Bernanke wins Nobel Prize while investors suffer crisis he helped create

What became clear in the data last week is that central planners have been unable to tame the inflation they unleashed. Ironically, the same week former Fed Chairman Ben Bernanke was given the Nobel Prize in economics.

The irony is that Bernanke created the wide array of new powers for the Fed which have been used to manipulate interest rates, bringing them down to multi-century lows, which created an enormous bubble in financial markets.

When asked on 60 Minutes whether the Fed would be able to withdraw that money so as to avoid inflation, Bernanke claimed it would. When asked how confident of that he was, he answered "100%." That is what the great Austrian economist, Hayek called "the fatal conceit," the excess intellectual pride which causes central planners to think that they know more than the rest of us combined, and therefore should have the privilege of overriding the financial decisions of billions of people through government decree.

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Last week's reports showed stubbornly, persistently, and broadly high inflation rates, and markets decided that the Fed had no choice but to continue to burst the bubble it had created, despite a worsening economy and the growing threat of a credit crunch. Markets are simply people with skin in the game, as opposed to bureaucrats like Mr. Bernanke, who helped trigger one of the deepest recessions in American history, was slow to react to it, eventually overreacted, and helped create the next crisis. This string of failures is not punished, but rather rewarded with the highest honor the international community offers in the field of economics. Investors, on the other hand, know better.

Big Picture: Last week was almost entirely about the various inflation reports. Wholesale goods price inflation and retail goods price inflation were both higher than expected. Furthermore, the minutes of the prior Fed meeting were released and they generally indicated that the members were committed to hanging tough on fighting inflation - though there were enough doubts expressed to cause markets a bit of confusion about whether the minutes  really were fully "hawkish" (inflation fighting). Eventually markets settled on hawk, which triggered a number of standard market reactions to that scenario:

• Fed rate futures rose for every meeting through the beginning of 2024.
• Current interest rates rose, especially the shorter duration rates, which are typically most sensitive to Fed tightening.
• The dollar rose as international investors moved money to the dollar as a currency which offers higher yields, but without the higher risk seen around most of the rest of the world.
• The dollar price of gold dropped, indicating increasing dollar strength.
• Crypto currencies sold off.
• Dollar-denominated markets outperformed global markets.
• Emerging markets and emerging market currencies sold off.
• Riskier bonds sold off more than lower risk bonds.
• The types of stocks that depend on low interest rates generally underperformed the types that are less interest rate sensitive.

Some trades did not conform with the standard pattern when interest rates are expected to rise:

• Some categories of US Equities rose.
• Some growth-dependent sectors overperformed recession-hedging sectors.
• The inflation expectations which are implied by TIPS (inflation protected treasury bonds) went up.
• Real Estate Funds were generally positive.

These comparative returns between asset classes such as stocks, bonds, currencies and commodities are consistent with the following account: The Fed has slowed inflation but is far from beating it. The Fed will continues to tighten, but will not bring inflation down to normal for some time. The US economy is likely to slow, but not a hard crash. The global economy is likely to have a harder time than the US. Tight money will likely cause a credit crunch, driving up default rates for risky bonds.

This coming week the big items will be about the housing markets: housing market index, housing starts, existing home sales. Of course, there's always the weekly unemployment claims.

Any one of those items has the potential to either intensify or reverse the narrative and market dynamics along with it. For example, if housing markets are surprisingly weak, that could shift expectations towards a Fed that will loosen up a little. The same thing could happen if there is a spike in unemployment claims.

Real Estate: REITS performed modestly well, which one would not expect given the prevailing interest theme of the week, though it is consistent with the improved growth outlook and those indicators that pointed to rising inflation risk.  REITS do well with inflation (real estate is an inflation hedge, growth (because in seasons of higher growth renters can afford to pay more); and low interest rates (because it is a debt-dependent sector). Last week they were given two of those things, which seemed to net out to modest gains. REITs performance is typically between that of equity markets and bond markets, and that held true last week. 

U.S. Stock Market: Domestic equity markets were mixed last week, with growth stocks significantly underperforming value stocks. That underperformance occurred among the large, mid and small size company categories. That underperformance could reflect at least two factors: growth stocks are more dependent on low interest rates than value stocks and they are also more dependent on high growth rates. Growth stocks tend to underperform value stocks during times of falling economic growth expectations (because growth presumably helps earnings actually deliver on growth companies' high expectations). They also tend to underperform value stocks when interest rates are rising because their long time horizon causes the discounting effect of interest rates to play out over a longer period of expected future earnings.

It is likely that it was the interest rate factor more than the growth factor which mainly drove the difference in performance between growth stocks and value stocks. That's because the interest rate picture was clear: interest rate futures showed significant shifts upwards for the foreseeable future, and current interest rates rose as well. The growth outlook was not quite as clear. Some growth signs were there: large cap-weighted stock funds outperformed bond funds; copper prices were up. However these growth trades were not universal nor of large magnitude. Also some anti-growth trades were there as well: falling energy prices; falling silver prices, and higher-risk bonds performing badly compared to lower-risk bonds. The bond sector dynamics might be reflecting credit-crunch risk rather than growth risk, which we'll look at in the bond sector below. The difference in performance between different stock sectors: S&P/NASDAQ, cyclical/defensive, discretionary/staples, discretionary/utilities, etc., were a mixed bag with some showing a more optimistic growth shift and others showing the opposite. 

So, the rising rate picture is clear, but the softer landing picture is a bit fuzzier. It's likely that the difference in performance between growth stocks and value stocks is large enough that interest rates are largely responsible but a tad less growth pessimism may have contributed to it as well.

International Stock Markets: International equity markets were down for the week, while, in contrast, most U.S. domestic equity markets were up. This was due at least in part to the headwind of a rising dollar. In other words, the international underperformance was stronger than it would have been because of the underperformance of the currencies in which foreign markets are denominated. However, the dollar strength was not universal, with some dollar indices rising and some falling depending on which foreign currencies the dollar is compared to by the different indices. Also, the fall of foreign currencies (which is just another way of saying 'the rise of the dollar') was smaller than the negative returns. In other words, foreign markets generally performed worse than U.S. markets mostly because those markets fell, not mostly because their currencies fell.

EM underperformed DM significantly: both the currencies and the markets. Although Asia was hit harder than the rest of the world, nevertheless the main pattern last week was not a geographical one, it was level of development one. That is, it wasn't mostly an Asia story; it was mostly an EM story. And that indicates that poor EM returns were driven by the same major theme of the week that drove domestic markets - the specter of more rate hikes. Higher interest rates attract investment away from abroad especially from risky emerging markets.  Our analysis shows that EM markets are historically vulnerable to very high investor losses when the dollar is strong, when global growth is slowing, and when the Fed raises rates. Markets have been signaling that all three of those conditions are present or likely coming.

Bond Markets: Bond markets were generally (but not universally) slightly down last week, which is consistent with the macro outlook discussed above - the Fed hiking rates is bad for bonds because literally the way the Fed hikes rates is by selling enough bonds to make the price go down, and bond math means the lower the price, the higher the yield.

But the real story is found by comparing different types of bonds, at individual sectors. The story was consistent with decelerating growth (just as the stock sector dynamics we described above were), with high yield bonds and investment-grade corporate bonds significantly underperforming treasuries. But since other indicators were signaling higher growth (or more precisely, less slowdown) it's worth asking whether the dynamics of different credit quality bonds really are a slow-down story or are instead about something else. The growth thesis is simple: when business slows down, companies find it harder to make their debt payments. So lower credit quality bonds are more likely to default and so forward-looking investors sell them now. But growth isn't the only thing that matters. For example, inflation helps debtors (who pay back dollars that are worth less than the dollars they borrowed) and so rising inflation risk can bail indebted companies out of trouble. For another example, credit crunches can also raise the risk of default. Often companies, instead of paying off their debt outright, roll it over. They issue new bonds in order to get the cash to pay off their old bonds that are coming due. But rising rates means the new bonds will put added cost-pressure on the company. And a genuine credit crunch might mean that lenders are simply not able to extend new credit to high risk companies. Press reports last week indicated that some of the mega-banks are moving into a precautionary mode and hoarding funds as an umbrella against a rainy day. That puts over-leveraged businesses in a tough position. The rising rate scenario is clearer in the data than the decaying growth scenario. Therefore, it seems more likely the bond market is agreeing with the rate hike scenario than it is with the slowing growth scenario. That explanation has the added advantage that it puts bond market in agreement with other indicators rather than dissenting from them. 

On the inflation side, TIPS over-performed non-inflation-protected treasuries, and were the only major category of bond to show positive returns last week. When inflation hedges do better than the alternatives, that tends to mean investors think inflation is more of a risk than they did before. The yield spread between TIPS and regular treasuries widened, which is an indicator of rising inflation expectations. Remember when the price goes down, the yield goes up. So if the price of TIPS goes up, the yield of TIPS goes down, and if the price of regular treasuries goes down, the yield of regular treasuries goes up. These two changes in price widen the gap between the two yields, which is considered a pretty pure expression of inflation expectations (in fact, it is called the "inflation breakeven rate"). This inflationary market signal disagrees with the anti-inflationary message of a rising dollar, falling gold and falling crypto currencies, so it's hard to be confident about whether markets got more or less optimistic about whether the Fed would be more or less effective in bringing inflation down a bit.

Investors are still wrestling with the inflation outlook. Remember, markets seem to be assuming higher than normal inflation; the question they're wrestling with is: how much higher than normal?