The Fed’s New Mandate: Tora Tora Tora!

I borrowed the title of this article from the 1970 movie of the same name. (I’ll tell you why in a second.)

It was the story of the time leading up to the Japanese attack on Pearl Harbor on December 7, 1941. The word “tora” literally translates to tiger, but the phrase was used as code for “totsugeki raigeki” which means “lightning attack.” 

Everyone knows how the story ends, but it’s still a great WWII flick.

I’ll get back to that in a minute.

First take a look at this…

Source: The Federal Reserve Bank of St. Louis

That’s the 10-2 Treasury yield curve. It’s the difference between the 10-year and the 2-year Treasury note yields.

Treasury yields typically trade higher the further out on the curve you go — 10-year notes yield more than 2-year notes. When that relationship inverts — when the spread trades lower like it is now — it signals some kind of policy error, usually on the part of the Fed, that precedes an impending recession.

You can see its track record below (recessions are noted in gray).

Source: The Federal Reserve Bank of St. Louis

There’s a reason the yield curve is one of the most reliable economic indicators anywhere.

I’ve explained it before, but it’s worth repeating…

It’s a bit like the difference between betting in Las Vegas versus betting at Churchill Downs.

When you gamble at most tables in Las Vegas, it’s you against the house and the odds are pretty much fixed, ever so slightly, against you.

But at the track, it’s you betting against all the other bettors in a race. A horse’s odds will move up or down depending on how much money is bet on it relative to the total money in the pool. By watching the odds move as you get closer to post time, you can effectively get an idea of what the “smart money” is thinking.

The yield curve gives you the same basic insight.

When you watch the yield curve, you’re seeing the entire market putting its money where its mouth is. As uncertainty about the future builds — for whatever reason — money rushes into what has always been considered the safe haven of long bonds (today the 10-year T-Note is the benchmark) which pushes yields lower. 

The shorter end of the curve is tied more closely to monetary policy — it moves relative to what the Fed is doing.

And since March of last year, the yield curve has been heading for the big flip.

Does the Fed Know What It’s Doing?

Over the last 14 or so years, it seems like the Fed’s mandate has changed from maximum employment and stable prices to keeping asset markets inflated at all costs.

And then trying to let the market down easy when things get overheated.

They’ve been hard at work doing that for the past year, as their stimulus-fueled inflation started picking up steam. 

It began with inflation being transitory. (Nothing to see here!) Then, as the inflation rocket approached escape velocity, they decided “transitory” wasn’t exactly what they meant. 

Then came the taper talk — and the “double taper” talk. Then the interest rate hike talk. 

The stock market responded to it all with a 14% sell off in the month of January. It hasn’t been pretty, but at least it’s been pretty orderly. 

But as the reality of coming rate hikes sank into the market’s subconscious, the discussion went from “if and when” to “how many and how much.” 

Then came the January CPI print which showed prices had increased 7.5% from a year ago. Suddenly the gloves appeared to come off. 

Fed uber-hawk, St. Louis Fed President Jim Bullard, took to the airwaves and suggested that inflation was “broadening” and “accelerating” and said the Fed should raise rates 100 basis points by July. That shook things up a bit — but no follow through down.

Fed proxies tried to walk those comments back a bit. But then the Fed spooked the market by scheduling an “unscheduled, closed” board meeting. No comment after. 

The market is at the edge of its seat and holding its collective breath over what comes next.

So all this “Fed kabuki theater” is really just a postponement of the inevitable. All the tiptoeing around is the opposite of what the Fed really should be doing right now.

Which brings me back to the title of this essay…

Tora! Tora! Tora!

The market — in fact, the economy as a whole — needs a Tora Tora Tora! moment from the Federal Reserve. 

They don’t need to gently take the punch bowl away, they need to kick the table over, throw the partiers out and let the chips fall where they may. 

There’s no escaping the fact that a recession is coming — look at the chart up above — and there’s no such thing as soft landing when the spread crosses zero.

This fight the Fed is entering into is about more than simply draining excess capital. There is a wage component to this inflation beast. And there is a supply chain component as well. This current price surge has all the marks of turning into a decades-long secular monster much like the U.S. endured in the 1970s.

They’ve fed this beast by keeping monetary policy too loose for too long. I’m talking long before the pandemic. To get it under control is going to take something more than 25 basis points a quarter. 

They’re going to have to slam on the brakes. Opponents of this idea will say that would crash the market — and likely the economy. That’s one way of saying it.

Another way is the Fed needs to take away its support, and let the market fix itself. 

That’s a tall order where the defenders of elite prosperity are concerned. It’ll take cojones the size of Paul Volcker (rest in peace), and frankly I don’t know if anyone on the current Fed has them. 

But here’s their reality…  If they don’t do it now, it’s going to happen anyway.

If they don’t make a definitive stand against the wave of inflation — even at the risk of putting the market into a tailspin — they risk losing control over any and all inflation expectations. When that happens, prices will skyrocket enough to cure “the problem of high prices” on their own. And that’ll be way more painful.

Right now, it’ll be like pulling that band aid off your 6-year old’s knee — actually, it’ll probably be worse — but it needs to be done. 

In the long run, our economy depends on it.

Whether they do it or not remains to be seen. But I believe it needs to happen.

Tora Tora Tora!

Make the trend your friend,

Bob Byrne
Editor, Streetlight Confidential