Returning from Orbit, Part 2

Our last edition of Volume Analysis stated, “The federal reserve’s rocket has since overshot its orbit, causing massive inflation while providing a speculative paradise for risk assets. Now how shall the Federal Reserve return the economy back to a post-pandemic normalcy?”

With the first interest rate hike now under the Federal Reserve’s belt, we have more clarity on how the Federal Reserve intends to land our economic craft. Per recent Fed speak, it seems the Fed may raise interest rates 50 basis points early next month, setting up a pattern of rate hikes and beginning a $95 billion monthly balance sheet reduction.

This series of Federal Reserve CHART 1: INFLATION actions is akin to punching the pedal to the metal, holding it down for nearly two years, and then suddenly slamming on the brakes. Although I applaud their original measures, the recent Federal Reserve expectations are probably not what investors envisioned as a soft landing.

The last time the Federal Reserve simultaneously raised rates while reducing its balance sheet was the “Powell Pivot” in 2018, which did not bode well for the markets.

Perhaps the market has already discounted these actions? Or could this time be much worse with inflation at 40-year highs?

Investor bullish sentiment presently resides at only 15.8%, perhaps due to inflation and the Fed’s newfound resolve to end it. This sentiment reading is among the ten lowest ever recorded and the lowest reading since 1992. Traditionally, low bullish investor sentiment readings indicate investors have already sold out and the markets may be overdue for a rebound.

Federal Reserve actions have already had a dramatic impact on bonds. After a negative year last year, year-to-date treasuries are down -7.9%, aggregate bonds are down -8.5%, corporate bonds are down -11.1%, and even municipal bonds are down -7.5%.

More concerning are yield spreads, which are the difference between long, intermediate, and short-term rates. Historically, when the rates of short-term bonds are higher than long or intermediate term bonds, a recession often ensues within a few years of the event.