On Thursday, the Bureau of Labor Statistics announced an annual inflation rate of 7.7 percent for consumer prices, based on the Consumer Price Index (CPI) for October. This news caused quite a stir among investors, who celebrated the decrease in the CPI headline figure.
The stock market responded with one of the largest single-day rallies ever recorded. The S&P 500 surged more than 5.5 percent, while the NASDAQ rose over 7.3 percent. Notably, the yield on the 10-Year Treasury note fell to 3.81 percent, marking its lowest level in over a month.
So, does this mean that consumer price inflation is no longer a pressing issue? Has the worst already passed? Can Jerome Powell make a shift in strategy?
Unlikely. It’s more probable that consumer price inflation will continue to be a significant issue throughout the decade. Nonetheless, this isn’t the time to invest heavily in stocks. We’ll delve into the reasons why shortly, but first, let’s discuss consumer price inflation.
Remember, consumer price inflation is a result of increased money supply. Between September 2019 and April 2022, the Federal Reserve inflated its balance sheet by over $5 trillion, creating money from nothing.
Since then, the Fed has reduced its balance sheet by approximately $300 billion—roughly 6 percent of the initial inflation. Clearly, there is much more inflation waiting to be addressed.
While the Fed, Treasury, and Congress were busy flooding the economy with printed money from late 2019 to spring 2022, other errors were taking place.
Supply chains were disrupted by strict lockdowns, many of which remain in disarray. Furthermore, imprudent energy policies, enforced through executive orders, hampered oil and gas production.
Unchecked consumer price inflation results from too much money pursuing too few goods. The central planners at the Fed and in Washington are responsible for both the massive money printing and the downturn in economic productivity that have led to today’s escalated costs.
A severe economic depression may be necessary to bring prices back down. Hence, the Fed is intervening in the debt market to induce debt deflation and curb demand in hopes of stabilizing consumer prices.
Since March, the Fed has been incrementally increasing interest rates. To clarify, these hikes target the federal funds rate but do, in fact, affect longer-term rates.
This year alone, the Fed has increased the federal funds rate from a target range of 0-0.25 percent to 3.75-4.00 percent. Consequently, the 10-year Treasury rate has escalated from approximately 1.63 percent at the beginning of the year to over 3.81 percent now.
The consequences of these rate hikes are becoming increasingly apparent.
Scrapping the Playbook
For many Americans, the residential real estate market exemplifies the relationship between asset prices and interest rates. Higher interest rates increase the cost of financing a home, necessitating a drop in housing prices to accommodate increased borrowing costs.
This dynamic extends to debt markets as well. When interest rates rise, the value of debt-derived financial assets—like bonds—declines, creating challenges for both borrowers and bond investors in 2022.
Take, for instance, the hospital chain Community Health Systems Inc. According to its website, “CHS is committed to helping people get well and live healthier.”
While this mission is commendable, potential investors should proceed with caution. The company’s bonds have plummeted around 35 percent since September, now valued at just 42 cents on the dollar.
CHS is struggling financially, attempting to manage a $12 billion debt load by recently repurchasing $267 million of its bonds. However, its earnings are declining faster than the rate at which it can pay down its debt.
During a recent earnings call, Chief Financial Officer Kevin Hammons summarized the situation: “Elevated contract labor and wage inflation continue to affect our…performance.”
In a favorable interest rate environment, as experienced over the past four decades, CHS could have simply refinanced its debt to obtain lower monthly payments. This strategy has been the go-to solution for both businesses and homeowners since the early 1980s.
However, this option has been eliminated by rising interest rates. Many businesses, homeowners, and debt investors are now finding the financial landscape to be harsher than they anticipated.
Instances of Disorder
The greatest asset bubble in history—spanning stocks, bonds, real estate, cryptocurrencies, digital art, and more—created by the Fed’s abundant cheap credit, is now beginning to deflate. What this will mean in practical terms remains unclear.
Thus far, financial markets are mostly adjusting in an orderly manner. However, significant turmoil could be just around the corner, and several notable incidents have already occurred.
Last month, the UK gilt market’s long maturities collapsed, forcing the Bank of England to acquire tens of billions of pounds in long gilts to avert a crisis akin to Lehman Brothers. While the gilt market might have stabilized temporarily, has the underlying problem truly been resolved?
Recently, Credit Suisse faced a liquidity crisis, as fearful depositors rushed to withdraw their funds—resulting in the bank admitting that one or more of its units breached liquidity requirements.
Should the remaining depositors be concerned? Even after Thursday’s significant market rally, Credit Suisse’s shares have plummeted over 56 percent year-to-date.
Following that, a massive crash occurred in the cryptocurrency market this week. Sam Bankman-Fried, co-founder of FTX, experienced a staggering 94 percent loss of his wealth.
Some prominent casualties include the Softbank Vision Fund, the Singapore wealth fund Temasek, and even Tom Brady (#tommy), among others. Of particular concern is the Ontario Teachers’ Pension Plan, which invested $400 million into the Bahamas-based cryptocurrency exchange at a $32 billion valuation last January. How did this due diligence slip through the cracks?
Other than these occurrences, the financial markets have not yet seen a major panic—at least not publicly. There have been no reports of bankers jumping from skyscrapers or CFOs facing dire consequences.
A major panic has yet to unfold. As the Fed continues implementing Operation Break Stuff, many wonder when the real upheaval will occur and where the next major breakdown will arise.
Death to Zombies
It takes time for financial pressures to materialize in an economy weighed down by debt. The impact of rising interest rates seeps through the system, revealing cracks that go unnoticed until they find their weakest points.
This past week, the Wall Street Journal uncovered critical findings from a recent investigation. They found that a significant vulnerability lies within American businesses:
“North American companies will need to generate at least $200 billion in 2022 and 2023 to manage rising interest expenses, according to a Wall Street Journal analysis of data from Fitch Ratings. If high inflation persists, borrowing costs could remain elevated for years, creating a divide between companies capable of reducing debt and those that cannot.”
Rising interest rates inevitably bring about the demise of zombie firms. By “zombies,” we refer to companies that would have failed long ago were it not for the lifeline of artificially low-cost credit.
These zombies—like Washington Mutual, Ringling Bros., Toys R Us, and various others that did not survive the last downturn—will soon vanish completely. The WSJ also noted:
“Funding for investment vehicles known as collateralized loan obligations has plummeted 97 percent from last year’s levels to $1.3 billion. CLOs are the primary buyers of junk-rated corporate loans that private equity firms use to acquire target companies, and the volume of these loans declined by roughly 70 percent this October to $54 billion.”
“The pain on Wall Street ripples across Main Street. Private equity firms executed about $1 trillion in deals last year, extending into niche industries like car washes. The cost of loans for these companies rises in tandem with interest rates. As private equity funds become less profitable, U.S. pension funds that increasingly rely on this asset class face significant losses in public stock and bond markets.”
In summary, the availability of credit for zombie companies has effectively dried up. Even if the Fed could enact a pivot (which it cannot), it would be too late—the damage has already been done.
Big defaults are on the horizon. Moreover, the bear market is far from over.
You can bet on it.
[Editor’s note: We find ourselves on the brink of a perilous descent into chaos. This troubling scenario has been developing for decades. However, you need not fall victim to it. After nearly twenty years of research, I’ve painstakingly compiled the Financial First Aid Kit. Inside, you’ll find essential strategies to safeguard your wealth and privacy as the global economy teeters on the edge of a worldwide depression.]
Sincerely,
MN Gordon
for Economic Prism
