The Die is Cast for the Fed

 With the headline consumer price index for August coming in at 3.4% and at 2.4% year-over-year for the core, the die has been cast for the Fed to increase its policy rate by 25 basis points at its meeting next week. As we noted two weeks ago, Fed Chair Kevin Warsh and his Open Market Committee members have all the evidence they need to hike rates. (See: https://shulmaven.blogspot.com/2026/08/warsh-strikes-right-chord.html ) Indeed with oil prices moving higher in September and diesel prices at record highs, it is hard to believe that August's increase in energy prices were a one-off event.

 

The bond market responded appropriately by flattening the yield curve with the yield on 2-year notes advancing by 6 basis points and the yields on the 10-year and 30-year Treasury bonds declining by one basis point and four basis points, respectively as of midday. For the moment, the Fed has gained a modicum of credibility, but time will tell as to whether or not it can be maintained. Shulmaven has long believed that inflation is more endemic than what most market participants believe, and thus the hike next week has to be viewed as the start of a tightening cycle, not one off.  

Warsh Strikes the Right Chord

Fed Chairman Kevin Warsh struck the right chord in his Jackson Hole speech yesterday. He noted that the Fed has missed its 2% inflation target for five years and the economy is operating at full employment. Although there has been some modest improvement in the recent inflation data, Warsh remains skeptical that it is on a clear glide path towards 2%. Although not giving forward guidance in the traditional sense, Warsh put the markets on notice that a rate hike is likely at the September Open Market Committee meeting.

 

The treasury market responded with a “bear flattener” where short rates went up much more than long rates. The 2-year surged by 12 basis points to 4.36% while the 10-year and 30-year yields advanced by 5 basis points and 2 basis points, respectively. The market action on Friday was the mirror image of the response after Warsh’s comments after the July Fed meeting. Then the market put on a “bear steepener” trade with short rates falling and long rates rising significantly. (See: Shulmaven: The Bond Vigilantes Strike)  I would remind readers that the 10-year treasury is trading at 4.72%, precisely the level when Treasury Secretary Scott Bessent announced his expanded bond buyback program. (See: Shulmaven: The Treasury Strikes Back )

 

Whether a September rate hike is one-off or the start of new tightening cycle remains to be seen. However, with the 2-year note yielding 4.36%, it looks like the federal funds rate is now on a slow road to 4.5%.

The Bond Vigilantes Strike

 Most market commentators attributed last week’s bond market sell-off to the lack of specificity in newly installed Fed Chair Kevin Warsh comments during his post-open market committee news conference. Although the Fed voted to keep the Fed’s target rate unchanged, regional bank presidents Beth Hammack, Lori Logan and Neil Kashkari voted for an increase thereby issuing a challenge to Warsh who has said that “inflation is a policy choice.” Warsh did not give any guidance as to how the Fed will bring inflation down to its long missed 2% inflation target. Thus, short-term interest rates declined as long-term interest rates rose in a classic bear steepener trade.

 

To be sure, I am in general agreement with Warsh on the limitations of forward guidance. The markets should not be spoon-fed the Fed’s outlook as to the course of short-term interest rates. As I noted a decade ago, the Fed should not be the stock market’s fairy godmother. (See:https://shulmaven.blogspot.com/2016/01/memo-to-stock-market-janet-yellen-is.html )

 

My sense is that the back-up in yields has more to do with the return of the late 20^th century bond vigilantes in a 21^st century form. Simply put, the back up in the 30-year Treasury yield to 5.27%, its highest in 17 years and new multi-year highs in British, French, German and Japanese yields is telling us that something more fundamental is going on than a Fed meeting. What the markets are coming to grips with is the fiscal train wreck across the industrialized world, combined with supply shocks and an unprecedented amount of business investment associated with AI. Put bluntly, there is not enough funding to go around and the bond vigilantes sense this. There are more uses of funds than sources of funds.

 

In my year-end outlook I noted that the 30-year Treasury Bond would end this year at around 5.5%. (See: Shulmaven: 2026: A Year of Turbulence ) My guess is that target is likely to be exceeded before year-end and that it will likely have a 6 handle on it next year. Although the stock market rallied late week in response Citadel’s covering the hedge fund Situational Awareness’ margin call, it will soon turn its focus to the bearish forces emanating from the bond market.

  

Reality Catches up to the Bond Market

Bond yields soared on Friday with the !0-Year U.S. Treasury yield rising 14 bps to 4.6%. Meantime the yield on the 30-Year Treasury hit 5.12%, its highest since 2007. Globally it was the same story, as Japanese yields are at their highest level since 1997 and government disarray in the U.K. is sending yields soaring there.

What’s going on? Three critical factors are coming together: rising inflation, government deficits, and an AI capital spending boom. Triggered by soaring oil prices caused by the Iran War, the U.S. consumer price index (CPI) is now 3.8% over year ago levels, and the producer price index (PPI) is now 6% over the same period a year ago. To be sure, core inflation at the CPI level is lower at 2.8%, but the core PPI is now running at a high 5.2% rate. More concerning is the likelihood that over the near-term, inflation will move higher, not lower. This clearly is not an environment for rate cuts.

Second, huge fiscal deficits are the order of the day. The U.S. continues to run a $2 trillion deficits around 7% of GDP, and with tariff refunds and higher defense spending it will go higher. Although the rest of the G-7 is doing much better, ex-U.S. the G-7 is running a deficit of 2.4% of GDP.

Last, the AI boom in the U.S. is sucking capital in from all over the world. Witness Alphabet’s recent $60 billion global offering. Here are the AI companies that used to supply capital to the rest of the world; they are now massive users of capital. Hence real rates have to increase and in the short run the massive expansion of data centers will put upward pressure on the price of inputs, ranging from memory chips to electrical equipment and construction labor.

 

This is the environment that incoming Fed Chair Kevin Walsh is facing. It is hardly an environment to cut rates. Indeed, with the two-year note now yielding 4.08%, well above the current midpoint of the Federal Funds rate of 3.63%, the market is now pricing in a rate hike. Those who say that Warsh will follow Trump’s orders to cut rates will soon be disabused of that notion. Kevin Warsh does not want to be remembered as the Fed chairman who looked inflation in the eye and blinked.

 

Finally, it is important to recognize that the recent rise rate is taking place in the context of a structural bond bear market. (See: https://shulmaven.blogspot.com/2025/01/we-are-in-early-stages-of-bond-bear.html ) Bond bear markets, just like bond bull markets last a long time. The last bond bear market lasted 35 years, from 1946 – 1981. We are now only in the sixth year of the bond bear market that began in 2020, when the 10-Year U.S. Treasury Bond bottomed at 0.56% in August of that year. So, buckle up, we are still early in a very long cycle.

Kevin Warsh and the Fed

President Trump announced this week that he selected, subject to Senate approval, Kevin Warsh to be the next chairman of the Federal Reserve Board thus ending this season's apprentice competition. Warsh seems to be a chameleon because doves see in him his call for a lower federal funds rates and hawks see his past positions that called for higher interest rates and a smaller Fed balance sheet. It seems the immediate market response was a collapse in gold and silver prices that were buoyed by the debasement trade.

In my view both hawks and doves will be disappointed. In the short run I think he will support lowering the Fed Funds rate by another 50 basis points taking it down to a 3%-3.25% range in the belief that rising productivity will lower the inflation rate to the Fed's long missed 2% target. As stated here previously, I think that is a losing bet.  ( See: https://shulmaven.blogspot.com/2025/12/2026-year-of-turbulence.html )  Further, consistent with recent market behavior I do not think that long rates will move lower thereby steepening the yield curve. Rick Rieder, Blackrock's CIO and former apprentice for the job) articulated a case for a 3-4-5 yield curve with funds at 3%, the 10-Year at 4%, and the 30-year at 5.5%. That looks like where we will end up this year, but with the 10-Year closer to 4.5%.

In the short run a Warsh Fed will let the economy run hot. That will bring with it higher profits, higher inflation, higher long term interest rates, and a volatile stock market with a downward bias. But if we step back a bit, it is becoming clearer by the day that we are in an era of fiscal dominance. The Fed would thus accommodate continual deficits of 6% of GDP that will put upward pressure on inflation. When the rubber hits the road the Fed will either be forced to tighten triggering a recession or adopt yield curve control to manage the long end of the curve. It will be only then that we will find out if Warsh is a hawk or a dove. If the Fed moves toward yield curve control the debasement trade will have legs.

The Fed is a Prisoner of the Stock Market

After a 6% sell-off from its all-time high the S&P 500, New York Fed Governor John Williams said on Friday that “I still see room for a further adjustment in the near term to the target range for the federal-funds rate to move the stance of policy closer to the range of neutral,” Stocks immediately responded to the signaled rate cut with a strong rally ending the day well off their highs, but up 1% at the close.  Yes, the Fed put is still alive and well.

 

It was no accident that Williams spoke when he did. Put bluntly the economy is being fueled by the bull market in stocks which is enabling the huge investment boom in artificial intelligence and spending by high income investors. Should the stock market falter, both investment and consumption will stall out, triggering a recession.

 

While the stock market has been chugging along the labor market has been weakening and inflation is running at a 3% rate, 1% above the Fed’s target. Were it not for the recent stock market weakness, the Federal Reserve Open Market Committee would be facing a close call in its upcoming December meeting in trying to meet its dual mandate of maximum employment and price stability.  Instead, it will likely opt to lower interest rates to appease the stock market.

 

By lowering rates, the Fed will run the risk that investors will soon realize that supporting stock prices will be added to the dual mandate. In the short run that could add fuel to the bull market, but over time investors will realize that the 2% inflation target has given way to 3% or higher to the detriment of both the inflation and labor market mandates. Thus, by being a prisoner of the stock market the Fed will have lost control of its dual mandate and ultimately it will fail because the stock market is too big for the Fed to tame.

My Review of Ray Dalio's "How Countries Go Broke: The Big Cycle"

 Paying the Piper

Ray Dalio, the founder of Bridgewater Associates, which became the world’s largest macro hedge fund, has written an important book on the inexorable reality that accumulated debts have to be extinguished one way or another. He utilizes a host of international examples and aside from the U.S. he focuses in on Japan and China. No matter the country, the piper has to be paid. Dalio’s big cycle lasts approximately 80 years, and it is in many ways similar to the long cycles discussed in Neil Howe’s “The Fourth Turning.” (See: Shulmaven: My Review* of Neil Howe's "The Fourth Turning is Here: What the Seasons of History......" ) It seems that we are on the precipice of Dalio’s big cycle joining  the crisis point  of Howe’s generational cycle. If that is the case, the turbulent time we are now living in is only in its early stages.

 

Dalio’s debt/credit/economy cycle big cycle is made up of a series of short cycles where credit expands and contracts. However, overtime debt increasingly accumulates because it does not generate the revenue needed to service it. The monetary authorities accommodate the increase in debt by going from MP0 where money is tied to a fixed standard, like gold to MP1 where policy is tied to a policy rate to MP2 where through quantitative easing money is printed. At the end of the day when the debt can no longer be serviced at reasonable interest rate, the debt is either directly repudiated or inflated away in order to deleverage the economy. If the debt is not denominated in local currency, it will be repudiated.

 

Overlapping the credit cycle are two other cycles and exogenous events such as acts of nature and the introduction of major innovations that spur growth. The cycles are an internal political cycle evolving around order/disorder and an external cycle similarly revolving around order/disorder. Today the confluence of the big credit cycle with disorder in both internally and externally means Howe’s fourth turning is upon us. What can mitigate this eventuality or make things worse will be the impact of innovative artificial intelligence on our society.

 

Dalio’s solution to the big cycle calls for reducing the federal deficit as a share of GDP from the current 6% to 3% by increasing taxes, lowering spending and lower interest rates. Similar to the 1990’s deficit reduction, if credible, would work to lower interest rates. Some of these nostrums sound similar to what the Trumpies are arguing, except the part about tax increase, tariffs aside. The Trump way of lowering the debt/GDP ratio relies heavily on much lower long-term interest rates that would bring with it other issues.

 

Dalio is clearly worried, and he makes a compelling case to be worried. My criticism of the book is that although he highlights his main points in bold, it still is way to repetitive and because I read the book on my Kindle, the numerous charts were too difficult to read. I therefore would recommend the hard copy.

The Guns of August*

One hundred and eleven years ago the guns of August opened fire signaling the start of World War I. Although far from being deadly, the July employment report reeked carnage on the stock market with the S&P 500 declining by 1.6% on Friday while the bond market sustained a massive rally with the 2-year note yields declining by 27 basis points and 10-year yields declining by 14 basis points. The markets are clearly sniffing out a recession.

 

Nonfarm payrolls increased by a meagre 73,000 jobs, but what really spooked the markets was a gigantic downward revision of 258,000 jobs for May and June. Further, all of the gain can be accounted for by healthcare and social services, hardly growth drivers. The three-month average for employment gains of 35,000 jobs is indicative of a stalled labor market. The far more volatile household survey was much worse with the average monthly decline from May to July of 287,000 jobs. My guess is that the administration’s immigration raids are now taking their toll on the job market. The labor market is experiencing simultaneous demand and supply shocks.

 

In March I called for the recession of 2025 to begin in the second quarter. (See: https://shulmaven.blogspot.com/2025/03/the-recession-of-2025.html ) That obviously didn’t pan out, but with real final domestic demand growing at only 1.2% in the second quarter and the job market stalling out, it was pretty close to a recession.

 

The day before the employment data came out, President Trump announced a panoply of tariffs on a host of countries that have failed to make a deal with him. Those tariffs and the earlier ones announced for the E.U. and Japan means that the U.S average tariff rate is now about 19%, eight times above where we started the year. Simply put, Trump called the market’s bluff on the TACO trade an eventuality we noted in June. (See: https://shulmaven.blogspot.com/2025/06/stocks-too-complacent-about-taco-trade.html )

 

As a result, with Trump’s tariffs now baked into the cake and with a stalled job market, the U.S. economy is on course for stagflation. The tariffs will keep inflation as measured by the core price indices above 3% and that will put the Fed between a rock and a hard place, especially because the unemployment rate will remain well contained, at least for now.

 

Adding insult to injury President Trump fired BLS Commissioner Erika McEntarfer because he didn’t like the revisions to the employment data. His big, beautiful economy is not as beautiful as he thought. This banana republic move will lower the market’s confidence in future data coming out for the government’s data mills, not a good thing.

 

Lastly, I have been skeptical of the stock market’s big rally off the April lows. (See: https://shulmaven.blogspot.com/2025/06/my-ucla-anderson-forecast-presentation.html ) My sense is that this skepticism will soon be justified.

*- With apologies to Barbara Tuchman

Regime Change: The End of the Economy as we have Known it

 “There are decades where nothing happens: and there are weeks where decades happen.”

                       Attributed to V. I. Lenin

In the short span of twelve weeks, Donald Trump has undone the Bretton Woods monetary order established in 1944, the GATT free trade order of 1947, and the NATO collective security order of 1949. (See: https://shulmaven.blogspot.com/2018/02/my-amazon-review-of-benn-steils-marshal.html) As a result the world is now facing a simultaneous geopolitical and economic crisis and it is no surprise,  that stocks and especially treasury bonds and the dollar have sold off. (See: https://shulmaven.blogspot.com/2025/04/a-broken-stock-market-and-broken-trust.html) Simply put, the old world order is gone, an there is nothing, as of yet, to replace it. The transition will be painful.

Those who expect that the Trump tariffs are negotiating tactic will be sorely disappointed. Trump needs the revenue to finance his tax cuts, and the Democrats only differ with Trump as to the way his policy has been conducted. They still hope to reclaim their union support by being pro-tariff and they too need the revenue to finance an ever-larger welfare state. The era of free trade, as we have known it, is over.

Three years ago, I wrote that the United States was about to enter a new 13-year economic cycle. I noted:

“My guess is that we are at the very beginning of new thirteen-year cycle with unknown consequences. I would speculate that the next thirteen years will bring with it a much higher rate of inflation than we have been used to, a multi-year bond bear market and a partial deglobalization of the economy caused by local politics, supply chain issues and geopolitical tensions. To me the big question is whether this cycle will bring with it a stagflation or a high cap-ex/high inflation economy with a cap-ex boom coming from the in-shoring production and energy transition. As they say, time will tell.” ( See: https://shulmaven.blogspot.com/2022/05/the-useconomy-is-entering-new-thirteen.html)  

Although it has taken a bit longer to play out, we are now in the midst of it and perhaps something much more. We are likely entering an eighty-year super cycle in what Neil Howe has called a “fourth turning” which will involve economics, politics, values, and the way we relate to each other in society. (See: https://shulmaven.blogspot.com/2023/09/my-review-of-neil-howes-fourth-turning.html)  This is far bigger than my 13-year cycle in that it encompasses six 13-year cycles that began in, not coincidentally 1945.

If this is close to correct, then we are now entering unchartered waters. The stock market and economic histories that we have been used to over the past 80 years may no longer be relevant in understanding the future. Instead of ever rising share prices we may now be in an era where stocks go sideways for an extended period of time. I would note that between 1924-1949 the Dow Jones Industrial Average traded in a range of between 100-200 with the significant upside exception of 1928-30 and the significant downside exception of 1931-1933. For example, in 1927 the high in the Dow was 201 and which was nearly identical to that recorded in 1949 and the 1929 high was not exceeded until 1954. The equivalent going forward would be for the S&P 500 to trade in a broad 3500-6500 trading range over the next several years.

The recent action of the bond, currency and stock market is indicative of a sea change in the markets. Instead of rallying in a time of turmoil both the treasury bonds and the U.S. Dollar have sold off. Indeed, the dollar has declined 9% since the end of February. Simply put foreigners are losing trust in the U.S. Dollar and with 18% of U.S. stocks held by foreigners the selling is only now beginning. I would say the same thing for foreign holdings of U.S. real estate.

Over the weekend the Trump Administration announced that it would reduce the Chinese tariff of 145% to 20% on smart phones, computers, and other electronic products. That action has lifted the Sword of Damocles hanging over Apple. This suggests a major relief rally for Apple and the stock market as a whole, but what multiple can you put on company and the stock market as whole whose share prices are subject to the whim of one very unstable man? I would sell the rally.  

The Week the Wheels Started Falling Off the Trump Train

 Last week the wheels started falling off the Trump train. We learned from Atlantic editor Jeffrey Goldberg, who some how was patched into a national security call on the messaging Ap Signal where he listened into a haphazard discussion on the imminent attack on Houthi bases in Yemen. To have such a discussion on Signal was a clear breach of national security by the principals involved who included National Security Advisor Michael Waltz, Vice President J.D. Vance, and Secretary of Defense Pete Hegseth. To add insult to injury, the principals lied about their conversation, only to be shown up by Goldberg, who published a transcript of the call. 

Also on the call was Trump’s envoy to Ukraine and the Middle East, Steve Witkoff. Real estate lawyer Witkoff committed the cardinal sin by listening in on the call from Moscow, where every normal diplomat knows everything is bugged by the FSB. Witkoff is a complete amateur in diplomacy, and he is so far in over his head. Further, Putin and is Minister of Foreign Affairs Sergey Lavrov have been run rings around experienced American diplomats over the past two decades. Simply put, Witkoff is being taken to the cleaners. 

This affair, now called Signalgate, will have a lasting effect on the Trump Administration. If any the American people don’t forgive, it is incompetence. Joe Biden learned this the hard way with his chaotic withdrawal from Afghanistan.

Later in the week Trump announced 25% tariffs on imported automobiles and trucks with its obvious inflationary consequences. In my largely Latino gym, the leading topic of conversation were the auto tariffs, and their imposition is obviously feeding into inflationary psychology.

The week closed out with new data on the deflator for personal consumption expenditures, which for core goods and services in February came in at a higher than expected 0.4%. Inflation has not gone away, and my guess is that market hopes for rate cuts later this year will be quashed. Not surprisingly, consumer confidence in March plummeted to a three year low. 

Further unnerving the public’s mood was Trump’s attacks on Big Law. Two big law firms (Paul Weiss and Skadden Arps) caved into his threats of pulling security clearances and access to Federal buildings. Apparently, they were guilty of supporting anti-Trump efforts. Fortunately, three firms (Perkins Coie, WilmerHale and Jenner Block) successfully filed suit to halt his efforts at intimidation. I am sure that this did not go unnoticed by Chief Justice John Roberts, a veteran of Big Law firm Hogan and Hartson. This will not augur well for the administration when their appeals hit the Supreme Court.

The already weak stock market took notice of these events and declined 1.5% on week and it is now down 5% on the year. Remember Tariff Day is set for next week on Wednesday April 2nd. To close I would note that the day before Herbert Hoover signed the Smoot-Hawley Tariff Act of 1930, the Dow Jones Industrial Average declined by 8%.

The Tariffman Strikes

Donald “the Tariffman” Trump will announce today a 25% tariff on all goods coming from Mexico and Canada and a 10% additional tariff on all goods coming from China. And this is only the beginning with additional tariffs on E.U. products and some specific duties coming. The tariffs on Canadian and Mexican products are an obvious violation of the United States-Mexico-Canada Treaty that Trump signed when he was president the first time. 

To put the tariff question in context, the U.S. imported $3.3 trillion of goods last year, about 11% of our GDP. On a purely arithmetic basis, a 10% tariff on all imports would raise the price level by approximately one percent and a 20% tariff would raise the price level by 2%. However, a potentially stronger dollar and foreign producers absorbing part of the cost would partially reduce the inflationary impact.

Although many economists poo-poo the long-term inflationary impact of the tariffs as a one-time increase, I am skeptical. Why? First, the tariffs will cause a costly rejiggering of supply chains in the longer run, and second in the short run there will be chaos at the Mexican and Canadian border points of entry where all goods shipment will be held up until the tariff is paid. Further it is not clear to me how consumers will respond to the price increases. Instead of thinking like an economist, many consumers might believe that a new inflationary spiral has started. Recall, all the talk about the transitory nature of inflation in 2022.

Importantly, we have to remember that tariffs are an excise tax on imports. As such they raise prices and reduce output with stagflation being the result. Throwing sand into the gears of the economy can hardly promote growth. To the contrary it will stifle growth and add to inflation.

We are in the Early Stages of a Bond Bear Market

Bond market cycles last a long time. For example there was a bond bull market from 1920-1946 when long term U.S. Treasury yields declined from 6% to 2.3%. Thereafter a 35 year bear market ensued to September 1981 which took the yield on 10-Year U.S. Treasury Bonds to 15.84%. This was followed by a 39 year bull market that ended in August 2020 with the 10-Year U.S. Treasury yield trading at a meager 0.56%. It seems clear to me that with the 10-Year bond closing this week at 4.76%, we have been in a bond bear market for over four years. 

Thus if history is any guide, we are only the the early stages of a bear market that could last another two decades. Of course, as in any bear market, there will be rallies along the way, the the path for yields will be decidedly upward.

The fundamentals underpinning the bear market include monumental budget deficits throughout most of the world's largest economies, unfunded pension plans, a still smoldering inflation, and, at least in the near term, the global electorate's preference for populist politics that is working to deglobalize the world economy.  Further, if you add to the mix the need for enormous expenditures to harden infrastructure for weather events and the costs associated with energy transition, all the forces are in place for higher inflation and higher yields.

As far as the stock market goes, stocks can and have risen in the early stages of a bond bear market. That certainly has happened over the last four years. However, as high interest rates begin to bite, the stock market will no longer have a bond bull market at its back to support a near record price-earnings ratio for the broad market.  

The views outlined here are consistent with an earlier blog in 2022 outlining the prevalence of 13-year cycles. (See: https://shulmaven.blogspot.com/2022/05/the-useconomy-is-entering-new-thirteen.html) Also see my recent short term outlook       (https://shulmaven.blogspot.com/2024/12/2025-revenge-of-bond-vigilantes.html)

2025: The Revenge of the Bond Vigilantes

 Before going on to our thoughts about the outlook for 2025, I would like to review what we got wrong and what we got right about 2024. ( See: https://shulmaven.blogspot.com/2023/12/2024-volatile-politics-volatile-markets.html)

• We were dead wrong about the stock market. Instead of trading in 5000-4200 range, The S&P 500 soared above 6000.

• Stocks completely ignored the geopolitical risks we outlined.

• The S&P 493 did not outperform the Mag 7. 

What we got right or close to right:

• Inflation, as measured by the core CPI, accelerated to a 3% run rate and the 10-Year Treasury closed well above 4%. (For my UCLA discussion on the economy see: https://shulmaven.blogspot.com/2024/12/my-ucla-anderson-talk-on-prospects-for.html)

• The Fed avoided a recession but did not cut rate soon enough to help Biden.

• The presidential election was close, and, at the time, we were leaning toward Trump.

• Ukraine did not set the West Siberian oilfields ablaze, but it did hit energy infrastructure deep into Russia.

• It looks like Israel has defeated Hamas, but Saudi Arabia, as of yet, is not on track to join the Abraham Accords.

Now for what 2025 will look like:

• Inflation will run at a 3% rate because of continued wage growth of above 4%, the imposition of tariffs and the beginnings of a mass deportation of undocumented/illegal immigrants.

• With continued inflation and a rising federal deficit, the yield on 10-Year Treasuries will exceed 5%. The bond vigilantes will exact their revenge.

• In this environment stocks will exhibit the volatility we though would happen this year and the S&P 500 will likely trade in a wide range of say 6400-5400, closing lower on the year.

• The House Republican Caucus which puts the “dys” in dysfunction will get is act together to renew the 2017 tax cuts with a $20,000 SALT deduction. The other elements of Trumps tax cut plans will be put in separate bills making passage unlikely.

• Two of Trump’s controversial cabinet appointees will be turned town by the Senate.

• France is fast becoming the new Greece and German dysfunction will only increase.

• Israel will attack Iran’s nuclear infrastructure which will bring with it unknowable consequences.

As they say in Las Vegas, read’em and weep, but remember I am often wrong and never in doubt.

After Action Report on the 2024 Election

Shulmaven did not cover itself with glory this year. We thought Harris would win because she would be successful in casting Trump as the incumbent. (See: Shulmaven: The Turning Point in the Election and Shulmaven: A Realigning Anti-Incumbent Election)       She obviously failed in that task. We also thought that the Democrats would retake the House, which is still possible, but unlikely. Our Senate call had the Republicans ending up with 52 seats: they ended up with 53.   

What we did get right was that the election would signal a major realignment in American politics. We wrote “Simply put, the Republican Party, by eating into the Democrats hold on Black and Latino voters, has put together a broad multi-racial working-class party with a strong populist bent. This is a far cry from the business and country club-oriented party of two decades ago. Lurking behind all of this is an ever-widening gender gap.” 

 

We also wrote: “At least to me, if Harris loses Pennsylvania, her biggest mistake would be not picking Governor Josh Shapiro as her running mate (See: Shulmaven: Kamala Harris Fails Her First Test with VP Pick)  and her failure to counter Trump’s attack on her position supporting federally paid for gender reassignment surgeries.” Both of these points were spot on. Finally, we noted: “I also have a hunch that the election might not be as close as the polls suggest. It is equally likely that either candidate will receive more than 300 electoral votes.”

Harris lost because her one-billion-dollar campaign and the near full support of the propaganda arms of the state, were insufficient to overcome the underlying fundamentals of the race which were:

1. Inflation is the graveyard of administrations.

2. 70% of voters thought we were on the wrong track.

3. The Biden-Harris Administration had a 40% approval ranting.

4. She failed to counter Trumps ads attacking her support for federal funding for gender assignment surgery for prisoners and immigrants held in custody.

5. Her much-vaunted ground game was over-rated.

Further she made two unforced errors. She failed to appear at the Al Smith Dinner and didn’t accept Joe Rogan’s invitation to appear on his podcast.

Perhaps most interesting the election, contrary to earlier thinking, where women fearful of losing their reproductive rights would drive turnout, instead turnout was driven by a wave of noncollege educated men of all races. It is this group that is driving the realignment towards the Republican Party. Also, of note in the deep blue states of New York, New Jersey and Virginia, Trump’s share of the vote surged. The blue governing philosophy is failing. Net Net. The Democratic Party is in a world of hurt relegating itself to be the voice of a cloistered college educated elite led around by its nose by the mainstream media and the boorish snobs of the faculty lounge.

 

The Fed's "Coup de Whisky" to the Stock Market

 Last week’s 50 basis point cut in the federal funds rate to 4.875% served up a “coup de whisky” to the stock market. Those words were spoken in July 1927 by Benjamin Strong, President of the New York Fed to Charles Rist, the Deputy Director of the Bank of France at secret central bank meeting on Long Island.* Much like today the U.S. economy was humming along, but Britain was rapidly losing gold. To take the pressure off the British Pound, Strong and several other regional banks cut the discount rate from 4% to 3.5%.

 

In response an already strong stock market was off to the races and would double over the next two years. That move put the roar in the roaring twenties. Although today’s circumstances are far different, but not so different; the economy is at roughly full employment, real GDP has likely grown at a 3% clip over the past six months, and inflation remains moderately above the Fed’s 2% target. Nevertheless, just like 1927 stocks roared in response to new highs.

 

The Fed’s move and it signals of further cuts of 100-150 basis points over the next nine months, is a bright green light for the stock market as investors now believe that the risk of recession is off the table and faster growth will ratify the very optimistic profits estimates for next year. I don’t think that we will repeat the late 1920’s blow-off but further new highs in stock prices appear likely.

 

Interestingly the yield on longer maturities increased. Why? On the margin the 50bp cut will increase both growth and inflation. The lower short-term interest rates will support corporate borrowing and auto finance. Housing, on the other hand, won’t be helped all that much because mortgage rates responding to higher long rates actually increased. That will force house buyers into variable rate paper.

 

The real risk in the Fed’s move is that inflation will not be as quiescent as it now believes. Simply put, the rate-cutting cycle that the market is banking on might be cut short.

* For a full discussion of this event see Ahamed, Liaquat, "The Lords of Finance" (New York: The Penguin Press, 2009) pp. 290-304

My Amazon Review of Frank McDonough's "The Weimar Years: Rise and Fall 1918-1933"

 On the Road to Perdition

 

Third Reich historian Frank McDonough has written a year-by-year tick tock history of the Weimar Republic from its founding in 1918 to its demise on January 30, 1933. It is largely a political history where he sometimes goes into excruciating detail about the various cabinet changes over the years. His hero is Gustav Stresemann, prime minister and for many years foreign minister. He was perhaps Germany’s most influential politician from 1925 -1929 where he negotiated a détente with the West though the Locarno Treaty. Unfortunately, deliberate, or not there was not Locarno for the East where Stresemann had designs on the eastern territories taken away from Germany at Versailles.

 

McDonough rightly notes that the premature deaths of Foreign Minister Walter Rathenau by assassination in 1922 and the deaths by disease of President Friedrich Ebert and Stresemann severely eroded the talent of the regime. I have written elsewhere that Stresemann’s death in 1929 removed the last politician of stature who could have stood up to Hitler.

 

Weimar was plagued from the beginning by a flawed constitution and its lack of legitimacy among the German Right. The two fundamental flaws in the constitution were proportional representation that allowed for the smallest of parties to have a voice in Reichstag and Article 48 which enabled the president to rule by decree. That would haunt the government as the economic crisis of the 1930’s hit.

 

Further, it was this government that signed the Versailles Treaty that established Germany’s sole guilt in starting World War I and placed a severe reparations burden on the economy. It was a tough start and that along with crippling inflation almost brought the government down. However, as Robert Gerwath noted in “November 1918: The Great Revolution” Weimar survived and with Dawes Plan loans in 1925 actually prospered.

 

So why did Weimar collapse? To McDonough the faults lie with the lack of responsible parties on the Right and with President Paul von Hindenburg, the hero of World War I, who in the late 1920’s was supportive of the government, returned to his monarchal roots as a Prussian land baron. It was he, along with the intrigues of Franz von Papen and Kurt von Schleicher who brought down the hapless Heinrich Bruning government in 1932. Bruning’s government was imposed on the Reichstag by Hindenburg. He never had a parliamentary majority and with the lack of foreign currency reserves he was forced to impose a draconian austerity policy on an economy already in depression. To me Bruning did not have much of a choice. By the way, the best tick-tock on the end of Weimar is in Rudiger Barth’s and Hauke Friedrichs’ “The Last Winter of the Weimar Republic.”

 

Indeed, the decay was evident in December 1930 when Nazi goons disrupted the German premier of the anti-war film, “All Quiet on the Western Front.” So great were their disruptions that the film was banned a week after the failed premier. This has a familiar ring today in America where pro-Palestine mobs are canceling Jewish performers and Israeli officials.

 

 

Away from politics McDonough discusses the flowering of culture in art (abstract expressionism), architecture (Bauhaus), and film (Metropolis). Indeed, Berlin was second only to Hollywood in film production in the 1920’s. There was also the very free and licentious culture of Berlin’s nightclub scene. It was not for nothing that the recent German TV series was called “Babylon Berlin.” What McDonough does not mention is that this Avant Garde culture just might have turned off small city and rural Germany who overwhelmingly voted for Hitler in 1932.

 

However, my two primary concerns with McDonough’s otherwise excellent work is that he down plays economics. He should have taken seriously the works of Frederick Taylor’s “The Downfall of Money,” and Tobias Straumann’s “1931: Debt Crisis and the Rise of Hitler.” Simply put, Weimar was not up to the task. However, to his credit, McDonough does not that Hitler’s opposition to the Young Plan in 1930 made him respectable.

 

My second concern is that he failed to emphasize the long-standing division in the Left between the Socialists and the Communists. The split started during World War I and was exacerbated by the Socialist government with the support of the Army and the Free Corps in putting down the communist Spartacist Revolt in early 1920. Later in 1929 a different socialist government put down the “Bloody May” communist demonstration in 1929. McDonough doesn’t even mention this and with the communists calling the socialists “social fascists” it less of a surprise seeing them join forces with the Nazis in bringing down the Bruning government and in supporting a transit strike in Berlin in late 1932. Thus, part of the blame for the rise of Hitler has to fall on the disunity of the Left. As I have written previously the global impact of the Russian Revolution was to split the Left and harden the Right. It certainly played out in 1930 Germany.

 

With my concerns aside, McDonough’s book is important. I learned much from it and there are certainly lessons for today.

For the full amazon URL see: On the Road to Perdition (amazon.com)

2024: Volatile Politics, Volatile Markets and the Fed Joins CREEP

Shulmaven did not cover itself in glory in 2023. (See: Shulmaven: 2023: Another Year of Living Dangerously ) We got much of it wrong:

* The economy did not enter a recession.

*Stocks did not trade in a broad range of 4200-3300 and instead approached its all-time high of 4800.

*Bitcoin didn't collapse to below $10,000 and and instead more than doubled to over $40,000.

*Trump was not a spent force and he now seems cruising towards nomination.

* The market has yet to recognize we have entered a new 13-year cycle.

We got a few things right:

*The Fed remained on the warpath for much of the year and wage gains remained solid.

*10-Year Treasury yields stayed above 4% for much of the year. Coincidentally  the yield ended where it stated at 3.9%

* Ukraine struck deep into Russia with missiles and sabotage as global tensions remained high.

Now, in the spirit of being often wrong and never in doubt here are my views for 2024:

* With the S&P 500 trading just below its all-time high and the VIX index at 12, I believe 2024 will be year of high volatility coming from volatile international and domestic politics. Think 1968.

* The stock market appears to be ignoring the warning of former Secretary of Defense and CIA Director Robert Gates where he noted in the November/December issue of Foreign Affairs "The United States now confronts graver threats to its security than it has in decades, perhaps ever."

* In retaliation for attacks on Ukraine's power plants, Ukraine will set ablaze several of Russia's prize West Siberian oilfields.

* Israel will defeat Hamas sufficiently to declare a victory and by yearend Saudi Arabia will be on track to join the Abraham Accords. (See: Shulmaven: Hamas Aggression Must be Punished)

*Domestically all of the signs point to a Trump victory for the Republican nomination and his victory in November, hardly a confidence building eventuality. Nevertheless, I am not yet predicting a Trump victory; I think it is a 50/50 call as of today.

* The Fed will do whatever it takes to avoid a recession in 2024. Their recent pivot is a step in that direction.  Objectively the Fed will join the Committee to Re-Elect the President. (CREEP, the name of Nixon's campaign in 1972.) As a pillar of the establishment and fearful of its independence, the Fed will effectively be all-in for Biden. Thus the Fed will plant the seeds for a very problematic 2025.

* Core CPI will likely run at a 2-2.5% rate in the first half, but accelerate to a 3% run rate by yearend. As a result the yield on the 10-Year Treasury will once again be north of 4%. In keeping with my view that we are in a new 13-year economic cycle, wage growth will remain solid.

* In this environment the S&P 500 should trade in a broad range of 5000-4200, approaching both ends more than once during the year, with the VIX exceeding 30 at least once during the year. Consistent with the past month, the S&P 493 will outperform the Magnificent Seven.

My Amazon Review of Benjamin Graham's and Jason Zweig's (Ed) "The Intelligent Investor (Rev. Ed.)"

 Margin of Safety

 I just finished rereading “The Intelligent Investor,” a book a I read many years ago and much of its investment insights are still very valid for today. I would note that I was weaned on Benjamin Graham’s “Security Analysis, Principles and Techniques” as an undergraduate at Baruch College. I guess you can say that Graham’s ideas are in my blood. Indeed, just as Graham probed the Standard and Poor’s stock guide, so too did I for many years. Today we have computerized databases.

 The most critical ideas that are useful today include:

·       * A stock certificate is more than a piece of paper; it represents an

      ownership interest in a business.

·      *  Investments should only be undertaken with a quantifiable margin of safety.

·     *   “Mr. Market” who on occasion is manic-depressive allows you to express a view on a stock or a bond every day.

·     *   Despite all of your efforts at security analysis the stock market is loosely efficient making it very difficult to outperform a broad index. Investment success flows from a few very special situations.

·      *  Investors can be characterized as defensive or enterprising, but even for the enterprising investor Graham’s rules are designed to minimize losses through diversification and heeding to margin of safety requirements.

 

As the classic value investor, much of Graham’s work is focused on tangible book value. That metric worked well though the middle of the 20^th Century, but that kept Graham and his acolytes away from growth companies who were powered by intangible capital. Thus, it was hard for Graham to get comfortable with owning many of the growth stocks of his era, but his discipline kept him away from the craziness of the bubbles that occurred in 1961 and in the late 1960’s.  Jason Zweig, the editor of this version discusses at the length the extremes of the late 1990’s dot.com bubble.

 

Graham was fond of public utility shares in the early 1970’s because they traded a low price/earnings and price/book ratios. Unfortunately, he did not foresee the debacle that cost over-runs in nuclear power brought on to this sector. Zweig points this out. Also, Graham really didn’t associate the rise in interest rates in the late 1960’s with the rise in inflation. He characterized common stocks as inflation hedges, which in the long run they are, but that is not necessarily true in the short run as rising inflation propels interest rates higher and price/earnings ratios lower.

 

Then there is a short discussion on Graham’s investment in Government Employees Insurance Co. (GEICO). There his partnership broke his diversification rule by investing 25% of its capital in it for 50% of the company. However, its valuation in terms of earnings and tangible equity was very low. It was his best investment and Warren Buffett, his best-known student, followed him into GEICO and as a result Berkshire Hathaway now owns the entire company.

 

Although the book’s examples are dated, the investing rules outlined here are timeless.

For the full Amazon URL see: Margin of Safety (amazon.com)

Random Thoughts on the Economy and the Stock Market - No. 5

 *-Contrary to what we have been thinking the stock markets as measured by the S&P 500 surged to  its highest level of the year and is just a touch off its August high. The stock market responded to strong employment growth in May and the signals coming out of the Federal Reserve that there will be the first pause in their rate hiking policy that began over a year ago. Further the White House and the Congress agreed to deal over the debt ceiling that postpones that issue well past the 2024 election. For that proviso alone Biden won the debt ceiling stand-off.

*- Obviously the May employment data indicates that my call for the recession starting that month was way off the mark. (See: Shulmaven: Has the Recession Arrived?) Nevertheless, with household employment down by 310,000, compared to a 339,000 increase in nonfarm payrolls, and the the unemployment rate rising to 3.7% all is far from perfect in the labor market.

*-  Little noticed last week was updated guidance from Equity Residential, the owner of 80,000 upscale apartment units,  which indicated that same store rents were up 6% from a year ago. This is hardly the news that the Fed has been looking for. Rents increasing anywhere near that level will make it impossible for the Fed to achieve its 2% inflation target.

*- Treasury bill and bond issuance is about to surge as the government reverses its special measures to avoid breaching the debt ceiling. This action will drain reserves from the system and put upward pressure on interest rates.

*- Net, Net. I would be a seller of the rally.

Random Thoughts on the Economy and the Stock Market - No. 3

* Last week a black swan flew over the markets in the form of the failure of the Silicon Valley Bank (SIVB) with assets of $211 billion, making it the second largest bank failure in U.S. history. Although shorts were hovering over the stock for awhile, the suddenness of the collapse shocked the markets. The failure was the result of two cardinal sins of banking: 1) like an early 1980's S&L the yield on its assets were far below its funding cost due to the rapid rise in interest rates and 2) like the Texas banks of the 1980s its assets and deposits were concentrated in one industry; oil in the case of Texas and technology in this case.

Thus far, unlike in 1984 when the FDIC bailed out all of the creditors of the Continental Illinois National Bank, with $40 billion in assets and the it being the 7th largest bank in the U.S., Silicon Valley depositors above the $250k insurance threshold (87% of the deposits) will have to wait in line to get paid out of the receivership. Thus there are more than a few companies that will not be able to meet payroll. Just to note the Continental Illinois bailout gave rise to the term "too big to fail."

* The bank failure triggered a 4.5% weekly decline in the S&P 500 and the yield on two year Treasury notes cratered from 5.07% to 4.59% in two days, the biggest such decline since the Lehman crisis of 2008. As result the Fed will likely ignore the 311,000 February jobs gain accompanied by a modest 0.2% increase in average hourly wages and whatever this week's CPI will bring thereby ignoring the hawkish 50 basis point increase talk of the earlier last week. Thus,  making for a modest 25bps increase in the federal funds rate. Of course, if there is wide fallout from the bank failure any increase would be off the table.

* My sense is that banks stocks will continue to trade under pressure given the recent FDIC report highlighting the fact that the banking system was sitting with $620 billion in embedded securities losses as of yearend and the growing awareness on the part of depositors that the minimal rates banks now pay are unsustainable. Part of Silicon Valley's problem was that deposits were leaving to find higher yielding alternatives. Simply put, net interest margins will be under severe pressure.

*For the stock market as whole, as I wrote previously, I believe we will soon retest the October 3600 low for the S&P 500.