So many people and institutions are overleveraged

Powell has said they want to see positive real rates across the whole yield curve. Inflation backing off to 3% or 4% while Fed funds is 5.5% would do it, even if long-term rates stay in a small inversion. It would be, if not exactly a “normalized” policy, much closer to normal than we’ve seen since 2008.

But the economy—and certainly financial markets—no longer wants this kind of normalcy. It has adapted to free liquidity. Adapting back won’t be easy, and it certainly won’t be painless.

The baseline remains a Fed pause with the Fed funds rate above 5% and maybe 5.5%. What would happen next?

Energy was getting more expensive even before the war, and not just in Europe. Here’s a chart of US gasoline prices (actual pump prices, not wholesale). 

What happens in China is key to energy because it affects demand.

Today’s headline unemployment number of 3.5% suggests a very strong, if strange, employment situation. The market, at least Friday morning, is loving this report.    

FTX  the disturbing part is what it said about risk-taking in the markets. 

This is my biggest fear entering 2023. Not that the Fed will make another mistake or inflation will get too high, but that the higher rates the Fed is (properly, if belatedly) using to fight inflation will set off a sandpile avalanche somewhere else. So many people and institutions are overleveraged.

Every debt has two parties: borrower and lender. When the borrower defaults, the lender loses. But the lenders are often borrowers, too, in a vast web of interconnected global debt. 
Take out a few key connections, and it can all fall apart. I think we are dangerously close to learning how bad it can be.

Too many stocks are simply overvalued relative to the profits they can generate in this kind of economy. If you can get 4%–5% on Treasuries, why reach for yield in a risky stock market?

John Mauldin 6 January 2023


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