The Federal Reserve’s Real-World Problem
The Federal Reserve is all but certain to raise the Fed Funds Rate by at least 25 basis points (0.25%) at its next meeting on May 2-3.
That’s because, in the abstract “Fed world” of numbers and models, the real-world consequences of the central bank’s actions are considered what the military refers to as “collateral damage.”
In other words, while you and I get whacked, the Fed just shrugs and says, “Stuff happens.”
As a result, stock traders are faced with a choice: to trade based on what’s happening either in the “Fed world” or in the real world.
In this article, I offer a practical solution to this dilemma.
The Fed World
Federal Reserve governors such as Christopher Waller — a voting member of the Federal Open Market Committee (FOMC) — make comments about policy as if the real world operated according to the Fed’s weird, static models, which are often based on outdated economics.
During a recent speech in San Antonio, Waller noted, “Because financial conditions have not significantly tightened, the labor market continues to be strong and quite tight, and inflation is far above target, so monetary policy needs to be tightened further.”
He then added, “All else equal, a significant tightening of credit conditions could obviate the need for some additional monetary policy tightening, but making such a judgment is difficult, especially in real-time.
“I would welcome signs of moderating demand, but until they appear and I see inflation moving meaningfully and persistently down toward our 2% target, I believe there is still work to do.”
Waller seems to be set on more rate hikes. And he’s not alone.
The Real World
According to recent data, the Fed’s rate increases have already had an effect. Things have actually “tightened.”
Retail sales fell by 1% in March, echoing recent data from Challenger, Grey, and Christmas that noted a rapidly rising number of layoffs — especially in the technology sector.
The recent government jobs openings report (JOLTS) delivered a surprising downshift in help-wanted activity.
And last week’s jobless claims delivered a surprising jump in new unemployment claims led by California, New Jersey, and Texas. The latter two states have had strong post-pandemic recoveries.
In the real world — the one in which many of us are working two or more jobs — the story is different.
Steve Roth, CEO of real estate investment trust (REIT) Vornado Realty Trust (NYSE: VNO), recently wrote in a letter to investors, “Defaults and ‘give back the keys’ have already started, led by some of the industry’s largest companies. There is no new debt available for office, so no buying, no selling, no new builds. When a loan comes due, the only refinance available (and that with a fight) is from the existing lender.”
That sounds a lot like tight monetary conditions are already in place.
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In fact, the Fed’s own Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS), which was based on data from the fourth quarter (Q4) of 2022, already sounded the alarm four months ago.
Here is how the survey described the banking system in Q4:
- A less favorable or more uncertain economic outlook;
- Decreased liquidity in the secondary market;
- Weaker loan demand from all types of firms;
- A decrease in queries from clients regarding new lines of credit or increases in existing lines;
- Tighter standards for home equity lines of credit and credit cards; and
- Weaker demand for consumer loans, especially auto loans.
Keep in mind, the survey results summarized data from before the Silicon Valley Bank implosion. The next SLOOS is likely to be even worse.
The bankers are not alone.
Three CNBC surveys recently concluded:
- Seventy percent of Americans are feeling financially stressed;
- A significant number of Americans are using their tax refunds to boost savings or pay debt; and
- Fifty-eight percent of Americans are living paycheck to paycheck.
Let’s put this in perspective.
The banking sector told the Fed that things were getting bad in November 2022. Yet the central bank raised rates four times after that — in November (75 basis points), December (50 basis points), February (25 basis points), and March (25 basis points).
Clearly, there is a disconnect.
When in Doubt, Focus on Supply
It’s not difficult to be confused in this market.
That’s why I use price charts, combined with a deep understanding of how the Federal Reserve, key market players, and company fundamentals interact to create what we see as the daily action in the financial markets.
Moreover, when faced with investment choices, I combine what I see in the price charts with information about supply and demand in individual sectors of the market.
Here are two contrasting examples.
Commercial real estate is in deep trouble.
The number of loan defaults is on the rise, and vacancy rates in major markets are climbing.
San Francisco’s office market has a 33% vacancy rate, while Washington, D.C., may have as much as a 43% vacancy rate, based on card-swipe data tracked by security systems company Kastle Systems.
In other words, the supply of rental offices is greater than the demand.
You can see this weakness reflected in shares of office-heavy REIT Vornado Realty Trust, which recently hit a new low.
The recent bounce seems to be little more than shorts covering their positions because the Accumulation Distribution Indicator (ADI) is off its lows.
But already, the shares are looking as if they are ready to roll over. On Balance Volume (OBV) — a reliable measure of real buying interest — failed to rally significantly.
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On the other hand, shares of homebuilder KB Home (NYSE: KBH), are near a 52-week high.
That’s the direct result of an undersupply of homes and stable demand from people moving from big cities like San Francisco and Washington, D.C., to suburbs and rural areas.
Note the contrast between the ADI and OBV for KBH compared to those for VNO. Money is flowing into KBH, while it can’t wait to leave VNO.
The Bottom Line
The Federal Reserve is likely to raise interest rates in May.
The economy is likely to be weaker than the Fed’s models and talking heads suggest.
Commercial real estate is a weak sector that is likely to get hammered again when the Fed raises rates.
And homebuilders may suffer short-term declines when the Fed raises rates.
But the secular megatrends we’re seeing now — a weakening economy, people working from home, and the potential for geopolitical instability — are fueling migration to suburbs and rural areas. This has created a supply crunch for housing that favors the builders.
In the end, even if the Fed continues to squeeze the economy, shares of companies in areas where supply is tight are likely to do better than those where there is too much supply and not enough demand.
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