The Apollo 13 Problem
In Jim Lovell’s book, Apollo 13, he describes one of the final hurdles the crew faced as they attempted to return their crippled spacecraft to earth. The crew had to approach Earth’s atmosphere at an angle no shallower than 5.3 degrees, and no steeper than 7.7 degrees. If re-entry was shallower than 5.3 degrees, the command module would skip of the atmosphere and send it into orbit around sun. If re-entry was steeper than 7.7 degrees, the g-force of re-entry would likely crush the crew to death before they landed.
The economy faces an analogous problem. If the Fed does not act with enough force to control inflation, the economy could skip off into a world of continuing inflation. If the Fed acts with too much force, they will crush the economy into a recession.
The talk of various economic ‘landings’ is everywhere in financial news. Until recently, the only two economic options considered were a ‘soft landing’ or a ‘hard landing’. The economic resurgence we saw in January has now added ‘no landing’ to the options. Here’s what all the different landings are about:
- Soft Landing: This is the ideal economic re-entry between 5.3 and 7.7 degrees. A soft landing implies that the economy slows enough to bring inflation under control, but a recession is avoided.
- Hard Landing: This is the economy coming in at too steep an angle. A hard landing implies that the Fed’s efforts to control inflation crushes the economy by sparking a recession.
- No Landing: This is the economy coming in at too shallow an angle. An economy running hot makes the inflation fight extremely difficult and we risk sending the economy skipping off into stagflation.
This new ‘no landing’ scenario is the least understood because normally, one would associate greater economic strength with stronger markets, but not this time. The problem is that while inflation has receded a bit, it is far from under control. If the economy continues to pick up steam, (i.e., final demand continues to increase), that is likely to push inflation higher, not lower. The threat then becomes stagflation, which is when we have a very unwelcome combination of inflation and modest real economic growth, which the U.S. experienced in the 1970’s.
From our perspective, the no landing option is simply a delayed hard landing. If inflation can’t be easily controlled, the Fed is will need to press harder to slow the economy. The harder they push, the more likely a hard landing will be the end result.
Of course, that is not the only possible outcome. The other possibility being discussed is simply increasing the target rate of inflation from the current 2% to something higher. Fed Chair Powell, has clearly stated that possibility is not currently being considered – the key word being ‘currently’. You never know what might induce the Fed to change its mind. If it happens, it probably does not happen soon, but that doesn’t mean it can’t happen.
Is the Fed Put Kaput?
The old Wall Street adage is ‘Don’t fight the Fed’. The Fed tends to get what they want, so fighting them tends to be a losing strategy. Nonetheless, until recently, the stock market was more than willing to fight the Fed. The recent correction is based largely on markets coming into agreement with the Fed’s outlook.
In the bond market, the 10-year Treasury note had a peak yield of almost 4.25% back in October, and then trended down through January ticking a bit below 3.4% several times. With the Fed consistently forecasting higher rates for longer, the bond market simply did not believe the Fed and was actually forecasting a Fed ‘pivot’ (that is, interest rate cuts) later in 2023. This pivot is effectively the Fed Put, meaning that when things get bad enough, the Fed will always cut rates and save markets.
While bonds rallied (rates declined), the stock market followed suit and also rallied hard for several months. The cart below is the S&P 500 index (red) and the 10-Year Treasury Note Yield (blue). The red and blue arrows show that when rates are rising, generally the stock market is not performing well and when rates are falling, the stock market tends to head north. What happened in January is that rates started to move up again, moving more in line with the Feds’ view of the world, but stocks did not follow this time around and both stocks and bonds were briefly headed in the same direction (green box). This week, that began to reverse once again.
In short, higher interest rates are a nod to the Feds’ current policy and raises the question of whether the Fed Put is finally kaput. Only time will answer that question, but whether the put has disappeared or not, higher rates are a huge headwind to any further stock market rally. For the time being, the bond markets’ current acceptance of the Feds’ rate trajectory creates a ceiling for stocks.
What We’re Reading
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