The Fed's "Head-Fake" Crash Is Here
How Jerome Powell will: try to tame inflation, fail, crash markets, then reverse course
In July of 2021 I wrote the following in Why The Fed is Bluffing.
At times, I suspect the Fed will “attempt” to raise rates and reduce quantitative easing (QE). And the stock market will not react well to that.
After stocks tank, the investment world will demand the Fed throw gas on the QE fire and send rates back to near zero. While a pretty nasty correction might happen first, I think the Fed will eventually oblige.
Until then, the Fed continues to bluff about how it plans to handle inflation. I think these bluffing periods can be excellent buying opportunities for inflation hedges such as gold and bitcoin.
We are near the betting stage of the bluff, when the Fed will valiantly attempt to conquer inflation, fail, and likely crash stocks in the process (possibly housing too).
It looks to have begun. Exhibit A is Cathie Wood’s formerly red-hot ARK Innovation ETF (Nasdaq: ARKK), which is filled with overvalued names, some of which were recently trading at 20x+ sales (ridiculously high).
This chart of ARKK vs Berkshire Hathaway performance tells a fascinating story. From the excellent Charlie Bilello.
What a boom and what a bust! ARKK made a killing with stocks like Tesla, which is still its largest holding. But now losses from former high-flyers has outweighed those huge gains. Look at this bloodbath, as of April 28:
An updated chart would be far uglier. As I write this, ARKK is down 8.9% on the day! The Nasdaq is down 3.78% with less than 2 hours til the market closes. I would NOT try to catch a falling knife here.
This market could get hideous quickly.
Popping The Bubble, For Now
The most bubbly assets are rapidly deflating, and I think the Fed wants it to happen. Over the past few years we’ve seen housing bubbles, hot tech stocks trading at 150x sales, and Dogecoin reaching a $88B market cap. Even by Fed standards it was a little much.
I suspect this head-fake crash will last until they get to around 2% on the fed funds rate, but they could try for 3% if they really want to tank markets. How long that takes depends on how quickly the Fed hikes, and how rapidly stocks puke.
Eventually Chairman Powell will perform a deft flip-flop and announce a reinvigorated QE program to pay the bills and monetize the debt. It could happen quite soon, or it may drag out as Fed governors cosplay as responsible monetary stewards.
Stocks will probably rip higher for a bit after GigaQE is announced, but who knows if the move will be sustainable. Stocks are a decent inflation hedge (better than bonds), but they’re still incredibly expensive today. Even after the recent pullback the Nasdaq 100 trades at around 26x earnings. That’s bubbly, so the dip would have to be huge to interest me much.
If we see a crash, I’ll mostly be looking to scoop up gold, silver, and cheap emerging market stocks. I will buy some BTC if we go low enough but am already well allocated there.
Historically precious metals tend to outperform domestic stocks during periods of high and sustained inflation. I strongly recommend reading Bill Bonner’s work on the Dow Gold System for more along these lines.
Low Inflation Expectations = Underpriced Hedges
As I mentioned the other day, the average CNBC aficionado has very little understanding of the risks we’re facing.
Just look at consumer inflation expectations. In 3 years the average person believes that US inflation will be at 3.7%. From the Federal Reserve’s Consumer Inflation Expectations Survey released April 14, 2022.
Median one-year-ahead inflation expectations increased to a new series high of 6.6% from 6.0% in February, while median three-year ahead inflation expectations decreased to 3.7% from 3.8%.
Expectations are likely higher now, but nowhere near where they should be. Inflation is likely to be far nastier, and last much longer, than 98% of people expect.
Most investors appear to be convinced that the Fed will successfully tame inflation. That they’ll raise rates and that’ll fix’er. Just run a variation on Volcker’s late 1970s playbook.
As Lyn Alden explains in her latest newsletter (must read), this is not realistic today:
The problem, however, is that public and private debt as a percentage of GDP was very low back in the 1970s, and it’s very high now. The economy could take higher rates without going into a financial crisis back then. Wealth concentration was relatively low at that time, and since that time it has reached record highs.
…if the Fed raises rates to 3%, 4%, 5%, and so forth when debt as a percentage of GDP is this high, the annual interest expense of the US Treasury would exceed $1 trillion, and many companies and households would run into trouble refinancing their debts.
The Fed’s not normalizing anytime soon. They’re managing expectations and keeping up appearances.
If I’m correct, most people are severely underestimating inflation risks, so hedges will be underpriced. Many investors won’t understand why they’re so attractive for a while yet.
Combine this with the potential for a stock market crash, and you have a recipe for bargains on hedges ahead (along with everything else).
Buying Opportunities
I would say we have high potential for a financial crisis in the near future. That would, at least temporarily, bleed over into crypto as we saw in March of 2020.
But at least we’d get some killer buying opportunities. As I mentioned in Thoughts on Building a Crypto Portfolio Today, it may make sense to enter some limit buys on Bitcoin from $5k-$25k if you’re in the market.
In terms of gold and silver, we may get a chance to buy lower than today, but I like gold at $1,850/oz and silver at $21/oz. I will buy more if it keeps going down. If we see another financial crisis, I expect precious metals to fall far less than BTC in the immediate aftermath.
In the long run, BTC has far more upside (10x+). But there’s more risk to go along with it, and the drawdowns can be brutal. That’s another great reason to own both as a pair. More here:
I agree with your perspective and enjoy Convivium very much!