Fed is Liquidating Banking Liquidity

With the recent hotter than expected 6.4% CPI inflation report, Federal Reserve Bank Chair Powell has even more credibility to stay the course to raise interest rates and drain reserves from the banking system until his 2% core PCE inflation target is reached. Over the last 4 months investors had assumed the inflation battle was almost over and that the Fed would stop tightening monetary conditions earlier in 2023 than Chair Powell has implied. The robust 2.5% Q1 GDP forecast and hot inflation report, have provided cover for the various Federal Reserve District Presidents to message the markets recently that larger for longer rate hikes are coming. The Fed’s monetary battle against inflation will be won, but the war is far from over.  Instead of one or two more quarter point hikes and done, the Fed is now communicating that a half point hike is coming in March and a parade of further hikes until inflation and labor demand fall much further. The entrenched trend of draining  loanable reserves (Central Bank assets) from the banking system in the US and around the world should continue all year. While this is a headwind for the economy and earnings that will eventually lower the inflation rate, it’s not necessarily a clarion call for the Bears to frighten the stock market to sharp new lows. Reducing bank assets, especially from such excessive heights, has not coincided with economic calamity in the past. It’s too early to tell what kind of landing – if any at all – will be the outcome of the Fed’s effort to fly this economy toward a more balanced growth horizon.

Bears may be disappointed in relying upon a falling money supply that is usually seen when the economy is running too hot. The concern will be when Money Supply starts accelerating upwards again as inflation approaches the Fed’s 2% target zone. It’s when monetary injections are needed to boost Money Supply that the alarm bells signal that the 70% of the economy driven by consumers is in trouble. Money creation has turned negative, an extremely rare event, but this was due to a year over year comparison of a monster stimulus that expanded money so much previously. Overall M2 money supply grew at rates above 20% for the 2 years since Covid began. Well ahead of the normal healthy pace of mid-single digit growth. Despite an M2 contraction of almost $700 billion since the April 2022 peak, there could be as much as $4 trillion in excess money in the economy to return to long term growth trends. The reduction of Fed bank reserves and money supply is not a tailwind, but it does not have to be the feared headwind should Chair Powell and other central bank leaders adroitly navigate the economic plane.

What makes this cycle so difficult to forecast is that virtually all of the traditional leading indicators or proxies for the economy point due south and have been doing so for almost a year. When the OECD Leading Indicator Composite fell to current levels back in 1990 and 2001. the economy was bottoming out after mild recessions. However, the actual economic data today tells a different story of increasing activity and healthy balance sheets among consumers and businesses. Airlines are experiencing increasingly healthy travel volumes. Mastercard reports that restaurant spending is up 24% over the past year. Auto production can’t come close to meeting demand – inventories remain very low. Cruise ship companies are experiencing record bookings. Housing stocks have mostly recovered all of their Bear market losses despite 7% mortgage rates and the industry continues to add construction workers to counter low inventories.  

Default rates on home mortgages, cars and credit cards are all at healthy levels.

We will make this simple: We continue to have a supply constrained economy that can’t meet demand, even with full employment. Since labor and production can’t rise to meet the Covid stimulated demand, then the inflationary consumption excess must be cut. The Fed’s job is straight forward: drain artificial money from banks to reduce lending and raise borrowing rates to discourage individuals from their Covid era spending spree. The manufacturing sector is nearing a supply and demand equilibrium, but the much larger service sector, led by travel and entertainment, has a long way to go. The stock market has been enjoying a resilient economy since the October bottom, while strategists keep pushing their expected next leg down in the economy further out on the calendar. With record low unemployment and new 40-year highs in Service sector inflation, the Fed will step on the brakes a bit harder to prevent any delays in bringing inflation down to 2%. There is a risk to the stock market later this year, as we assume the Fed’s restrictive efforts will eventually succeed in sowing doubt. For now, we still expect a broad stock market trading range this year with short term correction risk until at least mid-March to relieve overbought sentiment conditions in February.

 

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