Monetary Policy Tools: The Fed’s Latest Actions with Brad Kasper
Monetary Policy Tools: The Fed’s Latest Actions with Brad Kasper Show Notes
Our featured guest on this episode of The Guided Retirement Show is a very familiar one. LSA Portfolio Analytics President and Founder Brad Kasper made his seventh appearance on the podcast, as he joined Dean Barber to discuss some of the latest news with the economy, markets, interest rates, and the Fed’s monetary policy tools.
The last time Brad appeared on The Guided Retirement Show was a little more than a year ago. It was a very tumultuous time for the Federal Reserve, so Brad broke down the multiple headwinds that the Fed and the markets were facing. A lot has happened in the 13 months since Brad and Dean last discussed that, so you won’t want to miss their conversation on the Fed’s monetary policy tools and latest actions.
In this podcast interview, you’ll learn:
- How Historic Last Year’s Fixed Income Drawdown Was
- Jerome Powell’s Latest Outlook
- The Massive Wall of Private Credit
- The Difference Between a Recession and a Richcession
Looking Back on How 2022 Was a Brutal Year for Bonds
Last year was one of the worst years on record for fixed income. When Brad was last on the podcast, we were only just starting to see some historic pressure on bonds. But it got even worse for the remainder of 2022. The French Revolutionary War was the last time we saw a 10-year treasury drawdown anything near what we saw last year.
“That might sound wild when thinking about what a 10-year treasury bond looked like in 1788. That was the last time we even saw the double-digit drawdown profile that we saw out of fixed income last year. It was a wildly challenging year for bonds.” – Brad Kasper
The huge drawdown in bonds caught a lot of people by surprise and caused a lot of pain for the typical 60-40 investor. Fixed income is typically the lower risk ballast of your portfolio, but that wasn’t the case in 2022.
How Much Longer Will Interest Rates Remain Elevated?
We’ve seen that reprieve a little bit here in 2023, but we haven’t really seen a major rally in fixed income either. That rally probably won’t occur for quite some time. Dean and Brad think that we’ll see interest rates remain elevated for at least the next three quarters, maybe even the next full year.
At the beginning of 2023, most economists and strategists were talking about the Fed potentially lowering rates at the end of 2023. That seems to be well off into the future at this point. In January, the Barclays U.S. Aggregate Bond Index went on a run. Everybody that was saying there was a tremendous opportunity in bonds. Brad doesn’t think they’re wrong. He just thinks they were early.
“January gave us an indication of how bonds could potentially behave when we get through the worst of what the Fed is doing with their monetary policy tools. But then you get through the end of first quarter, and we have some additional rate increases.” – Brad Kasper
Those increases have happened at a much slower pace than last year, but they’re still having an impact. A lot of those early gains in bonds were given right back to the marketplace because we’re seeing the 10-year shoot right back up. We seem to be in the same problematic scenario that we found ourselves in last year with one big difference. That’s the pace of where we’re going with these interest rate movements compared to 2022.
Looking at the Fed’s Track Record of Specific Language with Their Monetary Policy Tools
On August 16, Jerome Powell said that the Fed has removed the word recession from their forecast. He stated that the economy is going to slow a little bit, but not to worry about going to go into a recession.
That’s a tremendous amount to unpack with some very strong language regarding the Fed’s monetary policy tools. Let’s start with that last point about inflation being under control. It is true that the year-over-year inflationary number looks a lot better. But remember, we’re looking at 12-month windows of inflation. When you had the massive drop, it’s rolling off some big numbers on the back side of it. The change in those numbers is what it’s representing.
“I would argue that most people probably aren’t feeling that big reduction of inflation rate. The grocery store is still expensive. The price at the pump is still expensive. We’re not really feeling it, even though the data suggests that we’re in a healthier range than where we were 12 months ago.” – Brad Kasper
When Will We Stop Feeling the Effects of Inflation?
It’s not reversing the effects of the massive inflation; it’s just slowing the rate of increase. It could take years to get back to more traditional levels. We had tremendous supply chain issues, geopolitical concerns, and energy running through the roof. Those things run up in price very quickly and are very slow to decline.
“I think inflation is still the Fed’s primary target. They still see it as being a little bit hot. I think that’s why they continue to stay engaged.” – Brad Kasper
Is a Recession Really Out of the Picture?
While killing inflation has been the Fed’s main objective with their monetary policy tools, Powell made quite a bold statement by saying that a recession is out of the picture in 2023. Brad believes that is an example of them front running for what they hope will play out.
“You need to be very careful with that because the Fed doesn’t have a perfect record of using language to kind of direct the markets as to what actually plays out.” – Brad Kasper
For example, do you remember when Powell said inflation was going to be transitory? That clearly wasn’t the case. The summer of 2008 was another example of when the Fed was wrong. That was when the subprime mortgage crisis was entering its worst timeframe. That summer, then Fed Chairman Ben Bernanke said that that the banking crisis was under control and that the worst was likely behind us.
Well, it wasn’t even a quarter later that Lehman Brothers went belly up. Freddie and Fannie had to be bailed out. Major banks and insurance companies had to be bailed out. But Bernanke said everything was fine. So, you need to take what Powell says, about taking the word recession out their forecast with a grain of salt.
The Fed’s Job with Utilizing Their Monetary Policy Tools Isn’t Easy
We do want to be clear that the Fed consists of people who probably have the best pulse of what is going on with the domestic and global economies. Brad and Dean would never want their job in a million years. But when they use the strong language like that regarding their monetary policy tools and it doesn’t ring true, it’s a reminder to everyone have cautious optimism about their recent projections.
Dean and Brad hope Powell is right about a recession being out of the cards. Brad does have some skepticism, however, about the Fed’s soft landing narrative. What does soft landing really mean that at the end of the day?
“I think they believe that they can fabricate a soft landing, if needed.” – Brad Kasper
The Fed’s Massive Balance Sheet
Here’s an example of what Brad is alluding to. The Fed became a $9 trillion behemoth on their balance sheets. Nobody voted for this. They just grew their balance sheets as quickly as possible. Then, last year, they said that wasn’t what the Fed was intended to do and started to unwind their balance sheets.
The Fed started dumping some of these bonds back into the marketplace at a decent clip. There’s probably some correlation to bond behavior when the Federal Reserve is getting out of the way of backstopping the overall economy.
“I tip my cap to them because I think that going through some of that painful movement puts us in a healthier position where real price discovery can happen and fundamentals matter again.” – Brad Kasper
The 2023 Bank Failures
They were on a tremendous path until hitting a bump in the road with Silicon Valley Bank’s bankruptcy. That sent a ripple effect through the regional banks. The Federal Reserve reacted by opening an overnight lending window. We saw about $750 to $800 billion tapped into overnight from all these regional banks.
We’re not suggesting that it wasn’t the appropriate decision to make because it allowed these banks to continue to be solid on their money market positions, make sure that they had plenty of reserves to operate through this event. But how does the market interpret it?
If the Fed is going to continue to step in and bail us out of those painful moments, this is where Brad starts to think about if there is a fabricated soft landing that the Fed has in mind.
“That movement in March suggests that they’re going to continue to be a player in backstopping this. Now the question is, what are the next couple of bubbles that we need to be thinking about?” – Brad Kasper
Fitch Downgrades Regional Banks
Fitch, which is a rating agency, recently said that they’re going to have to downgrade a lot of the major and regional banks. Brad thinks it’s twofold. There are two big bubbles that the markets are going to have to be thinking about in the next six to 12 months—private credit and commercial real estate.
From an investment perspective, we’re trying to identify what are the potential risks that we’re facing. The bigger plan is to think through how your portfolio behaving through these events. Do you have good risk controls associated with them?
A Huge Wall of Private Credit
There is a massive wall of private credit that is due within the next six to eight months. When that private credit comes in, they’ll need to extend those loans, that debt. But they’re not getting the 6% or 7% rates that they had five, 10 years ago. They’ll need to re-up that debt at about 12% to 14%. That’s going to hurt the company.
Private credit has grown tremendously. It’s about a $1.4 trillion asset class, which is roughly the size of bank loans these days. When you have all these companies using private credit at slightly increased rates versus what you could do if you went through the more traditional channels, that was fine. They were willing to pay the enhance the increase so that they could receive the capital.
But now a lot of that capital is coming due. They do these issuances for a certain timeframe. And when those bonds come due, they now need to repay their capital if they still need the money to continue to operate. So, the company needs to have enough cash to pay off the debt or they’re going to refinance that debt through private credit again at a higher interest rate.
“If they need to refinance at 14%, what is going to happen to these companies? We could potentially be in a movement where the default rates on private credit start to increase.” – Brad Kasper
The Only Thing That Kills Higher Prices Is Higher Prices
If that happens, that means that you have companies that are filing for bankruptcy, laying off employees, or potentially closing. Yet the Fed is still saying that a recession is no longer in the forecast when they discuss their monetary policy tools.
The flip side of that is if we’re going to pay this debt, we need to raise our prices. And if we need to raise our prices, inflation goes up. The only thing that kills higher prices is higher prices. That goes against what the Fed is trying to do with their monetary policy tools, as they’re trying to kill inflation.
“That’s the equation of how you get there. It’s taken a lot longer than what we probably expected, but you still see the formula in play. The Fed and markets are hoping that we grow our way out of it and I don’t see enough growth yet—not to say that we can’t have it.” – Brad Kasper
Brad and Dean don’t like to be pessimistic about this, but they want to be realistic about the headwinds the Fed and markets are facing. They don’t see a scenario where we’re growing at a rate quick enough to outpace some of these concerns.
The Big Problem in the Banking Industry
Let’s shift gears from talking about private credit to talking about the banking industry. It has the exact opposite problem with having loans on the books in the form of mortgages at 2.5%, 3%, 3.5% in an environment where you can buy a three-month treasury at 5.25% or better.
The Banks Want a Recession
For banks to compete and get deposits to support their reserve requirements, they’ll be forced to pay a higher rate on the deposits than what they’re getting on the loans that they have out. That’s why Fitch is saying that may need to downgrade some banks because their P&Ls are all messed up.
“The best thing that could happen for banks is if we have a recession. They want Jerome Powell to put the word recession back in there. Because as soon as we go into a recession, the Fed will be forced to lower rates, which would be great for banks.” – Dean Barber
Again, most pundits expected rate cuts at the end of 2023. When you start thinking about business planning for some of these banks, they weren’t projecting this to be prolonged through 2024 or maybe even 2025. Who knows when the rate cuts will start to happen.
Issues within Commercial Real Estate
This leads right into the second bubble that we’re concerned with, which is commercial real estate. The amount of debt that these banks have on the books is somewhat problematic. And there are two different sides of it. We elegantly described one side. The other side is some of these distressed cities where we now have low occupancies within corporate buildings.
For example, Target in Minneapolis just shut its doors and couldn’t handle it anymore. It’s a crime issue. You see it in very pocketed areas all over the country. But at the same time, it is compounding on itself.
Somebody recently asked Brad if regional banks are through the worst of it. He thinks that they are healthier than where we were in March and April because they had to clean up their books very quickly to stay healthy. But they aren’t through the worst of some of the debt issues that they still have on the back side. Commercial real estate is a big portion of that.
Hopefully Turning Headwinds to Tailwinds
Now, there is a tremendous story with Target in Minneapolis as well. There is a private real estate group that bought the Target and are going to work to turn that into a residential property.
“The strength of the American companies and American ingenuity is a very powerful thing. You have somebody stepping in, seeing a distressed opportunity to make something good out of it. And I hope they do. If they do, maybe it’s the blueprint to find the growth pattern to get out of it.” – Brad Kasper
Right now, these are headwinds that hopefully turn into tailwinds at some point in time. But we need to be patient. We need to be wildly observant of risk within portfolios to make sure that we’re thinking about it properly.
What Is a Richcession?
As we continue to discuss the Fed’s monetary policy tools, we have a question for you. Have you heard the term a richcession as opposed to a recession? Unemployment has remained stubbornly low, which we would view that in a normal environment as positive. It’s strong, people are working, etc.
The term richcession comes from the opposite of a recession. Typically, when the economy softens and it slows, the lower income people start to lose their jobs first. We’re seeing the opposite in what’s happening in the job market right now. The banks and tech companies are the ones that are doing most of the layoffs because of the pressure that they’re under. Dean believes that the technology companies are going to be caught in this private credit and overextended debt scenario that we just talked about.
“That’s going to force layoffs at the higher end with the white-collar jobs as opposed to the blue-collar jobs.” – Dean Barber
The Fed Leaning on a Strong Unemployment Number Could Be Dangerous
There are several companies that are going to need to make difficult decisions. Depending on the stress that they have on their on their books, it could be the higher earners that are finding that need to find new jobs and new positions. There’s a scenario where that could play out.
In terms of the stubborn unemployment rate, it’s funny to talk about it in a negative lens because that’s a positive thing to have unemployment at a wonderful level. But at the same time, we didn’t define what we were going through last year as a recession because employment stayed strong. If the Fed leaning on a strong unemployment number that could be wildly dangerous.
Keep in mind, we just went through half a year where the S&P 500 was up 20% and technology was up 40%. You would think that this is the most euphoric time with all this growth and opportunity. But you don’t have to go too far back to think that it feels like we’ve gone way too far, way too fast. With this idea of a richcession, these companies that have run quickly may not be quite as healthy as we believe.
“It circles back to the fact that earnings are going to matter. Some of these names have been highfliers, partially because they got beat up last year. There’s a big narrative that tech is growing because of the AI movement and there’s some truth to that.” – Brad Kasper
But at the same time, the trends with the highfliers in tech will need to settle down at some point. They’ll need to have better earnings as they’re going through to validate some of these valuations that we’re finding ourselves in.
The Magnificent Seven Stocks
Apple, Amazon, Microsoft, Tesla, Meta, Google, and Nvidia are being referred to as the Magnificent Seven stocks. Those seven stocks make up over 50% of the market capitalization and most of the return of the Nasdaq. Those seven stocks make up 25% of the capitalization of the S&P 500 and are driving most of the return of the S&P 500.
“I haven’t seen a scenario where you have such a narrow group of companies driving the markets since 1999.” – Dean Barber
Getting Back to Fairly-Valued P/E Ratios
When you take us one step removed from those big names, you see much more muted growth. Here’s an example. Look at a price-to-earnings ratio on Amazon. On June 22, it got up to 309.88. A week later it went from 304.52 on June 29 to 102.65 on June 30. As of August 24, it’s 103.81.
Now, check the price-to-earnings ratio of some of the big energy companies. Most of them are seven, eight, or nine. They’re in the high single-digit price-to-earnings ratios. There are a bunch of companies that Dean thinks are undervalued at this point. They haven’t done anything to help the market participation.
Either the P/E ratios of those big energy companies need to rise to come up to fair value or the ones like Amazon that have out-of-sight P/E ratios need to keep coming back down. Or a combination of the two. It’s all about diversification.
The Power of Diversity
Diversification within our industry is becoming a bit of a cuss word. We’re all looking at the S&P 500 or the Nasdaq because that seems to be where all the growth is. But if you take the S&P 500 or the Nasdaq from January 1, 2022, through today, you’re barely breaking even, if that. You’re probably still slightly negative yet. If you took the equal weight of the S&P 500 and you went from January 2022 through today, you’re in almost an identical position, but without those wild swings.
“There’s value in having good exposures across names within your portfolio.” – Brad Kasper
It’s hard because a lot of these names that you’ve carried over the last four or five years or even 10 years plus haven’t kept up with the octane of some of these highfliers. But we keep watching these highfliers continue to hit multiple expansions that are ridiculous.
And these are good names that have played a role within our economy and have served well to have the growth that they’ve had. But at some point, that’s going to shift. Even if you look at last year, the value names relative to growth names were a much better performer. The power of equal weight was just leaning more on the impact of diversity within a model or within a position. And it played its role last year.
“It was interesting last year that financials and energy both did well. And then this year it’s just the opposite.” – Dean Barber
It’s hard to say who’s going to be the next categorical winner. At the beginning of each year, we wonder if it’s going to be growth market or a value market. Is it going to be a large cap versus a small cap? There’s a fair amount of speculation that goes into it. It’s similar to the speculation with the Fed and what they’ll do with interest rates.
Markets Can Sober You Very Quickly
When Brad joined Dean on the podcast in July 2022, they envisioned the Fed capping out closer to 4%. They share that with complete humility. One thing about markets is they will sober you very quickly.
“You can have as much information in front of you as you think and think that you have good controls and then figure out that there’s something beyond what we understood. That’s what we saw with the Fed. And same thing with large cap and small cap growth versus value.” – Brad Kasper
The role of both is significant within an overall strategy. Instead of speculating who’s going to be the categorical winner and making that bet year over year—likely getting those odds wrong more than a few times—this is where you split it and have some growth.
Growth and technology play a significant role in real alpha generation to portfolios over time. But the value names have a role as well. That’s more of the defensive posturing like 2022. We’re at a significant high in the markets where P/Es are starting to go back to levels that they were in the summer of 2022.
“When we get to those levels, I don’t want to make big bets one way or the other. I want to know that I have good exposures on both sides so that I can find a smoother ride through these events instead of trying to make big bets at each event.” – Brad Kasper
When Is Residential Real Estate Going to Come Down in Price?
There’s one more sector that we want to discuss in this overall discussion about the Fed’s monetary policy tools. That’s residential real estate. There was speculation that residential real estate was going to start to come down in price. We’re not seeing that yet, though. We’re seeing people bidding at ask or over to get a home.
We’ll need to watch Fed activity to see what happens here, but Brad thinks there is a path where residential real estate stays healthy through this. If you go back through real recessionary events, residential real estate does well.
“That seems counterintuitive, especially in a rising interest rate environment. But there’s perceived value in those homes and there are still have a tremendous amount of people looking for homes.” – Brad Kasper
The problem is the real estate is so high. Think about all the kids that are still living with their parents. It’s because the price that they need to pay to get into a home today at a rate that is higher than what we’ve had to do over the last couple of decades has made it incredibly challenging. It’s not that the demand side isn’t there. The price is just keeping them out of the markets.
“Can there be a bit of a balance? We might see a healthy reset, but I think the demand is big enough that it keeps it a relevant asset class.” – Brad Kasper
Looking at the Future of the Housing Market
Dean doesn’t think real estate prices will go back to where they were in 2021, early 2022. He believes real estate prices are going to remain elevated for the supply demand issue. Dean thinks apartments stay healthy because there are so many people that are locked into somewhere between 2.5% and 4% mortgages. If they want to move, they know that they need to go get a new mortgage at over 7%. So, they’re staying put. That’s the supply side of things. It’s remaining extremely tight.
“I believe that will keep the home prices elevated. The consumer is strong enough now for us not to have any worry about major defaults in the residential real estate industry or that sector like we saw in the Great Recession.” – Dean Barber
Residential Real Estate vs. Commercial Real Estate
There are some pockets of commercial real estate where it’s a completely different conversation, though, with offices and retail—depending on location.
Go back to global shutdown. Everybody started working from home and a lot of people still are. Look at how much money some companies are pumping into their buildings. They’re trying to increase the attractiveness of coming into the office.
Patience Is Key
As you can see, there have been many headwinds that the Fed and markets have been facing. How will the Fed utilize its monetary policy tools going forward and will it achieve a soft landing? Brad will likely join Dean again on The Guided Retirement Show next season to see how things panned out and how the Fed will continue to use its monetary policy tools.
“We’re at a moment where people are fearful of missing out. It’s a polarized market environment. Unfortunately, our crystal balls as clear as anybody else’s. We just need to be patient.” – Brad Kasper
It’s a very interesting time for diversity to come back into play and be a buzzword again. We started touching on it with growth versus value, it extends into the fixed income conversation and across asset classes.
“This is one of the most exciting time frames I’ve been around with the real role of diversity and risk controls within portfolios. I think we’re going to find it’s a meaningful market cycle to have those conversations.” – Brad Kasper
Do You Have Any Questions About the Fed’s Monetary Policy Tools?
Brad and Dean covered a lot of ground related to the Fed’s monetary policy tools. If you have any questions about anything they touched on and how it could impact you, you can schedule a 20-minute “ask anything” session or complimentary consultation with one of our CFP® Professionals by clicking here. We can meet with you in person, virtually, or by phone.
Resources Mentioned in This Article
- The Fed and the Markets Face Multiple Headwinds with Brad Kasper
- 2022 Was Unusual for Bonds, Tough on Stocks
- Rebalancing Your Portfolio: Looking at a Midyear Rebalance
- The Effect of Rising Interest Rates on the Economy
- 10 Ways to Fight Inflation in Retirement
- Is Inflation Slowing?
- Inflation and Supply Chain Issues Are Intertwined
- Geopolitical Uncertainty Creates Chaos … And Opportunities
- Inflation Rates and the Fed
- A Banking Crisis Amid the Fed’s Fight Against Inflation
- Investment Risk in 2023 with Garrett Waters
- Mortgage Tips for Different Phases of Life with Tim Kay
- Richcession or Recession: Where Are We Heading?
- Magnificent Seven Stocks Continue to Drive the Market
- Proper Portfolio Construction with Stephen Tuckwood
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The views expressed represent the opinion of Modern Wealth Management, LLC, an SEC Registered Investment Adviser. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management, LLC, does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.