Fed Lag Times

Yesterday marked a milestone as the wife of a friend of mine received the vaccine shot for Covid-19. With that milestone achieved, we move closer to the day of reckoning when the Federal Reserve starts to remove liquidity support and tighten. This will be an epic move.

The Fed's moves take about 6-18 months to show up in the economy. However, the responses in March were almost instantaneous as multiple approaches, both fiscal and monetary were implemented. In addition, market participants sharply changed with the visible engagement of the Fed.

With the market, especially in the technology sector (examples are too numerous to mention), experiencing unprecedented bubble characteristics, the Fed will have no choice but to remove support without impairing the real economy. To do this will require fiscal support to step up its pace. If the fiscal support does not show up, the Fed will have to wait.

The likely trajectory is that fiscal support does show up, however, both for small businesses and in the form of direct individual supports. This is reasonable as the Fed's actions have overwhelmingly been a "wealth effect" for the higher income and net worth segments of the economy. 

As this support shows up and the vaccine takes hold, likely pent up demand will drive a strong economic recovery. In the face of such strength, the Fed will have the opportunity to tighten while communicating that the Fed will be "measured" in its response. Given the Fed's typical lag time, the Fed can waste no time in implementing early actions - at the very least in the form of Quantitative Tightening to shrink its bloated balance sheet.

Beyond that initial point, the Fed must tighten until a blood-letting occurs in the technology sector - at the very least. Given the length of time it takes before the Fed begins its tightening journey and then the lag effect, 2021 could be a buoyant period. Beyond that though, bond buyers and Big Tech investors may have significant opportunities.

Bubblenomics

The Bubble is back. In a world of paper money, then Chairman of the Federal Reserve Alan Greenspan commented that part of his job was to make sure that paper money retained value as if it were gold. At that time, I took his comment to apply strictly to the framework of inflation. Yet since then, I have seen that his comments also referenced asset inflation or "bubbles." 

Although Chairman Greenspan claimed that he did not have the ability to spot bubbles, he did take action against the Tech Bubble of 1999. He consistently tightened money supply until short-term and long-term rates reached high levels despite a notable absence of inflation. What was he acting against if not the perception of a bubble?

Those actions contrast sharply with the current market. Despite similar bubbly valuations in a wide range of noticeably unprofitable companies such as Snowflake or Tesla, the Federal Reserve is forced to support liquidity and market euphoria. With political tension in rapid decline, people are able to turn their attention to the dramatic rise of the stock market and ask themselves, "does this make sense?"

I finally understand why the Fed always takes away the punch bowl when the party gets fun. It is not simply so that inflationary structures get built in. It is also to discourage speculation and gambling as activities that denigrate the fundamental concept of hard work as the way to build wealth. There is a moral structure built into the Fed's design. Further, the Fed has to be careful about how many "white elephants" get built with cheap capital combined with rosy projections. Those structures are sunk costs.

But as long as the Fed is required to support a Covid-impaired economy, it appears to me that the punch bowl is here to stay.  It will be taken away at the first opportunity. When that punch bowl removal happens or is perceived to be likely, the notion of a punch hangover will wreak havoc on valuations in these bubbly areas. Caveat investor.