Graham’s Newsletter

The Fed pushes rate cuts

Published 27 days ago • 10 min read

There are some mysterious questions that keep me up at night: Are we alone in the universe? Will AI take over humanity? Why did the Fed decide that 2% is a good target for inflation? I don’t know about the other questions, but I discovered how the Fed chose 2% and it wasn’t what I expected.

In 1988, Roger Douglas, New Zealand’s Finance minister gave a TV interview to talk about the government’s monetary policy, and the media put him on the spot. The country was just recovering from a heated spell of inflation. Rates had just dropped below 10% from 15% highs. The reporter asked him whether the government was satisfied now, with this lower level of inflation.

Douglas replied, no, they’d ideally want an inflation rate between 0% and 1%. Now the Governor of the Reserve Bank, Don Brash had a problem.

Douglas had come up with this number off the cuff, but now the pressure was on Don Brash to achieve this number. After some discussion, Don’s team figured out that there was usually an error margin of 1%, so a target of 2% was realistic. Why a 2% target? Nobody knew. No country was running its economy based on inflation targeting at that point, but once Don and his team decided on this number, they went around the country setting expectations so that people could plan for a 2% increase.

Other countries liked the predictability that came with the “2% increase” target. It wasn’t too high, and it wasn’t too low (a target of 0% left governments with no room to reduce rates if there was a recession in the future for example). So Canada adopted the idea next, the UK followed suit, and it was only in 2012 that Ben Bernanke made it an explicit policy target for the US.

That’s right, we’re playing catch-up to an inflation policy that isn’t even old enough to watch a PG-13 movie. Anyway, this is the reality we have to deal with now, and in an effort to hit this target, the Fed has once again paused rate cuts.

Let’s try to understand how they’re measuring inflation, how this is reflecting on the stock market, why Bitcoin is making a surprising comeback, and what we can expect the Fed to do in the coming months.

Measuring inflation

There are two ways to measure the price of goods and services:

  1. Track the price of everything
  2. Core CPI

When you calculate the cost of all items, inflation increased from 3.1% to 3.2% Year over Year, mainly because several categories have “sticky inflation” – they just won’t go down. While food, shelter, and services were up by less than 0.5% last month, energy increased by 2.3% in February. But then we also have Core CPI which excludes volatile categories like food and energy – and even without counting “seasonal” increases, Core CPI came in higher than expected, at 0.4% month over month.

For the most part, inflation isn’t going away. Certain categories are only increasing, and since May of 2023, month over month, it’s only trended higher. Rate cut expectations have been lowered as a result, and even Michael Burry had warned about this in the past.

“Inflation appears in spikes. It resolves, fools people, and then it comes back.” Sounds like something Thanos would say in Avengers: Infinity War, but it looks like he’s right. Since the 1940s, inflation never just occurred once and disappeared – every time inflation declines, people celebrate by spending more money as stocks increase, and then, inflation returns for as long as a decade. Even the White House’s analysis agrees. Post World War 2, in almost every case, inflation took several years to normalize from the peak and never flatlined within just a year.

All that’s to say that inflation numbers are completely normal. What I’m worried about though is whether all that money is being channeled into the stock market and creating a bubble.

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Now back to the report…

Is AI a bubble?

We don’t quite know for sure whether AI is living up to the hype, but one thing’s for sure – companies investing in AI are shooting up ever higher.

Consider this: The number of stocks hitting 52-week highs just hit a 52-week high. The overall market has been on an absolute tear, having increased by 10% this year alone. And based on history, the most likely scenario isn’t that stocks will go down, but rather that they will continue going up. As Ben Carlson points out in his article,

“The average one, three, five and ten-year total returns following new highs were +16%, +27%, +59% and +206%, respectively.”

But what’s worrying is that a lot of momentum is just because of one term: AI. According to Bespoke Analysts, 67 AI-related stocks in the S&P 500 have surged by an average of 45.3% since November 2022 when ChatGPT was opened to the public. And year-to-date, the average S&P 500 AI stock is up 3.7% compared to 1.1% for non-AI stocks. For a lot of people, this feels like a worrying sign that it’s a bubble that’s poised to pop at any moment.

On top of this, 7 companies are responsible for the majority of these returns: Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla, known as the Magnificent Seven, make up more than 30% of the S&P 500 and drive 87% of the world’s stock market gains. To complicate matters further, just Nvidia, Meta, and Microsoft make up most of those gains even within the seven.

Unlike the tech boom where new stocks were fuelled by cheap money and the hype of the internet right from the start, the leaders in the Generative AI boom are large, profitable companies that don’t need to borrow money to fund their projects, unlike money-losing publicly traded companies. There is one situation where things could blow up though. The WallStreet Journal referenced Cisco in the early 2000s as an example:

“Its price-to-earnings ratio of 126 in the year 2000 was clearly overblown…although the issue wasn’t being in a bubble, but selling networking equipment to firms that were. When the digital rush ended, Cisco’s profit and growth suddenly halved.”

In the AI economy, a lot of tech companies are selling to other AI companies, and if the market begins to pull back, that could have a ripple effect throughout the economy. This article is a good (albeit doomy) breakdown of the AI hype. How it plays out remains to be seen… Meanwhile,

Bitcoin is making a comeback

Since the beginning of January, prices have increased from $44,000 to $72,000. In the last year, prices are up by more than 220%. What’s going on?

I never thought I’d make this comparison, but Bitcoin is going through the same pains as the housing market: Not enough supply and a lot of demand. The demand is coming from one factor putting upward pressure, namely, The Bitcoin ETF. The ETF works by creating a publicly traded “holding company” that offers exposure to Bitcoin and tracks its price movements without you having to go and buy Bitcoin. In simple terms, you buy into a FUND that holds bitcoin – giving you a piece of Bitcoin.

This somewhat defeats the very purpose of Bitcoin purists, which is to have absolute control over your money without involving any institution or authority. But Bitcoin has evolved from its original purpose to be an asset class that others are looking to experiment with – and an ETF is easy, convenient, and by the looks of it, very popular.

  • It allows “direct” exposure to Bitcoin in a Roth IRA, 401k, HSA, or brokerage
  • It’s way easier than buying and transferring to an external wallet.
  • It also solves the problem of “losing your keys” accidentally so that you’ll never be stuck in a situation where you have $220 million in Bitcoin but forget your password. (You know what’s crazy? 20% of all Bitcoin, about $140 BILLION, is locked away in lost accounts)

The downside is that you won’t actually own the Bitcoin yourself and there’s a 0.2 to 0.25% convenience fee. That convenience is paying off. In less than 2 months, Blackrock’s Bitcoin ETF passed Michael Saylor’s entire stockpile. In just the last week, the entire market saw a $2.7 Billion inflow of capital. ETFs have purchased 3,500 to 4,300 Bitcoins every day since the start of February with only 900 coins being created every day. Soon, only 450 Bitcoin will be mined per day beginning April – there just might not be enough bitcoin for everyone, and demand is surging.

Price predictions for Bitcoin are all over the place.

  • The manager of 3IQ anticipates an eye-popping target of $350,000 to $450,000 next year.
  • Another analyst arrived at a $150,000 price target assuming $10 billion inflows for $2024 and $60 billion for 2025.
  • Cathie Wood believes $1 Million Bitcoin could happen around 2030.

Others like Jamie Dimon are skeptical though – comparing Bitcoin to smoking. At the end of the day, Bitcoin is still extremely volatile and highly risky, we’ve already seen several 80% drops over the last 7 years, and if you buy in, just mentally prepare yourself for anything to happen.

Now with all that said, here’s what the Fed has to say about the coming months…

Where does the Fed go from here?

Alright, in the latest Fed meeting, Jerome Powell said what we already expected: They’re going to remain tough on inflation until they’re sure it’s calming down and staying that way for good. But the path isn’t as simple as people want it to be.

Every quarter, the Federal Reserve releases what’s known as their summary of economic projections which encompasses their overall expectation on employment, inflation, interest rate hikes, and other metrics associated with the economy. This time, their projections forecast core inflation coming in at 2.6% by the end of the year, dropping to 2.2% by 2025, and finally ending at 2% by 2026. In addition to that, they also believe that the unemployment rate is going to increase slightly to 4% this year, and then remain relatively flat throughout the next 2 years.

What does this mean for interest rates? They’re still expecting the full three rate cuts this year, ending at 4.6% and then tapering off until eventually they reach a long-term federal funds rate of 2.6%. This is a bit higher than expected, of course, but the bigger problem is that we might be on the verge of a banking crisis… yeah, again.

CNBC pointed out that out of 4,000 US Banks, 282 institutions have both high levels of commercial real estate exposure and large unrealized losses from the rate surge. This includes banks whose commercial real estate loans made up over 300% of capital and firms where unrealized losses on bonds and loans would push capital levels below 4%. Jerome Powell even acknowledged this by saying that “Commercial real estate losses are likely to capsize some small and medium-sized banks. This is a problem we’ll be working on for years. I’m sure there will be bank failures.”

Studies have found that stocks tend to drop after the Fed begins cutting rates. In this case, it’s not the rate cuts themselves that force the market to drop but rather, the Fed only tends to lower rates when something breaks – and the market perhaps reacts negatively to that premonition. Besides that, they’ve reiterated that they want inflation to return back to their 2% target, and that means we’re likely not going to see a substantial rate cut anytime soon, at least until inflation subsides. Now, in light of all that…

Overall, in terms of my thoughts on the most recent decision by the Federal Reserve, I feel that we’re not going to see rate cuts as quickly, or as much as expected. The belief is that we would see 3 rate cuts this year, most likely at 25 basis points each – but we probably won’t see our first rate cut until July or September, after which they’ll wait an extra meeting or two for more data to come in. That leaves them with one more opportunity to make an adjustment on December 18th, before the end of the year.

The Fed has made it clear that unless inflation comes down meaningfully, in a way that they believe is going to be permanent, they’re not going to lower rates. I think we should believe them, since inflation is not coming down to the degree they want. If they lower rates while inflation is sticky, they risk increasing inflation and making the problem worse. If they hold rates the same, they don’t risk much – because the economy is already strong, the job market has withstood their tightening so far, and unless something breaks, they’re good to go the same way.

A more realistic outcome is to expect a 25 basis point cut at some point this year, maybe another if inflation comes down – but hey, I could be totally wrong, because I’m just a guy writing on the Internet.

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Graham’s Newsletter

by Graham Stephan

A 33 year old real estate agent and investor with over $120M in residential real estate sales. This is my way of sharing actionable ideas that will make you a smarter and wealthier investor.

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