There is bad economic news coming out of Europe. We hear that major banks are in trouble there. And just recently, the Bank of England changed course to support its bond market because of the risk of pension funds not being able to meet their obligations.
On Monday, October 3, 2022, the American markets soared higher. Stocks were up big. Gold was up. Bonds were up as long-term yields fell. Didn’t investors get the message about what is happening in Europe?
In our upside down world where bad news is good news, I think investors did hear the message.
There was also a closed meeting of the Board of Governors of the Federal Reserve. What is this all about? I don’t think it was to discuss the weather or the inequity of Federal Reserve inflation.
The official agenda says under matters to be considered: “Review and determination by the Board of Governors of the advance and discount rates to be charged by the Federal Reserve Banks.”
The closed meeting was likely to discuss the economic turmoil in the world and how to prevent it from happening in the United States, or at least to not make it as severe.
The Fed has recently pledged to make fighting inflation its number one goal, even though it was the Federal Reserve that gave us inflation in the first place.
If you look at the yields on government debt, it doesn’t look good. This is while the Fed has pledged to continue to drain its balance sheet (even if slowly) and to hike its target of the federal funds rate.
The 10-year yield is highly inverted against the 2-year yield, and it has been this way for months. Meanwhile, the 3-month yield is not far away from the 10-year yield at this point.
Maybe the big up day on Monday was just investors reacting to what they see as stocks being oversold. Maybe everything will reverse course the following day.
Still, I can’t help but think that some investors are counting on the Fed to step in and pivot as soon as economic conditions get bad. A 20% drop in stocks won’t cause a reversal, but maybe a 50% drop will. If any major financial institutions get in trouble, it is pretty obvious based on history that the Fed is not going to allow them to fail.
So maybe it won’t happen as fast as the Bank of England, but I think a pivot will be coming. It’s just a matter of how long they will wait.
The stock market is down the list of concerns for Fed officials. They aren’t going to reverse course just because some people took a 20% hit on their 401k. They are more worried about the bond market and the solvency of financial institutions.
Still, if stocks go down 50% or more, that may be enough to start a pivot. They may not immediately go back in full inflation mode, but they may stop hiking rates and draining the balance sheet.
The reason is because a dramatically falling stock market is indicative of worse things to come.