The Fed’s Racing Toward Dead Man’s Curve

Dangerous curves come in all sorts of forms. 

A woman can have dangerous curves that can lead a man to make some very bad decisions. I mean, before you know it, you’ve bought a ring, then a house, and then you’re changing diapers. 

Then there are dangerous medical curves, such as diseases of the spinal cord that can cause the bowing of a person’s back. Often, these kinds of dangerous curves can be constant sources of pain and agony for the afflicted. 

Then there’s the dangerous curves on the roads we drive, as many unlucky motorists are killed each year in automobile accidents. Perhaps the most popular dangerous curve was made famous by the musical duo Jan & Dean in their 1963 hit, “Dead Man’s Curve.” 

Here’s the opening stanza from the song, which as you will soon see, I manage to connect to financial markets.  

I was cruisin’ in my Stingray late one night
When an XKE pulled up on the right
And rolled down the window of his shiny new Jag
And challenged me then and there to a drag
I said, “You’re on, buddy, my mill’s runnin’ fine
Let’s come off the line now, at Sunset and Vine
But I’ll throw you one better if you’ve got the nerve
Let’s race all the way to Dead Man’s Curve”

This song tells the tale of an impromptu road race located near my old stomping grounds in Los Angeles close to where I spent my college years at UCLA. Now, there are several things about this song that I identify with, so indulge me for a few sentences here. 

First off, I’ve owned both of the cars in the race (a Corvette Stingray and a Jaguar XKE). The Stingray was the essence of American muscle while the Jag was classic British elegance. And while the Stingray was faster, the Jag was no lackey in the speed department. I also identify with the song because on many weekend nights, I would go with my “car guy” friends to drive Sunset Boulevard from the UCLA campus, head east toward Vine, then come back home late at night through the winding road filled with tough-to-navigate turns and traffic lights that would come up on you unexpectedly — even though you knew they were there. 

Yes, I did get more than a few speeding tickets on that road over the years, and one too many of those is what inspired me to go to the legal safety of the racetrack, where I could drive as fast as I wanted without the threat of law enforcement engagement. 

Ok, so, I’m coming to the part that relates to financial markets. You see, “Dead Man’s Curve” was actually a real part of the road on Sunset Blvd. near Doheny Dr. in the 1950s and ’60s. The road has long since been fixed, but in the Jan & Dean era, it was a dangerous turn that took many lives. It also nearly ended the life of “Bugs Bunny,” or at least the voice of Bugs Bunny. In 1961, the great voice actor Mel Blanc was severely injured when his car crashed and went off the road at Dead Man’s Curve. 

Today, the Federal Reserve appears to be facing its very own Dead Man’s Curve, i.e. a treacherous section of road that must be carefully navigated lest you lose control and cause your vehicle to crash — and in the Fed’s case, cause the vehicle that is the U.S. economy to crash into a ditch called inflation. 

Indeed, the major question for markets right now is not whether there is inflation, but whether the Fed is right in its assessment that the increase in inflation is just temporary, or “transitory” as the Fed calls it, or whether it’s a more structural result of the massive flood of loose fiscal policy, i.e. federal spending related to the pandemic, and Federal Reserve accommodation, i.e. massive bond buying via quantitative easing (QE)?

The market is certainly beginning to get spooked about inflation, and that was evidenced by the May 12 release of, and swift and downbeat market reaction to, the April headline Consumer Price Index (CPI). That metric rose to its highest level since 2008 at 4.2%, while the all-important “core CPI” figure rose 0.9% to its highest level on a month-over-month basis since 1981. Not coincidentally, that’s also the last time inflation was a real problem for the economy. 

The stronger-than-expected numbers resulted in a “hawkish” reaction across markets, as stocks plunged, and Treasury yields rallied. However, while clearly inflation pressures are stronger than economists’ forecasts, “reopening” and temporary-related issues did make these numbers run hot. 

Case in point, within the details of the CPI report we saw airfare, used vehicle prices and lodging prices all rose 10%. Those are enormous, unsustainable gains that were related to reopening (e.g. travel) and supply issues (e.g. semiconductors). If those metrics had been ignored, core CPI would have risen just 0.4% month/month, less than half of the 0.9% increase and just above economists’ forecasts for a 0.3% rise. 

While inflation pressures in the April CPI report were stronger than expected, there’s still a lot of evidence to imply that those pressures are being caused by temporary factors. So, despite the market reaction on Wednesday, May 12 (recall the S&P 500 sank 2.14% that day, igniting several days of selling) nothing in the CPI report substantively changes the outlook on inflation, nor does it imply the Fed is “wrong” about its contention that surging inflation is transitory. 

I say that because sustained inflation and an economy that is running “too hot” essentially flips the script on the Fed and investors, at least the script that’s worked for the past two decades. Let me explain. 

You see, since roughly the late 1990s, investors have been conditioned to believe that whenever there is any economic or market trouble, the Fed will ride in and save the day via interest rate cuts and/or QE. How long it takes for these Fed measures to essentially “fix” any market declines has varied depending on the severity of the crisis/economic pullback, but ultimately the result has been the same: The economy and markets get in trouble, the Fed cuts rates and/or does QE, and some years later, stocks are at new highs. Additionally, and most importantly, the Fed riding to the rescue allows the market to essentially look past near-term economic pain and move higher. This was especially evident exiting the financial crisis, as the stock market rallied consistently despite the actual economy taking a long time to recover, and again last year when stocks aggressively rallied despite a raging pandemic and partially shut down economy. 

As it is often said, markets don’t care about now, they care about what’s next. And the Fed cutting rates and instituting QE reassured the markets that brighter days were ahead, which is why stocks have quickly recovered from any economic setback during the last 20-plus years.

But the reason sustained inflation and a potential “economic overheat” is such as scary road to navigate (like that Dead Man’s Curve) is because, in that paradigm, what has saved the markets for the past 20-something years will only make the problem worse and make stocks and bonds fall.  

If markets are worried about inflation and an economic overheat, and stocks and bonds begin to fall as a result, the Fed can’t just hint at rate cuts or keeping QE on forever to fix the problem. Those are the policies that would be causing the problem, and doing more of them will only make the problem (inflation) and market reaction (declines) worse.  

Instead, in this scenario, the only policy the Fed can employ to actually fix the underlying problem is to hike rates. This situation famously played out under the helm of then-Fed-Chair Paul Volker, who aggressively raised interest rates throughout the late ’70s and early ’80s, culminating in a double-dip recession in 1981/’82.   

As anyone around back then can attest, that situation was painful. Unfortunately, that pain is likely to be dwarfed by comparison, as this time there’s massive bond and fixed income ownership due to aging Baby Boomers, and those investments (which haven’t gone down in 20 years, broadly speaking) will get hit very hard. Additionally, with Consumer Credit near multi-year highs, a painful increase in interest rates would be a substantial headwind on the economy and consumer spending.  

Thankfully, it remains entirely possible the Fed is right that inflation is only “transitory.” Sadly, though, there’s not been a Fed in history that thought it was willingly creating an inflation problem. Yes, these people are very smart and experienced, but like all people, they aren’t perfect. 

That’s why over the coming months and quarters, I will be hyper-focused on whether inflation is temporary (or not), and whether the economy is overheating — because the stakes are high for the markets and the economy for the remainder of 2021 and well beyond.  

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On The Road Again 

On the road again

Just can’t wait to get on the road again

The life I love is making music with my friends

And I can’t wait to get on the road again

–Willie Nelson, “On The Road Again” 

The country music icon is still going at it at age 88, hitting the road again and doing what he does best — playing some of the best music ever written. This summer, Willie and an all-star cadre of country and Americana acts will be playing live shows again, and this time at a series of events called the Outlaw Music Festival. And after last year’s pandemic-punctuated absence of live music, I can’t wait to attend this event, as well as many others. 

Your editor with Americana singer/songwriter and Oscar winner Ryan Bingham. 

So, if you are in Southern California in October, and you see a stocky editor in a black shirt and a cowboy hat watching Willie, Ryan Bingham, The Avett Brothers, Chris Stapleton, Sturgill Simpson, Kathleen Edwards and many more performing, then don’t hesitate to come up to me and say hello. It’s high time we all celebrate existence with live music again. 

Wisdom about money, investing and life can be found anywhere. If you have a good quote that you’d like me to share with your fellow readers, send it to me, along with any comments, questions and suggestions you have about my newsletters, seminars or anything else. Click here to ask Jim.