Throttling Back Quantitative Tightening (“QT”)
The most significant action from last week’s Fed announcement is the throttling back of QT. What that means in plain English is that the Fed will no longer be dumping bonds from its portfolio (balance sheet) onto the market at that same pace. This is more of a short-term psychological boost to the market in terms of reduced fear of increasing interest rates.
It is short term because the ever-expanding deficits and associated growth of interest rate expenses continue unabated. To put it another way, the USA has maxed out its credit card and the consequences will not be pleasant. I have not heard a single politician flag this as an issue that needs to be addressed. Spending other people’s money is an addiction that they cannot shake.
Things that I am watching include the following:
- Insiders’ Behavior. While they have been selling more company shares than they have been buying for some time, their actions in April were telling. Even though the market was down about 4 percent they did not change their behavior and go into buying mode. This seems a clear signal that they believe their shares (or the entire market) is overvalued.
- High Yield Bond Statistics. The default rates on high yield bonds have been increasing for a few months and yet the interest rate spreads over Treasuries have declined or stayed the same. There will be a rebalancing of this relationship in favor of higher interest rate differentials over US Treasuries (bond prices go down). That is clear reading on businesses that are struggling to stay afloat. Anecdotally, there were a number of businesses that were conceived when interest rates were close to zero and we are seeing that their business models cannot survive a more normal interest rate environment.
- Stealth Oil Production Decline. As energy companies in the Permian Basin of west Texas and eastern New Mexico drill through their best reservoirs they are finding that their mix of production is changing from oil to gas. For example, five years ago a well-run producer might have a “cut” of 70% oil and 30% natural gas. That same producer is now seeing a mix of 60% to 65% oil and 35% to 40% natural gas. This will make a measurable difference in non-OPEC production in the near future. This will be inflationary as the supply of oil is reduced.
- Reshoring of Manufacturing. This will continue to be inflationary as the Government continues to try to implement an industrial policy via fiscal spending. Not only is it inflationary from the fiscal perspective, but also from an operating cost perspective. Employees in the US are much more expensive than those overseas and the regulatory burdens are higher. In fact, if a company takes money to build a computer chip fab, there are a whole slew of “social equity” requirements that the company must adopt as well.
The bottom line is that the Fed has its work cut out for it in trying to strike a balance between inflation and employment in a Presidential election year.
ENDNOTES
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