Inconvenient Facts for Federal Reserve Board: Signs of Approaching Risk Expansion
U.S. stocks are reaching record highs day after day. It is typical for stock prices to increase when there is good news, but U.S. stocks are now setting records on no particular news at all.
The larger economic backdrop for this seems to be that the Federal Reserve Board, despite America’s remarkable economic rebound and corporate performance, is aiming to prolong its extreme mitigation measures. In a situation that no investor would wish for, the increasing surplus money is flooding the U.S. stock markets.
The sudden rise in the Volatility Index signaled that investors were overwhelmed by anxiety and markets were unstable. At the time of the COVID-19 shock last spring, the VIX surged to 82.6% at market close on March 16. However, since then, economic measures such as qualitative easing and fiscal stimulus measures have been successful, and the index has continued declining to 15.1% as of July 2, the lowest level since spring of last year. This suggests that investors have likely become more optimistic and less conscious of risk.
The Mitigating Fed
This situation is based on the assumption that the Fed will extend its extreme mitigative measures. In June, the Federal Open Market Committee revised its growth rate and price outlook upward, and the FOMC members’ graphs also contained more hawkish positions than previously expected. With the FOMC revision in June, the Dow Jones Industrial Average fell by $1,189 over five business days.
However, Fed Chairman Jerome Powell, who testified before Congress as the markets were wavering, reemphasized the need for temporary price increases and the continuation of extreme mitigation measures, and the markets regained confidence.
The Mechanism of Rising Used Car Prices
Even still, inconvenient facts are beginning to emerge in the Fed leadership’s strategy of temporary price increases. First of all, the increases in new and used car prices due to a shortage of semiconductors is remarkable. There are cases where delivery times on some popular new cars are between six months and a year, and consumers will inevitably turn to used cars.
Used car prices (year on year, before seasonal adjustment), announced by the U.S. Bureau of Labor, surged by 21.0% in April and 29.7% in May. Even so, it seems that the semiconductor shortage, which is the biggest bottleneck, will be difficult to resolve in the short term. Beginning with the U.S., semiconductor companies in advanced nations have specialized in planning and design, and have maintained a structure in which actual manufacturing is outsourced to East Asian semiconductor foundries like Taiwan Semiconductor Manufacturing Corporation.
Each country has put forth policies encouraging domestic production of semiconductors, but this won’t happen overnight. Intel CEO Patrick Gelsinger said that he “doesn't expect semiconductor supply and demand to align until 2023,” and so used car prices are likely to remain high.
Conditions for Rising Crude Oil Prices
Second, crude oil prices continue to rise. OPEC+, which consists of the Organization of Petroleum Exporting Countries and non-OPEC oil-producing countries such as Russia, have agreed that they will decrease production by 400,000 barrels per month from August through December, and extend the final deadline for production cuts from April 2022 to December 2022.
Since the forecast was for a reduction in output by 500,000 to 550,000 barrels, the extension of the output reduction period was expected to be a factor in the rise in crude oil prices. However, at the last minute, the United Arab Emirates strongly opposed the agreement, spurring a rise in crude oil prices.
The Iranian presidential election of Iranian Chief Justice Ebrahim Raisi, a hardline conservative, is also cause for concern. If a nuclear agreement between Iran and the West is reached, the ban on Iranian crude oil exports would be lifted, and it was expected that the supply and demand of crude oil would be eased. However, not only is any nuclear deal far away, but it could even increase geopolitical risks in the Middle East.
Meanwhile, U.S. crude oil inventories are on a sharp decline, from a peak of 540.7 million barrels in June last year to 452.3 million barrels on June 25. After all, the U.S. economy has recovered sharply, and demand for crude oil has surged. However, U.S. crude oil production has been slow to recover, and the Biden administration is promoting an “eco-shift” policy, and its strong regulatory measures for pipeline construction and oil and gas field development are also putting upward pressure on prices.
Due to high oil prices, U.S. gasoline futures prices rose to $2.31 per gallon on July 2, the highest since 2014. In the United States, typical of a society that uses cars, this increase in gasoline prices has had a significant impact on rising energy costs for households and businesses. High crude oil prices may lead to higher prices for petrochemical products, widespread product price increases and increased transportation fares, but the ISM Manufacturing Business Conditions Index's purchase price index for June was a whopping 92.1, reaching its highest level in nearly 42 years since the second oil crisis in 1979.
Sharply Rising Shipping Expenses
Third, sea freight rates continue to increase. The price of moving a 40-foot shipping container between Hong Kong and Los Angeles hit an all-time high of $7,383 on June 30, more than five times higher than last March's low of $1,325. In addition, the Baltic Dry Index, which is a fare index for bulk carriers of iron ore and agricultural products, has risen more than eight times from the low of $393 in May last year to the high of $3,418 on June 29.
The background to this is that, first, the world economy is showing a clear recovery trend, and it is expected that trade volume and shipping demand will increase in the latter half of the year; and second, in response to the sharp decline in demand due to COVID-19, the supply chain has deteriorated due to the progress of shrinking equilibrium such as restructuring of cargo handlers, reduction of port processing capacity and the reduction of container production. It is highly probable that rising transportation costs will lead to higher prices.
Remembering the Housing Bubble
Fourth, there is a surge in house prices. The national S&P Case-Schiller Home Price Index was up 14.9% year on year, the highest since the index began recording statistics in 1988. This breaks clear of the 14.5% increase set in September 2005 during the housing credit bubble era.
“This is scary,” said Larry Summers, former treasury secretary and a paid contributor to Bloomberg. “Rising house prices in most people’s common sense of the word represents inflation.” Not only actual demand, but also the influx of funds for investment and speculative purposes are large, and the color of the bubble is gradually getting darker.
Nassim Nicholas Taleb, author of “The Black Swan: The Impact of the Highly Improbable,” who foresaw the Lehman Brothers shock, also said that U.S. house prices are at risk of falling by about 25%-45%. Under these circumstances, the logical validity of the Fed's continued purchase of $40 billion in mortgage-backed securities each month is likely to diminish.
Within the Fed, there are many regional governors, including Jim Bullard, president of the Federal Reserve Bank of St. Louis, who insist on prolonging price inflation, tapering (gradual reduction in quantitative easing measures) and pushing forward with rate hikes.
However, the executives under Chairman Powell are sticking to the logic of temporary high prices and prolonged ultramitigation measures, despite the completely different economic and price trends from this spring. This may be an incentive to reduce investor risk awareness.
As a person who experienced the bubble in Japan during the 1980s, the U.S. bubble in 2002 and the information technology bubble along with the 2007 housing and credit bubbles from within the maelstrom of those markets, I cannot help but be strongly aware of the adverse effects of prolonging ultra-easing measures more than necessary. Even in the Tokyo market which had until recently not returned to their historic highs since the summer of 1989, the days of stock prices returning to their highest levels without any particularly favorable news has continued. Somehow, it seems that the strange fear, similar to the discomfort I had in 1989, is gradually growing.
If the Fed leadership’s perception of inflation is delayed and monetary policy is put in place in pursuit of continuing current conditions, this will likely lead to considerable disruption in the stock markets. Of course, we cannot deny the possibility that further excess liquidity in the markets will continue and bold risk-taking will produce good performance. However, it should be recognized that risks are increasing as much as the returns are. This is like dancing on thin ice until you become aware of the risk once the ice breaks.
The larger economic backdrop for this seems to be that the Federal Reserve Board, despite America’s remarkable economic rebound and corporate performance, is aiming to prolong its extreme mitigation measures. In a situation that no investor would wish for, the increasing surplus money is flooding the U.S. stock markets.
The sudden rise in the Volatility Index signaled that investors were overwhelmed by anxiety and markets were unstable. At the time of the COVID-19 shock last spring, the VIX surged to 82.6% at market close on March 16. However, since then, economic measures such as qualitative easing and fiscal stimulus measures have been successful, and the index has continued declining to 15.1% as of July 2, the lowest level since spring of last year. This suggests that investors have likely become more optimistic and less conscious of risk.
The Mitigating Fed
This situation is based on the assumption that the Fed will extend its extreme mitigative measures. In June, the Federal Open Market Committee revised its growth rate and price outlook upward, and the FOMC members’ graphs also contained more hawkish positions than previously expected. With the FOMC revision in June, the Dow Jones Industrial Average fell by $1,189 over five business days.
However, Fed Chairman Jerome Powell, who testified before Congress as the markets were wavering, reemphasized the need for temporary price increases and the continuation of extreme mitigation measures, and the markets regained confidence.
The Mechanism of Rising Used Car Prices
Even still, inconvenient facts are beginning to emerge in the Fed leadership’s strategy of temporary price increases. First of all, the increases in new and used car prices due to a shortage of semiconductors is remarkable. There are cases where delivery times on some popular new cars are between six months and a year, and consumers will inevitably turn to used cars.
Used car prices (year on year, before seasonal adjustment), announced by the U.S. Bureau of Labor, surged by 21.0% in April and 29.7% in May. Even so, it seems that the semiconductor shortage, which is the biggest bottleneck, will be difficult to resolve in the short term. Beginning with the U.S., semiconductor companies in advanced nations have specialized in planning and design, and have maintained a structure in which actual manufacturing is outsourced to East Asian semiconductor foundries like Taiwan Semiconductor Manufacturing Corporation.
Each country has put forth policies encouraging domestic production of semiconductors, but this won’t happen overnight. Intel CEO Patrick Gelsinger said that he “doesn't expect semiconductor supply and demand to align until 2023,” and so used car prices are likely to remain high.
Conditions for Rising Crude Oil Prices
Second, crude oil prices continue to rise. OPEC+, which consists of the Organization of Petroleum Exporting Countries and non-OPEC oil-producing countries such as Russia, have agreed that they will decrease production by 400,000 barrels per month from August through December, and extend the final deadline for production cuts from April 2022 to December 2022.
Since the forecast was for a reduction in output by 500,000 to 550,000 barrels, the extension of the output reduction period was expected to be a factor in the rise in crude oil prices. However, at the last minute, the United Arab Emirates strongly opposed the agreement, spurring a rise in crude oil prices.
The Iranian presidential election of Iranian Chief Justice Ebrahim Raisi, a hardline conservative, is also cause for concern. If a nuclear agreement between Iran and the West is reached, the ban on Iranian crude oil exports would be lifted, and it was expected that the supply and demand of crude oil would be eased. However, not only is any nuclear deal far away, but it could even increase geopolitical risks in the Middle East.
Meanwhile, U.S. crude oil inventories are on a sharp decline, from a peak of 540.7 million barrels in June last year to 452.3 million barrels on June 25. After all, the U.S. economy has recovered sharply, and demand for crude oil has surged. However, U.S. crude oil production has been slow to recover, and the Biden administration is promoting an “eco-shift” policy, and its strong regulatory measures for pipeline construction and oil and gas field development are also putting upward pressure on prices.
Due to high oil prices, U.S. gasoline futures prices rose to $2.31 per gallon on July 2, the highest since 2014. In the United States, typical of a society that uses cars, this increase in gasoline prices has had a significant impact on rising energy costs for households and businesses. High crude oil prices may lead to higher prices for petrochemical products, widespread product price increases and increased transportation fares, but the ISM Manufacturing Business Conditions Index's purchase price index for June was a whopping 92.1, reaching its highest level in nearly 42 years since the second oil crisis in 1979.
Sharply Rising Shipping Expenses
Third, sea freight rates continue to increase. The price of moving a 40-foot shipping container between Hong Kong and Los Angeles hit an all-time high of $7,383 on June 30, more than five times higher than last March's low of $1,325. In addition, the Baltic Dry Index, which is a fare index for bulk carriers of iron ore and agricultural products, has risen more than eight times from the low of $393 in May last year to the high of $3,418 on June 29.
The background to this is that, first, the world economy is showing a clear recovery trend, and it is expected that trade volume and shipping demand will increase in the latter half of the year; and second, in response to the sharp decline in demand due to COVID-19, the supply chain has deteriorated due to the progress of shrinking equilibrium such as restructuring of cargo handlers, reduction of port processing capacity and the reduction of container production. It is highly probable that rising transportation costs will lead to higher prices.
Remembering the Housing Bubble
Fourth, there is a surge in house prices. The national S&P Case-Schiller Home Price Index was up 14.9% year on year, the highest since the index began recording statistics in 1988. This breaks clear of the 14.5% increase set in September 2005 during the housing credit bubble era.
“This is scary,” said Larry Summers, former treasury secretary and a paid contributor to Bloomberg. “Rising house prices in most people’s common sense of the word represents inflation.” Not only actual demand, but also the influx of funds for investment and speculative purposes are large, and the color of the bubble is gradually getting darker.
Nassim Nicholas Taleb, author of “The Black Swan: The Impact of the Highly Improbable,” who foresaw the Lehman Brothers shock, also said that U.S. house prices are at risk of falling by about 25%-45%. Under these circumstances, the logical validity of the Fed's continued purchase of $40 billion in mortgage-backed securities each month is likely to diminish.
Within the Fed, there are many regional governors, including Jim Bullard, president of the Federal Reserve Bank of St. Louis, who insist on prolonging price inflation, tapering (gradual reduction in quantitative easing measures) and pushing forward with rate hikes.
However, the executives under Chairman Powell are sticking to the logic of temporary high prices and prolonged ultramitigation measures, despite the completely different economic and price trends from this spring. This may be an incentive to reduce investor risk awareness.
As a person who experienced the bubble in Japan during the 1980s, the U.S. bubble in 2002 and the information technology bubble along with the 2007 housing and credit bubbles from within the maelstrom of those markets, I cannot help but be strongly aware of the adverse effects of prolonging ultra-easing measures more than necessary. Even in the Tokyo market which had until recently not returned to their historic highs since the summer of 1989, the days of stock prices returning to their highest levels without any particularly favorable news has continued. Somehow, it seems that the strange fear, similar to the discomfort I had in 1989, is gradually growing.
If the Fed leadership’s perception of inflation is delayed and monetary policy is put in place in pursuit of continuing current conditions, this will likely lead to considerable disruption in the stock markets. Of course, we cannot deny the possibility that further excess liquidity in the markets will continue and bold risk-taking will produce good performance. However, it should be recognized that risks are increasing as much as the returns are. This is like dancing on thin ice until you become aware of the risk once the ice breaks.
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