Time to Act or Time to Intimidate?

Last Wednesday, the U.S. Federal Reserve announced it will accelerate its monetary tapering and added it expects at least three rate hikes next year. Remarkably, the European Central Bank (ECB) and the Bank of England (BoE) followed suit. We eyed a sharp selloff of all risks, including the cryptocurrencies, ostensibly in the wake of anticipation of rising bond yields (many bonds are tax-exempt, so, as we already mentioned in our previous story, many Americans opted to cut their increasingly taxable investments in order to beef up their non-taxable holdings). However, raging inflation that may easily reach 10% or more in 2022, requires quite a robust series of central banks’ rate hikes going forward. Although many economists easily repeat the official line mentioning up to three key rate increases throughout the next year, the reality tells us something diametrically opposite. Namely, the Federal Reserve will face heavy headwinds even after a single 0.25% rate increase, let alone repeating the action. So the markets may be factoring in a big systemic error, which will ultimately transform into yet another malicious market rotation resulting in violent upsurges of many high-risk high-return assets.

More precisely, the Federal Open Market Committee, FOMC, said at the conclusion of its two-day policy-setting meeting that it would double down on the reduction of its asset-purchase program to $30 billion a month, a timeline that could phase out the purchases entirely by March rather than the original June trajectory laid out last month. The Fed also raised its median projection for 2021 consumer inflation to 5.3%, from 4.2% in September. The core component excluding volatile food and energy prices is now seen at 4.4%, up from 3.7%. The Fed expects headline inflation to ease next year to 2.6%, with core at 2.7%, and to continue ratcheting down slowly through 2024 but remaining slightly above the 2% average target. In an effort to keep inflation down, the committee also penciled in more rate hikes in 2023 and 2024. Arguably, the dollar has already been pricing in at least two rate hikes next year.

Meanwhile, to fight the economic crisis and the surging inflation, central banks across the globe ventured to adjust their monetary policies last week. Apart from the Federal Reserve’s move, the Bank of England surprisingly increased its key interest rate from 0.10% to 0.25%.

According to a recent note published by the Bank of America, inflation always precedes recessions and “is like a very high body temperature” that “must be reduced via tightening or recession to return the body to normal and ensure future good health.” So, in other words, central banks need to prioritize their fight against inflation by monetary tightening, in order to… avoid a recession. Doesn’t this mean that the impending recession is all but predetermined?

Two Sequential December Market Corrections Out of Pattern

Although last year the December correction was mainly associated with political reasons – the Presidential elections in the United States appeared anything but smooth and enjoyable, and there were many partisan accusations and judicial battles regarding their results, this year, it would seem, the reason for such a long correction is not quite evident.

It all started around mid-November this year when the already peaking US dollar began to further strengthen against most of the world’s currencies and major asset classes. When the dollar appreciates, then, as we all know, all assets denominated in it, by the counterbalance effect, begin to fall.

The reason for the dollar strengthening is quite obvious: the US Federal Reserve began rhetoric in favor of tightening monetary policy, as the world economy is gradually emerging from the period of a pandemic, and the need for emergency funding to support it is gradually diminishing.

Additional psychological pressure on investors was applied through the adoption of a new tax code which will be enacted next year, by the Joe Biden administration. Investors have rushed to cash out their open investments in order to be in time to fall under the current, lower, taxation bar. Multiplied by the total number of people, the rash had a huge impact on everything starting from stocks and indices and ending with cryptocurrencies.

New US tax code, including a new capital gains tax and a universal tax for corporations. The Biden administration has come up with some new tax rule changes that we don’t want to miss. One of the goals of the Joe Biden administration is the Net Investment Income Tax (NIIT). One of the most talked-about proposals is an increase in income tax rates, as a result of which the individual tax rate on ordinary income will rise to 39.6%.

We have to keep this in mind because most US citizens report their digital assets in the same way they report their regular investments in real estate and the stock market. There will also be an additional 3.8% income tax on net investment income (NII), which US residents may have to pay on top of capital gains tax. Net interest rate includes, but is not limited to, taxable interest, dividends, profits, passive annuities, annuities and royalties.

The maximum capital gains tax will also increase from 20% to 25%. Net investment income tax of 3.8% under section 1411 of the Internal Revenue Code will be amended to expand the definition of net investment income to include any income generated in the ordinary course of business for individuals who filed taxable income in excess of $ 400,000 United States ($ 500,000 for co-applicants) from 1 January 2022

Under current law, the 3.8% tax is usually only applied to passive investment income (interest, dividends, gains from the sale of shares, etc.)

In addition, 136 countries have agreed on a global deal to force large companies to pay additional payments of the minimum tax rate of 15% and complicate their tax evasion within the United States – that is, it turns out that the US Treasury will now collect taxes from all over the world, and not only from American taxpayers and American businesses. The global minimum tax rate will apply to the overseas profits of multinational companies with sales of 750 million euros (currently about 868 million US dollars) worldwide.

It’s Hard to Beat Food Price Inflation by Hiking Interest Rates

The principality of the Fed’s actions at the moment can hardly be overestimated due to the fact that the inflation flywheel is spinning at an unprecedented speed not just in the US, but globally. It is already clear that next year the US central bank will insist on not just one, but a series of steps to tighten its monetary policy. It is apparent, that winding down its asset purchase program will not be enough to get a desirable outcome. However, whether these standard steps will be sufficient to improve the macro situation with inflation is a big question. Personally, I do not believe that the inflationary picture can be significantly improved by mere percentage arithmetics.

We can easily highlight a particularly rapid rise in prices for cars, staples and food. If for example the problem was caused by a shortage of microchips, it would be dealt with by the very raising borrowing costs through an increase in interest rates, then in the case of the basics, when we are talking about food products that barely use the credit leverage at all, an increase in interest rates can only aggravate inflationary picture, and not bring it down per se.

Therefore, investing with a medium-term horizon of half a year, for us, investors, it is now much more important to assess the inflationary component of the economy than the policy of world central banks, which has limited opportunities to overcome it.

In other words, non-inflationary instruments should be present in the portfolios in maximum proportions. But if inflation-indexed bonds remain low-yielding and therefore not very attractive, then the purchase of low-inflation stocks promises also quite a decent increase in profitability.

A Bit of Retrospect of Fed Funds Rate

The all-time Fed funds rate low is effectively zero. The Fed has twice lowered the rate to a range of 0.0% to 0.25%. The first time was during the financial crisis of 2008, and the Fed didn’t resume raising rates until December 2015.

The second time was in March 2020, as a result of the global coronavirus crisis. The Fed announced in June 2021 that it would keep rates in that range until 2023. Most recently, at the December 2021 Federal Open Market Committee (FOMC) meeting, the Fed said that it would keep its target for the fed funds rate at a range of 0.0% to 0.25%.

The lowest Fed funds rate (before 2008) was in the range of 0.75% to 1.0% in 2003 in a move to combat the 2001 recession. There were fears that the economy was drifting toward deflation at that time.

The Fed funds rate reached a high of 20% in 1980 to combat double-digit inflation. Inflation began to skyrocket beginning in March 1973 when President Richard Nixon disengaged the dollar from the gold standard. Inflation increased from 4.7% to 12.3% in December 1974.

The Fed increased the fed funds rate from 7% in March to 11% by August. But inflation continued to remain in the double digits through April 1975. The Fed increased the benchmark rate to 16% in March 1975, worsening the 1973 to 1975 recession.7 It then reversed course, dramatically lowering the rate to 5.25% by April 1975.

We are not Alone Foreseeing Troubles with Dollar Assets by Fed’s Plainly Hiking Interest Rates

In a recent Bank of America research note, the bank’s analyst demonstrated that all but every Fed’s tightening cycle ended by the recession.

BofA: history of Fed rate hike cycles – all tightening cycles led to chaos in the markets:

A new off-cycle recession is, indeed, very likely. If the Fed wouldn’t stop the inflation by then, we will face stagflation – a very painful, but increasingly frequently mentioned scenario. Stagflation will pave the way to non-equity non-debt capital protection behavior. More specifically, cryptocurrencies and precious metals will be shelters of last resort under such a scenario.