The Different Ways Monetary Tightening Can Play Out
The Different Ways Monetary Tightening Can Play Out
Interest Rate Hikes. Inflation. Earnings. Employment.
THE BIGGEST QUESTION FOR INVESTORS: How will the monetary tightening cycle play out?
Bridgewater Associates had a fantastic recording with their two Chief Investment Officers - Bob Prince and Greg Jensen.
I’ve compiled the conversation into two parts identifying the two CIO’s arguments.
Inflation has been shifted to the rearview mirror for investors. But for how long? Bob and Greg discuss what they’re most concerned about when it comes to monetary policy.
So lets set the table:
If you re-read the last CPI report, you will notice that the Fed has reached a point in the tightening cycle where they can finally take their foot of the preverbal brake. Inflation has dropped below expectations for the first time.
This has caused the equity markets to re-rate higher.
For example: The multiple on the Dow and S&P has expanded 20% since the last fed meeting/CPI report in October.
Now, this has some unintended consequences for inflation and what the feds stated goal is:
Full employment
2% inflation
These two goals have different lead times. Employment lags 18 months while inflation lags 9-12 months.
The equity rally often contributes to a stronger consumer and economy. The two are very correlated. This results in a demand headwind for the fed.
Likely scenario #1: Bob Prince
Base Case: central banks under-tighten and we have to start and stop the process over and over until we get back down to 2% (price stability)
We’re currently eight months into the tightening cycle that started in February of this year.
Nine months from October 2022, it’s likely we see a scenario where inflation has come down from 9% at its peak this past summer to 4% by Q1 of 2023.
However, its believed that we will flatline at this 4% number. Which is 2% higher than the fed wants.
The fed will then either start another tightening cycle. Or it accepts 4% as good enough…
So how will this decision be made?
How will the fed and bank of Canada decide between maintaining economic growth or dropping inflation from 4% down to 2%?
Keep in mind: policy choices are made on where they think inflation and growth will be in 12 months.
Bob Prince thinks that the fed is going to need to go back and forth between a tightening and loosening of monetary policy.
Why?
Remember, wages lag 18 months. And Equity price demand is immediate.
This push and pull is going to play out like a slow motion accident.
Note: The battle between under-tightening and slower inflation retraction is one that seems to be less consensus with market participants today. Greg’s opinion below, seems to be the Fin-twit consensus.
Scenario 2: Greg Jensen (over tightening)
Base case: The usage of fiscal policy has changed the game. Once the economy starts going down, we are underestimating how much easing will be required to restart the engine.
Self reinforcing decline in employment, consumer spend and company earnings.
Greg thinks that the thing that everyone is missing is velocity of the slow down spiral.
The fed is going to make a mistake on the tight side which will result in the economy cracking. And that crack will be much harder to patch with monetary policy than in previous slowdowns.
He emphasizes that the crack is likely to require fiscal policy stimulation that wont be possible. He highlights a divided government in place in the USA as the main headwind for the required fiscal policy.
Basically - A divided government won’t have the appetite for stimulus after a $9Tn print cycle in 2020 and 2021.
This causes a deeper recession than equity markets are anticipating and hits the markets where real estate is weakest.
Short duration variable mortgage markets - Australia, Canada and UK.
He believes the combination of global debt, speed of tightening and weak balance sheets is going to out weigh the prior inflation trend of “markets bottom when inflation peaks”.
The opinions of both CIO’s has a lot of overlap: Just differing order of outcome
Slow down in growth of non-farm payroll/employment
De-globalization is inflationary and its intensifying
Fiscal stimulus will be required to keep us from a hard landing
Risk of over tightening is biggest risk to markets
Over tightening will demolish company earnings
Over the coming 2 fed meetings, Jerome Powell and his minions will be parsing through these issues. And investors and fed watchers will be watching closely for signals.
The mechanics of fed signal will be changing day by day - it’s just my humble opinion that Bob Prince is right, and we don’t run into the self reinforcing decline that Greg Jensen is worried about.
There’s plenty of fiscal still sloshing around the system - between the chips act, inflation reduction act and the college debt reduction plan.
Either way - hold onto your butts.
Volatility in the markets isn’t done.