**The stock market is on a 6-week losing streak, the longest losing streak since 2001. How did we get here?**
The economy is in a very tight place and is likely going to get worse. This has caused stocks to come down, with major indexes down anywhere from 15% to 30%. CPI inflation is at 8.3% and has consistently been worse than expectations. The Federal Reserve is going to start tightening by essentially popping dollars out of existence (the opposite of money printing) and increasing interest rates to slow down the economy. Whether you’re trading or investing long term, it is important to be familiar with the market landscape and understand the reasons behind the volatility and price action we are seeing. Therefore I am making this post to help anyone who does not have a full picture of what is currently happening.
**Inflation**
The combination of the 2020 COVID lockdowns, Delta lockdowns, Omicron lockdowns, sanctions in response to Russia’s invasion of Ukraine, and decreasing globalization as countries try to reduce reliance on others, have all been inflationary. The lockdowns were originally disinflationary on the demand side (because people slowed spending when they were locked at home), which is why the Federal Reserve and central banks around the world expanded the money supply (i.e., printed a crap ton of money). However, we are now suffering the consequences of those actions. People were saving money because it was harder to spend it during the lockdowns, creating pent-up demand which is now showing itself in the form of unusually high spending and a very strong consumer. Coupled with the supply bottlenecks, this caused inflation to soar higher than at any point since the 1970s once economies began to speed back up.
**The Federal Reserve**
Stocks move up and down for a combination of different reasons. In my opinion, the most important factor deciding how stocks move is the Federal Reserve’s policies. The second most important factor is *earnings*. This is my opinion, and I know many people might disagree with me, but what you can’t disagree on is how important the Fed’s policies are in influencing stock prices. The Fed’s priority is to maintain price stability (i.e., control inflation). To do this, it has three main tools: the Fed Funds interest rate, open market operations, and setting reserve requirements.
**Fed funds interest rate**
The federal funds rate is complicated, but it can be thought of as the price to lend money. When the fed funds rate is low, then banks can lend at very low interest. But when the fed funds rate is high, banks will lend at higher interest. When COVID hit, people stopped spending, so the Fed lowered the fed funds rate to 0, so banks could lower their interest rates and lend more money, which encouraged consumer and business spending and investment and ultimately boosted stock prices. However, now we are at a point where the economy is too hot and inflation is out of control. When inflation was this high in the 1970s, the Fed raised the fed funds rate to almost 20%. That’s not a typo. 20%. When the Fed pushed the funds rate this high, banks were going to lose money if they lent money at lower than 20%, and borrowers would have to be stupid to borrow money at 20% interest. Therefore, the economy was forced into a recession by the Fed in an attempt to stomp out inflation. This is the same thing the Federal Reserve is doing now. Inflation is very high, so the Federal Reserve is raising the fed funds rate to slow down the economy until inflation is stomped out. If inflation keeps increasing (or even staying the same), the Fed will have to increase the funds rate even more. During the pandemic, the rate was 0. In March, the Fed first increased the rate to 25 basis points (bp), or .25%. On May 4th, they increased it to 75 bp. But as inflation keeps persisting, economists are expecting the fed funds rate to go even higher. Last year, we were expected to reach a funds rate of .25% by the end of 2022. We reached that expectation two months ago. Right now, we are expecting to reach 2.75% by the end of this year. That is over 11 times higher than what we expected last year.
**Open market operations (“printing” money)**
The Fed can also conduct open market operations, which means they can buy securities from banks or sell them to banks. When the Fed buys securities from banks, then the bank has more money to lend, which means there is more money, or more *liquidity*, in the economy. This is essentially how the Fed “prints” money (also called quantitative easing). Again, this encourages consumer and business spending and investment and boosts stock prices. The Fed only stopped this in March of this year. It was essentially keeping the money printer on while inflation was already over 7%. Now, the Fed needs to do the opposite of what it was doing two months ago. This time, the Fed needs to sell securities back to banks (the same ones that the Fed has spent the last two years buying). In June, the Fed is going to start doing this–selling securities back to banks and on the open market and then popping those dollars out of existence (the opposite of money printing). This is called quantitative tightening. Of course, this will have the opposite effect of money printing. The Fed essentially needs to sell back over $4.7 trillion worth of securities to banks, yet commercial banks currently only have about $3.38 trillion in cash. See the problem? The Fed will have to continue tightening for years if they want to get rid of all those securities, which means that if we go into an economic downturn, it will likely be prolonged.
**Reserve requirements**
Setting reserve requirements does the same thing as open market operations in the sense that it controls how much money banks can lend out. Essentially, if the Fed requires banks to hold more money, then they lend less. This is very straightforward.
**What does this all mean? A recession?**
Look at where we are. Inflation is out of control. Recall that the Fed forced us into a recession just to bring inflation to its knees. This is because uncontrolled inflation is single handedly the most dangerous thing to an economy, so a recession is always preferable. The Fed was continuing to stimulate the economy while inflation was running very hot, and now that it’s even worse, the Fed has to do the complete opposite of what it has been doing the past two years. The Fed will increase interest rates for the next year (or more), remove liquidity from the economy for years to come, and the economy will inevitably go into a downturn. In my opinion, people are underestimating the probability of a recession. Technically, a recession is defined as two consecutive quarters of negative GDP growth. Did you know that GDP fell 1.4% in Q1 of 2022? Another quarter of this and we will officially be in a recession. What about inflation? Is inflation peaking? If you look superficially at the Consumer Price Index (CPI) numbers, it shows 8.5% year over year inflation in March, and 8.3% YOY inflation in April. Does that mean inflation has peaked? Maybe, but a slight decrease in the year over year inflation rate is not enough to suggest that., especially because the 8.3% figure was actually higher than expectations. The Producer Price Index (PPI) shows inflation in terms of how much more producers are paying for the same things. This is a lot more effective in gauging the direction of inflation because it is a leading indicator of inflation. When producers are paying more, they pass those costs onto consumers afterwards, and it could be months until producers decide to pass on these costs. In April, PPI was 11%, which means that CPI inflation could go much higher if producers decide to pass on costs to consumers.
**Conclusion**
Inflation is too high. The Fed is slowing the economy using every tool it has, just to keep inflation under control. In doing so, the Fed may put us into a recession. We are one bad quarter away from being in a recession. If we go into a recession, the Fed can’t save us. If you did not read the entire post, please read it.
Yes, I wrote all this. Personally I'm up on the year because I sold everything in January (before the crash) and have been only trading options (puts and calls) based on technicals. Please ask questions if you have any (in replies or DMs).
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