Zombies Run For Shelter As Federal Reserve Hawks Look To Higher Points Plot
As expected, Jerome Powell and the Federal Reserve raised interest rates by 75 basis points for the fourth straight time this year, in the 3.75%-4% range.
This was in line with market expectations as the CME’s FedWatch tool showed an over 85% probability of a three quarter percentage point hike just before the FOMC announcement.
When it comes to the powers of the mighty central bank, Powell has certainly flexed the institution’s muscles. However, policy measures appear to have disproportionately influenced sectors of the economy that are highly vulnerable to the interest rate environment.
For example, in a recent article, I explained how real estate investor George Gammon predicted a possible 50% drop in home prices over the next two years.
Since the beginning of the year, stock markets have also fallen, the floor has collapsed under bond prices, and now mortgage rates are above 7%.
At the same time, inflation remains high – in the case of the CPI and the Fed’s favorite measure, the PCE. Moreover, everyone’s core metrics have accelerated in recent months, signaling that the Fed may not have as tight a grip on inflation as it once thought.
Hawkish Powell and dot plots
In his speech, Powell’s tone was seen as more hawkish than expected, dispelling the idea of any slowdown in the rises in the near future.
The combination of high inflation, high incomes and the continued resilience of the labor market with historically low levels of unemployment, indicates that rates need to rise.
The NASDAQ composite, heavily compromised by highly leveraged technology and growth stocks, was hit hard on the news, falling 3.4% on the day.
Initially, the market might have expected a more dovish message, judging by the initial rise in stock prices.
Ramin Nakisa, veteran investment banker and founder of Pension Craft, said:
…a surge in the NASDAQ and S&P 500, but moments later I think the markets realized that Powell wasn’t saying anything that suggested a pivot or a downturn, in fact he was saying the opposite…and then the markets fell.
Yet the labor market continued to surge and even saw an extremely tight 1.7 vacancies per worker, now dropping to 1.9, threatening to ignite the long-term price-wage spiral (which you can read in this May article).
This growing demand for employees may be due to the high degree of savings that many households have accumulated during the pandemic and the associated tax support schemes. In addition, soaring inflation could force some purchases forward.
In my previous article on the Fed’s September meeting, I discussed the dot chart and the direction members were seeing towards rates. Given the aggressive stance taken by Governor Powell at this point, the December dot chart could have the potential to move higher.
Despite the Fed’s constant signal that it would raise December rates by 50 basis points, the CME’s FedWatch tool shows that the odds of a 50 basis point or 75 basis point hike are roughly divided by the middle.
This seems to suggest that the market perceives that a path of higher rates is quite possible in the short term.
The Fed’s pace of quantitative tightening reached its expected maximum of $95 billion a month in September, thanks to a mix of government bonds and mortgage-backed securities.
Instead of reinvesting the coupon and principle, the Fed will withdraw these instruments to suck excess liquidity from the system.
Liquidity has increased significantly with the Fed’s program of injecting $120 billion a month into the economy via quantitative easing in the wake of the pandemic.
Although the effects of monetary policy and the QT are not yet evident on leading indicators such as the CPI and the Fed’s preferred PCE, the Fed’s balance sheet is starting to shrink. Since its peak on the 13e April 2022, the balance sheet decreased by 2.704% on 26e October 2022.
Due to the drying up of liquidity, the control of inflation, which is the central bank’s mouthpiece for the destruction of demand, seems to affect the borrowing and repayment conditions of small, medium and large companies .
Given the Fed’s hawkish policy and determination to keep raising rates, highly leveraged and unprofitable companies will find it increasingly difficult to stay afloat.
In a study by the Bank for International Settlements, the proportion of zombie firms in 14 selected economies rose to 15% in 2017, from 4% in the 1980s, due to easy money policies.
Swiss Re economists Jerome Haegeli and Fiona Gillespie predict that high-yield default rates of 15% could materialize if a recessionary environment occurs. This is compared to the average high yield default rate of around 4% over the past 10 years.
The authors argue that this wave of defaults would be beneficial for capital allocation and that delaying it could lead to increased stagflationary risks.
They suggest authorities should consider bailing out entities that show potential for long-term success, a job that is likely easier said than done.
Small-cap and growth stocks are likely to be particularly vulnerable and see a series of sell-offs, having only recently emerged from a prolonged and seemingly never-ending 0% rate environment.
In a previous article, I noted that Joseph Wang, a former senior free market trader at the Fed, believed that new tools, including swap lines, the repo facility, and debt buybacks, to manage Treasury market turmoil, corporate bond market volatility and banking crises, respectively, could prolong rate hikes.
In essence, he argues that the Fed will continue to rise by being able to step in strategically when cracks appear.
Thomas Hoenig, former president and CEO of the Kansas City Federal Reserve, also believes that the Fed has no end point for its rate hikes at this point, which of course would spell disaster for the majority. companies in difficulty.
While that may be true, I expect the burden of interest payments to weigh on the Fed, along with the political unpopularity of restricting lending in the economy.
Either way, the hangover and criticism of the 2018-19 pivot would be fresh in the Fed’s collective mind. The institution undoubtedly wants to restore its credibility with its opponents, and a pivot of rhetoric or action should not be expected at any time in the first quarter of 2023.
Part of the fight to restore credibility is to relentlessly signal the Fed’s willingness to crush inflation in the face of rising social and financial costs.
The 2% trap
Perhaps global central banks, in an effort to maintain credibility, have committed themselves too firmly to the 2% level.
To my knowledge, there is nothing sacred about this figure and it certainly wouldn’t make sense for it to be uniformly applicable in so many countries over the decades.
The Economist referred to the 2% target increase in these terms,
When New Zealand’s parliament decided in December 1989 on a 2% inflation target for the country’s central bank, none of the lawmakers dissented, perhaps because they were keen to go home for the Christmas holidays… owes its origin to an offhand remark by a former financial minister… Should we change the somewhat arbitrary target of 2%?
The flexibility to admit that inflation will likely have to head north, in the long term, to say 3%, may have given monetary authorities some much-needed breathing space.
However, today, inflation-targeting central banks have locked themselves in a corner, which has the potential to inflict huge costs on economies chasing that 2% figure.
Any capitulation on their part could lead to stagflationary forces and a loss of credibility.
While no immediate pivot is likely, the Fed’s 2% mandate will continue to weigh heavily on zombie firms and contribute to significant job losses in this area.
Although we are unlikely to see a pivot in the first quarter, the Fed left the backdoor open, saying,
…the committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, as well as economic and financial developments.