But this time there is over 8% inflation.
By Wolf Richter for WOLF STREET.
The Dow Jones Industrial Average closed about 300 points below its June 16 low on Friday, more than erasing gains from the bear market rally. For the Dow, the bear market rally began on June 17th and ended on August 16th. During the two-month rally, the Dow was up 14%. By the close of trading on Friday, it was again 20% below its all-time high.
The S&P 500 index fell through its closing low of June 16 — the infamous 3,666 — for the day on Friday, then rallied a bit to close 27 points off the June 16 low of 3,693. During the two-month bear market rally ending August 16, the index was up 17%. As of Friday, the index was down 23% from its all-time high.
The Nasdaq closed about 2% above its June low. It was up 23% during the two-month rally. Many of my imploded stocks, which now trade for a few dollars, had skyrocketed 50% or more, and a bunch of them doubled before imploding again after mid-August.
The bond market – and with it the mortgage market – had a huge bear market rally, but people over there came to their senses two weeks earlier, on August 1st.
The 10-year government bond yield had risen to 3.48% by June 14 (rising yields mean falling bond prices; falling yields mean rising bond prices). By August 1, the 10-year yield had fallen to 2.57%, and that had been a tremendous rally.
The mortgage market witnessed an even more startling bearish rally: the average interest rate on 30-year fixed-rate mortgages hit a 14-year high of 6.28% on June 14, according to the daily measurement by Mortgage News Daily. The average interest rate then fell 1.23 percentage points to a low of 5.05% by August 1st. Realtors were already talking about improving home sales. On Friday, the average 30-year fixed-rate mortgage rate hit 6.70%, according to this daily measurement.
The bear market rally came as the Fed had already embarked on its most aggressive tightening cycle in decades and started quantitative tightening, meaning it was replacing Treasuries and mortgage-backed securities.
The Fed Pivot Fantasy has done it.
The bear market rally happened because the markets – that is, people and algos playing in them – had this fabulous reaction to the Fed’s aggressive rate-hike scenario: they started speculating about a Fed “pivot” and about rate cuts and some even about QE fantasize again. Asset prices started to rise and yields started to fall.
Many of us had anticipated a rally in our illustrious comments on Wolf Street. And I drew parallels with the bear market rally during the dot-com bust. During this rally, which lasted two months from mid-May to mid-July 2000, the Nasdaq rose 33% without ever recovering from its old high. Ultimately, the Nasdaq collapsed 78%.
That two-month bear market rally in the summer of 2000 drew a lot of people back into the market because they thought stocks were going to the moon again, and they got crushed.
The 2022 bear market rally started in mid-June and also lasted two months. It came as the Fed pivot fantasy mongers – including some well-known hedge fund managers – had spread across financial media, social media and the rest of the internet, claiming that the Fed would soon turn the tide, the fact that it didn’t even do QT, and yada-yada-yada.
So we had a huge two-month rally and the Fed pivot traders, including the hedge funds that got out in time, made a huge amount of money. But the people who believed in the pivot fantasy and bought when the pivot traders sold, well, those people took the losses. But that’s how it always goes.
The dot-com bust parallel is forming.
It was easy to spot what they were doing, and it became a hot topic in Wolf Street’s comments. For example, on July 19, I said the following in a comment:
Of the last 8 trading days, the S&P 500 has closed 2 days (including today) higher and 6 days lower. We’re due for a summer rally, but so far it’s been a pretty crappy summer rally.
In the summer of 2000, from May 27 to July 17, the Nasdaq rose 33% in the midst of a 78% plunge. Well THAT was a summer rally in a bear market! However, it did not reach a new high in the summer of 2000. Not even close. It peaked at 5,000 in March 2000. On July 17, 2000, it reached 4,275 again.
The Nasdaq didn’t make a new high until July 2015, 15 years later, and it took trillions of dollars of Fed money printing to get there. Now the money printing has stopped and the Fed is QT. And CPI inflation is 9% and the wage-price spiral has started and there’s a chance the Nasdaq will take a very long time to get back to 16,200.
I repeated the dotcom-bust parallel because it’s becoming more and more parallel, so to speak.
The bear market rally continued to the point where on July 31st I warned on a much-missed podcast that markets are fighting the Fed and that fighting the Fed would only make the Fed more aggressive, transmitted to markets to get its message across, because it relied on markets to relay its monetary policy to the actual economy and demand through financial conditions – the markets being its “transmission channel” – and on the Fed eventually winning this battle would.
The podcast received 317 comments on Wolf Street. The transcript of the podcast, released on August 3, received an additional 259 comments. This was a hotly debated topic.
The simple fact is this: an everything bubble inflated by the Fed.
Since 2008, the Fed has inflated asset prices with rate cuts and QE, huge amounts of QE. It created the biggest wealth bubble of all time – the Everything Bubble.
QE is designed to make wealth holders wealthier so that they can then spend a little more and trickle down a few drops of their newfound wealth. In 2010, then-Fed Chairman Ben Bernanke explained this “wealth effect” theory to the astonished American people in a Washington Post editorial.
The Fed got away with it because it didn’t trigger big consumer price inflation because consumers didn’t get that money; it triggered huge asset price inflation because the asset holders got that money and chased the assets with that money with their profits from those assets instead of spending them, so there wasn’t much trickle down.
But in late 2017, as Yellen prepared to hand over the reins to Powell, who had been appointed Fed Chair by Trump, the Fed began incremental quantitative tightening. At first, the steps were so small that they were difficult to see. Then QT picked up speed.
In early October 2018, the markets started falling. In November, mortgage rates hit 5% and the real estate market began to gasp. By Christmas 2018, the S&P 500 index had fallen 20%. Even the small and slow-moving QT and small 25bp rate hikes – just four of those in 2018 to just 2.5% at the high end of the target range – had a big impact on these artificially inflated markets.
But there is one big difference between then and now: inflation.
In 2018, inflation was at or below the Fed’s target and the Fed was just trying to “normalize” policy and it was just trying to get its balance sheet to manageable levels. It just wanted to return to a kind of “neutrality”. Still, Powell came under crushing pressure from Trump, who had taken over the Dow. And with inflation below the Fed’s target and with the Dow in free fall and Trump hauling Powell daily, the Fed did its infamous turn and markets rallied again.
The lesson was this: these artificially inflated markets cannot hold their levels even amid rate hikes and QT. Even small rate hikes, just four in one year, and small amounts of QT sent markets tumbling just as rate cut and QE sent them spiking. Everyone realized: QT had the opposite effect of QE.
But in 2022, inflation has risen to over 8%, its highest level in 40 years, and has spread across the economy, now peaking in services, away from supply chains and commodities, albeit gradual inflation in some goods subsides. And there won’t be a Fed pivot until that inflation makes what the Fed calls “mandatory” progress and backs down to 2%, which could still be a long way off.
QT until something breaks? Wait a minute…
There have been many people saying that the Fed will continue QT “until something breaks”. Last time QT did it until the repo market crashed. At that point, banks stopped lending to the repo market, which then exploded, prompting the Fed to bail it out in September 2019.
But this time the biggest thing is what the Fed is in charge of is already broken: price stability. Inflation is the worst in 40 years. And the Fed is tightening to fix this huge thing that broke – to get that inflation back under control and down to 2% (based on core PCE). This could be a long and hard work. And other things that might break along the way are minor inconveniences by comparison.
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