In a Nutshell: What Financial Stability?

The Federal Reserve painted a somewhat concerning picture of the global financial system in its latest semi-annual Financial Stability Report, citing particular examples that warrant more attention. 

Surging inflation, as well as Russia’s evil war against Ukraine, now are more worrisome than the ongoing coronavirus pandemic. 

A quick monetary-policy-tightening cycle may also result in lower economic output, as it increases borrowing costs. In turn, that could lead to job losses, unsustainable debt levels for some businesses, as well as a negative impact on the housing market because of much higher mortgage rates.

In addition to broad economic issues, the Financial Stability Report also looks at trends in trading and investing. A sharp rise in interest rates could lead to higher volatility, stresses to market liquidity, and a large correction in prices of risky assets, potentially causing a cycle of losses. 

There is the potential for continued volatility and unevenness of global growth as countries continue to grapple with the pandemic, and Russia’s unprovoked invasion of Ukraine has further increased economic uncertainty. Declining investment in times of rising uncertainty and volatility could result in the beginning of a negative economic cycle, as lower liquidity in turn may cause prices to be even more volatile. 

That could be particularly worrisome considering the share of U.S. household wealth that comes directly or indirectly from stocks. That contribution to household wealth has been measured to be a record 41.9 percent through the end of 2021, more than double where it was 30 years ago.

Despite a marginally lower headline inflation rate in April, the details of the CPI remain clearly awful. First, it is hard to feel very positive about inflation dropping when it drops from 8.5 percent to 8.1 percent. It is harder still to feel good about lower gas prices in April when they are already back near record highs in May. 

Additionally, while base effects from 2021 may lower reported year-on-year CPI inflation toward 7.5 percent in the
next two months, those same base effects may then push calculated inflation higher for the three months after that. No one should be celebrating temporary minor price relief from the USA’s worst inflation since the painful Carter years. 

Hoped-for inflation moderation this year is premised largely on improvement in core goods prices from supply-chain normalization and steadying goods consumption. But pandemic-inspired shutdowns in China could easily delay the supply-side improvement by a few months, making the need for demand fulfillment more pressing. Additional upside inflation surprises may cause the Fed to tighten more aggressively through the year. In fact, it could lead to some participants arguing that 75 basis points should be considered in June.

April historically had been one of the best months for the market, but that trend certainly did not continue in 2022. The Dow lost almost 5 percent for the month. Much more concerning, the NASDAQ fell 13.3 percent in April—its worst month since 2008—putting that index deep into bear market territory (now 24 percent below its November peak). The S&P 500 also lost 8.8 percent in April.

Just a couple of weeks ago, the yield curve was inverted, sounding recession alarm bells around the globe. Since then, the curve has somewhat normalized as yields have pushed higher across the entire curve. 

At this point, investors will take any sliver of good news that is fit to print. A cooling of inflation rates would be a major headline for the market to embrace. However, a tamer set of inflation numbers alone won’t fix the same issues that have been (and will continue to be) stiff head-winds. 

The prolonging of the Ukraine war, the continuing zero-tolerance lock-down against COVID in China, the illegal immigration disaster at our southern border, and continuing clogged supply chains will keep prices high for gas, food, and almost everything that consumers and businesses depend on. 

Do you miss Trump yet?