Zoltan Pozsar - On The Fed And "Shocks" To The Markets
In which the Fed has a "Volcker Moment."
I was recently alerted to a recent article from respected analyst Zoltan Pozsar of Credit Suisse. As I read through it, I found it interesting, and concerning, enough that I wanted to quickly summarize it for the benefit of my readers.
No doubt most readers are well aware of the dramatic steps that then-Fed Chairman Paul Volcker undertook in the early-1980s to curb runaway inflation. If you are interested, a brief summary can be found here.
In his piece, Pozsar submits that the Fed, while perhaps not having to go to the extremes of the Volcker era, might have a “Volcker moment.” If he is anywhere close to correct, this material is worthy of consideration for all investors. In addition to investors in the stock market, homeowners could be affected as well.
“Shocking” The Market
Pozsar opens his piece with some recent quotes from Bill Dudley, former President of the Federal Reserve Bank of New York. From the piece:
[Per Dudley], if financial conditions don’t tighten on their own, “the Fed will have to shock markets to achieve the desired response”, that is, “it’ll have to inflict more losses on stock and bond investors than it has so far”. If that wasn’t clear enough, the former vice chair of the FOMC closed by saying: “one way or another, to get inflation under control, the Fed will need to push bond yields higher and stock prices lower”.
As Pozsar says, the message could not be clearer. What might this entail? Pozsar suggests that the Fed could go as far as engineering “a (covert) recession . . . in order to maintain price stability.”
Essentially, Pozsar argues, the longstanding regime of low interest rates and Quantitative Easing (QE) was essentially “monetary policy for the asset rich, with trickle-down benefits for the less wealthy.” Therefore, to reverse the asset price inflation that came from all this stimulus, the Fed may need to generate asset price deflation.
If you think about it, this asset price inflation has not been confined to the stock market. Most of us are all-too-painfully aware that is has been manifested in the real estate market. For purposes of this brief piece, let’s refer to this as the cost of shelter. Recently, the price for both owning and renting, in other words, providing any sort of shelter, has soared. It goes without saying that this comes at a cost, particularly for young singles and families just getting started on their life’s journey.
Given all of this, despite the fact that the Fed has a multi-pronged mandate, Pozsar argues that what they are laser-focused on at this point is price stability. Put a different way, “slaying inflation.” In so doing, it appears that the Fed, while guarding against systemic failure, may even be willing to allow some measure of financial instability, and even turmoil.
You may have seen the concept put forth that both household and business balance sheets are far stronger today than, say, they were back in 2009. This strength, it is argued, should guard against slowing demand, and a potential recession. Pozsar makes an interesting argument here. Namely, that just as these balance sheets have been artificially inflated by the excesses in assets, the Fed could engineer things such that they are deflated by the “shock” of tightening financial conditions.
To conceptualize this simply, imagine, for just a second, that the value of your stock portfolio and the price of your home both drop by 20%. For many, that “reverse wealth effect” could have the effect of dramatically reining in spending.
What does Pozsar ask us to consider? In summary, this:
Consider the possibility that the Fed, on a singular mission to slay inflation, won’t rest in its pursuit of tighter financial conditions until yields shift higher, stocks fall more, and housing turns as well.
What might that imply? Using the S&P 500 as a benchmark, is the Fed satisfied that it has fallen to the 4,000 level? Or would they like to see all post-pandemic gains wiped out, which would imply a level of 3,500 on the S&P? What if they felt it would take even more to truly slay inflation?
Summary and Conclusion
I found Pozsar’s piece most sobering to consider. If my brief summary above has piqued your interest, and you have the time and attention span, please click on the link above and read his piece, in its entirety, for yourself. In terms of shaping your own investment positioning moving forward, you may be happy you did.
Lastly, if you think this would benefit someone you know; whether family members, friends, coworkers, or anyone else, I’d be honored if you would click the button below and share it with them.
If you’re new to my newsletter, and would like to receive more stuff like this on a regular basis, please consider subscribing.