wide range of information, including readings on public health, labor market conditions, inflation pressures and inflation expectations, and financial and international developments.”

So in the spirit of the ECB, the FED will have great flexibility and optionality as it strives to break the cycle of inflation expectations. In the Powell press conference, the media came with its own agenda, and as a result, failed to ask questions relevant to international developments, as in concerns over the appreciating U.S. dollar. CNBC’s Steve Liesman did ask the critical question about a possibility of future 75 basis point rate hike, which Chair Powell seemed to dispel which resulted in a massive rally in the S&P, DOW AND NASDAQ.

What also helped the equity market rally was the news that the FED wasn’t starting its balance sheet unwind until June 1 and at a more gradual pace. Instead of incrementally increasing its reinvestment caps, the monetary authority will keep the target caps at an aggregate of $47.5 billion for the first three months before rising to the maximum $95 billion. So for about 18 hours, all asset classes breathed a sigh of relief.

Yet by the May 5 close, the markets had reversed the move, sending equities, precious metals and commodities lower and the DOLLAR HIGHER. The critical issue for equity markets was Chair Jerome Powell’s statement on May 4 in response to a question about whether the FED’s toolbox is capable of dealing with supply bottlenecks but is equipped to affect DEMAND. If the FED seeks to succeed in curbing headline inflation it will mean DEMAND DESTRUCTION.

The essence of demand destruction can be achieved by CRUSHING WAGES and/or a huge DESTRUCTION OF WEALTH through the crushing of myriad asset prices. This White House would be in favor of wealth destruction rather than downward pressure on wages. It appears that the equity markets have realized what Powell’s sense of demand destruction entails. How much wealth destruction will it take to slow demand? How tight will financial conditions have to get in a world carrying the burden of massive global debt

In a must read piece by Chris Whalen titled, “Chair Powell’s Duration Problem,” the question is asked in response to a Powell answer at the press conference about the impact on financial conditions from the proposed $95 billion of monthly balance sheet shrinkage: “You know, people estimate that broadly on the path we’re on — this will probably be taken too seriously. But sort of 1/4%, one rate increase over the course of a year at this pace. But I would just say with very wide uncertainty bands, very wide.”

This is critical for the plan of wealth destruction as a drag on demand to bring down prices. The compression of asset prices is seen as the path of least resistance as the White House will applaud the narrowing of the wealth/income gap. The questions remain: How much leverage is there in the global financial system? How much compression can the global system absorb until the authorities become aware of the fragility it created through more than a decade of massive QE? If balance sheet shrinkage is a rate increase of some degree, how about the rise in the dollar? Are the Chinese fighting back against the developed world’s central banks crushing of global liquidity by weakening the YUAN?Difficult times demand difficult questions.

Tags: balance sheet unwind, demand destruction, inflation, Jerome Powell, QT, U.S. Dollar, wealth destruction

This entry was posted on May 10, 2022 at 6:12 pm and is filed under Fed. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.