What did Econ 101 teach us?

One weak-ish employment report followed by two encouraging inflation reports has convinced the market that the Fed is done raising interest rates.

While one should never underestimate the incalculable ineptitude of the Fed, I’m siding with the market. Therefore, let’s rewind the clock this week to see how stocks and bonds performed during similar periods.

Moving on…

Milton Friedman was right. Again.

Econ 101 teaches that when the supply of something rises, and the demand for that something remains constant, the price of that something must come down. Everything from widgets to wine obeys this fundamental principle, including currencies.

The Federal Reserve increased the money supply by over 40% in two years for several “third rail” reasons that aren’t worth mentioning. Since demand didn’t rise much along the way, U.S. inflation exploded at a rate unseen in over four decades.

But everything changed 18 months ago when the Fed began removing money from the economy (how they do this is quite technical and irrelevant to this discussion).

The chart below compares the growth rate in the money supply (red line) with inflation 16 months later (blue line). This lag is important because adjustments to the money supply take time to work their way through the massive U.S. economy.

Notice how both peaked at the same point. That’s no coincidence, nor is there any reason to suggest this relationship will decouple anytime soon.

It’s just going to take time to get inflation lower. Sure, a recession could speed things up, but we also don’t need one for the blue line to continue tracking the red line.

Furthermore, while inflation has been a terrible byproduct of the complete failure of our government to do anything even remotely rational over the last four years, it’s not been all bad. Let’s not forget the resulting schadenfreude that’s warmed our hearts along the way.

Think about that Swiftie, who paid over $92k to see Taylor Swift in concert. Imagine the soul-crushing feeling of trading a Taycan to see not some deity but rather just another flesh and blood mortal stand on stage for two hours and sing songs readily available on Spotify for $9.99/mo.

Or what about all those pundits who claimed Modern Monetary Theory (MMT) can’t cause inflation for the world’s reserve currency? This fairy tale is so dead that even Google appears to be shadow-banning it, so here’s my attempt to keep it alive through the artistry of a meme generator:

Lastly, imagine the PTSD from levering up into NFTs with diamond hands. I’d wager it felt something like this.

Like I said, it hasn’t been all bad.

‘Tis the season

Using history to estimate short-term movements in markets is a key theme this week, and a good rule of thumb is to only rely on history when the result is bullish and/or feeds confirmation bias (joking, obviously). Otherwise, past performance does not predict future returns.

Within this spirit, whereas September and October tend to be bad for stocks, November and December are usually pretty awesome. Since 1980, the stock market has delivered a gain in the final two months of the year 79% of the time for an average of 3.5%.

Markets don’t operate on calendars, but there appear to be some clear drivers of short-term returns that repeat around the holidays, like year-end bonuses, Christmas music, recovery from Sep/Oct overselling, Black Friday shoppers losing limbs to save $12 on a Furby, etc.

There may also be some games played by large asset managers who are trailing their benchmarks with bonuses on the line (yes, this happens).

It's hard to say for sure, but I do know that after the last two years, I don’t care either. If we get a Santa Claus rally, I won’t look a gift horse in the mouth.

Worst trade ever.

No matter your walk of life, everyone has a bad trade every now and then. It’s inevitable. Ignoring Waze, shorting Elon Musk, taking the red-eye to save $20, eating at Arby’s, etc.

Nobody bats a thousand, but some bad trades are unforgettable, others are unforgivable, and some are both.

Here’s an alarming chart by Charlie Bilello at Creative Planning, depicting the rise in interest expense on public debt to $924 billion over the last year. He points out that if it continues to increase at the current pace, it will soon be the largest line item in the Federal budget, surpassing Social Security.

Rewind the clock to when the Fed cut rates down to zero. Homeowners, corporations, and pretty much anyone else who wanted to borrow money took advantage of the time to lock in historically low interest rates at long durations.

This was a great trade, and it’s paid off in spades. Homeowners now have a massive cushion if the economy were to fall into a recession, and companies have pushed maturities so far out that they’re in better shape than any other time at this point in the economic cycle.

Our fearless leaders had repeated opportunities to do the exact same trade but chose not to. Instead, they preferred short-term debt to long-term, and as a result, the country has a problem.

This is not hindsight bias, either. Other countries saw the opportunity and took advantage in a big way. Austria sold 100-year bonds at a 0.85% yield in the summer of 2020. Why didn’t we do that?

There are only two reasons why you trade long duration for short. It’s because you expect rates to either stay where they are for a very long time or you expect them to fall even further.

Had anyone at the Treasury or the Fed read anything Milton Friedman wrote about inflation, they might have seen this coming.

Well, maybe there’s another reason unrelated to financial theory. Perhaps it’s because the current and former Secretary of the Treasury aligned debt maturities to the duration of their time in office. Keep costs as low as possible so they look good and will be remembered as such. If so, it’s another lesson from Econ 101 – we are all self-interested.

Worst. Trade. Ever.

Disclosures

This newsletter/commentary should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the authors as of the date of publication and are subject to change. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no guarantee that any investment plan or strategy will be successful.