Federal Reserve Crossroads - 3/20/2022
ES. Daily view.
First off, you can't solve supply chain issues (Keynesian economics) with rate hikes. Rate hikes might slow down some demand due to lack of cheap credit, but this type of inflation goes much deeper than just the Fed's money printing. Economies are complex beasts that don't have one simple cause or answer. Even the 2008 Recession had several factors that aligned all at the same time which was an anomaly in itself.
Normies kept thinking that the money printing (treasury securities purchases or bond purchases) was the cause of all the inflation. That is an intellectually lazy viewpoint. That is like saying all of the US' problems were caused by obesity/guns/capitalism/whatever singular variable. Here are some supply chain issues that are unrelated to money printing. For the sake of saving up space, you can look up the articles yourself in the following subjects.
1) Crude Oil - Oil production was approx. 78 million barrels per day throughout 2021. Oil demand was around 96 million barrels per day throughout 2021. So, there is already an 18 million barrels per day deficit. What happens when demand outweigh supply over time? Price increases. Back in 2020, lenders and banks abandoned oil companies after oil futures crashed. Think about it. If an oil company almost went bankrupt back in 2020, they will need more workers for oil production. What if there are no loans available? This results in less production. Ironically, this is the one time where that cheap credit could've helped back then. OPEC also agreed to production cuts back in 2020. Those production cuts don't expire until Sept 2022.
2) Grains or food - Natural gas is the most costly component used in manufacturing nitrogen fertilizer and for ammonia plants. When natural gas (refined from crude oil) prices skyrocket, then the cost to farm also increases. Much of the agricultural industry has been consolidated to an oligopoly (www.ers.usda.gov/amb...riculture-continues/). With this much consolidation, agricultural companies have pricing power over farming equipment and supplies. Meaning, they can upcharge their products when selling to farms. If one of the biggest agricultural corporations makes one mistake in supply chains, then it tends to ripple throughout the whole industry.
Furthermore, China's Ministry of Agriculture warned of the worst winter wheat crop in China's history. Russia and Ukraine accounted for nearly 30% of grain in the global supply chains. So what happens when you have 3 countries which are struggling to produce crops? Food prices will rise.
Did you know that Kansas (farming state) is facing a drought emergency too?
3) Semiconductors - It takes 2,200 gallons of water to produce a 30 cm wafer. Taiwan is one of the biggest semiconductor producers in the world. Taiwan has been facing one of its worst droughts in decades. Less water means less semiconductors... which means prices increase due to scarcity.
4) Cars - With oil prices ramping up, it's pretty obvious that producing cars also becomes more expensive. Lots of machinery (that needs oil and natural gas) involved to produce a car.
With this list of issues, can you see how lazy it is to just pin money printing as the source of inflation? I cannot see how rate hikes would solve droughts. I cannot see how rate hikes could produce more oil. Powell was not exactly lying when he said that the global supply chains are causing a lot of the inflation. In fact, that statement was more true given the situations above.
So now the Federal Reserve is at a crossroads. Hiking rates too slow and might exacerbate inflation rates. Hiking rates too fast and that might cause a recession and hurt working class Americans more. The average credit card debt per person alone is around $6,000. The average debt is around $38,000. That extra interest expense hurts the working class more than it hurts the top 0.1% incomes. Hiking rates way too fast was the Bank of Japan's mistake back in the early 1990s. There are a few scenarios ahead.
Scenario 1 (Best Case): Somehow, the supply chain issues above get resolved and inflation rates enter into a downtrend this year. This is not too likely since droughts and oil production take more than just a few months to resolve. If this scenario happens, then the Federal Reserve would have much less pressure to hike rates. Then the big funds would think "the worst is over" and might buy more.
Scenario 2: If commodities (especially oil and grains) settle down by June 2022, then the Federal Reserve would continue to hike rates at a slower rate (0.25% per quarter according to the Fed's dot plot). This was the expected path anyways. Institutions would then play defensively and would be in capital preservation mode until the uncertainty is over. That means we might see volatility again later this year, but more subtle than scenario 3.
Scenario 3 (Worst Case): Commodities (especially oil and grain), PPI, and CPI reports are still rising at extreme high rates throughout this year. That would pressure the Federal Reserve to raise rates even faster than in recent history. That type of scenario might cause stagflation for the first time since the 1970s... which was facing influenza and multiple wars back then. The time before that was 1920-1921 with the aftermath of WWI and the Spanish Flu... Gee... those situations sound oddly familiar... That might cause institutions to play very defensively and might make retail panic as well. Company costs would also rise due to commodities skyrocketing. This scenario usually leads to a deflationary recession afterwards.
Remember, the Federal Reserve must maintain an image of stability and calmness. Whatever they announce, the public will exaggerate it in some way. That's why the Chairman must remain "bland" or have a poker face. On the flip side, given these 3 scenarios, you now see why big funds and institutions are uncertain. They are in the same boat of trying to read the Federal Reserve too. This can go in multiple directions. It's not bad news that scares the big money. It's uncertainty that scares them. I'm not sure where this goes myself which is why I have been playing very defensively since the 30-05 bond yield curve flattened in early December.
We are entering a seasonally bullish season of the year soon. So, a medium-term rally is more likely than not. Getting closer to June, I'm less optimistic to say the least. I'll playing defensively or doing smaller trades until I see more signals by June's FOMC.
First off, you can't solve supply chain issues (Keynesian economics) with rate hikes. Rate hikes might slow down some demand due to lack of cheap credit, but this type of inflation goes much deeper than just the Fed's money printing. Economies are complex beasts that don't have one simple cause or answer. Even the 2008 Recession had several factors that aligned all at the same time which was an anomaly in itself.
Normies kept thinking that the money printing (treasury securities purchases or bond purchases) was the cause of all the inflation. That is an intellectually lazy viewpoint. That is like saying all of the US' problems were caused by obesity/guns/capitalism/whatever singular variable. Here are some supply chain issues that are unrelated to money printing. For the sake of saving up space, you can look up the articles yourself in the following subjects.
1) Crude Oil - Oil production was approx. 78 million barrels per day throughout 2021. Oil demand was around 96 million barrels per day throughout 2021. So, there is already an 18 million barrels per day deficit. What happens when demand outweigh supply over time? Price increases. Back in 2020, lenders and banks abandoned oil companies after oil futures crashed. Think about it. If an oil company almost went bankrupt back in 2020, they will need more workers for oil production. What if there are no loans available? This results in less production. Ironically, this is the one time where that cheap credit could've helped back then. OPEC also agreed to production cuts back in 2020. Those production cuts don't expire until Sept 2022.
2) Grains or food - Natural gas is the most costly component used in manufacturing nitrogen fertilizer and for ammonia plants. When natural gas (refined from crude oil) prices skyrocket, then the cost to farm also increases. Much of the agricultural industry has been consolidated to an oligopoly (www.ers.usda.gov/amb...riculture-continues/). With this much consolidation, agricultural companies have pricing power over farming equipment and supplies. Meaning, they can upcharge their products when selling to farms. If one of the biggest agricultural corporations makes one mistake in supply chains, then it tends to ripple throughout the whole industry.
Furthermore, China's Ministry of Agriculture warned of the worst winter wheat crop in China's history. Russia and Ukraine accounted for nearly 30% of grain in the global supply chains. So what happens when you have 3 countries which are struggling to produce crops? Food prices will rise.
Did you know that Kansas (farming state) is facing a drought emergency too?
3) Semiconductors - It takes 2,200 gallons of water to produce a 30 cm wafer. Taiwan is one of the biggest semiconductor producers in the world. Taiwan has been facing one of its worst droughts in decades. Less water means less semiconductors... which means prices increase due to scarcity.
4) Cars - With oil prices ramping up, it's pretty obvious that producing cars also becomes more expensive. Lots of machinery (that needs oil and natural gas) involved to produce a car.
With this list of issues, can you see how lazy it is to just pin money printing as the source of inflation? I cannot see how rate hikes would solve droughts. I cannot see how rate hikes could produce more oil. Powell was not exactly lying when he said that the global supply chains are causing a lot of the inflation. In fact, that statement was more true given the situations above.
So now the Federal Reserve is at a crossroads. Hiking rates too slow and might exacerbate inflation rates. Hiking rates too fast and that might cause a recession and hurt working class Americans more. The average credit card debt per person alone is around $6,000. The average debt is around $38,000. That extra interest expense hurts the working class more than it hurts the top 0.1% incomes. Hiking rates way too fast was the Bank of Japan's mistake back in the early 1990s. There are a few scenarios ahead.
Scenario 1 (Best Case): Somehow, the supply chain issues above get resolved and inflation rates enter into a downtrend this year. This is not too likely since droughts and oil production take more than just a few months to resolve. If this scenario happens, then the Federal Reserve would have much less pressure to hike rates. Then the big funds would think "the worst is over" and might buy more.
Scenario 2: If commodities (especially oil and grains) settle down by June 2022, then the Federal Reserve would continue to hike rates at a slower rate (0.25% per quarter according to the Fed's dot plot). This was the expected path anyways. Institutions would then play defensively and would be in capital preservation mode until the uncertainty is over. That means we might see volatility again later this year, but more subtle than scenario 3.
Scenario 3 (Worst Case): Commodities (especially oil and grain), PPI, and CPI reports are still rising at extreme high rates throughout this year. That would pressure the Federal Reserve to raise rates even faster than in recent history. That type of scenario might cause stagflation for the first time since the 1970s... which was facing influenza and multiple wars back then. The time before that was 1920-1921 with the aftermath of WWI and the Spanish Flu... Gee... those situations sound oddly familiar... That might cause institutions to play very defensively and might make retail panic as well. Company costs would also rise due to commodities skyrocketing. This scenario usually leads to a deflationary recession afterwards.
Remember, the Federal Reserve must maintain an image of stability and calmness. Whatever they announce, the public will exaggerate it in some way. That's why the Chairman must remain "bland" or have a poker face. On the flip side, given these 3 scenarios, you now see why big funds and institutions are uncertain. They are in the same boat of trying to read the Federal Reserve too. This can go in multiple directions. It's not bad news that scares the big money. It's uncertainty that scares them. I'm not sure where this goes myself which is why I have been playing very defensively since the 30-05 bond yield curve flattened in early December.
We are entering a seasonally bullish season of the year soon. So, a medium-term rally is more likely than not. Getting closer to June, I'm less optimistic to say the least. I'll playing defensively or doing smaller trades until I see more signals by June's FOMC.