Rally or Plunge? How Long Can Delusion Last?

Will stocks plunge after the Federal Reserve meeting tomorrow or rally? I am still holding my TLT calls because today's action didn't compel me to close it out. The case for an extended rally is flimsy, but a one or two day pop is possible. As long as SPY is above the descending support line, then a plunge isn't in the cards.

I can express my opinion best by my long position in TLT. The Federal Reserve fails if inflation stays high. They will trigger the worst recession in 40 years if they cannot get long-term bond yields lower because this is important for long-term planning, including home construction and home buying. The housing market shows signs of cracking, but prices have held up thus far.

How does the Fed support bonds? It craters the stock market. Break it down to the most simplistic model possible, one you may have heard expressed in various ways. Simply, all the money in stocks, crypto and other assets isn't creating anything. It's dead money hiding from inflation. The Fed doesn't actually want all its efforts going into a stock and bond bubble. It wants organic economic growth and accompanying credit growth. Getting money out of stocks and into the real economy is a win, but how can they do that without creating inflation? They have to destroy the money.

Unlike in the 1970s, the Fed can extinguish money in financial markets because it's all on paper. Financial asset wealth doesn't exist at all. It is merely a valuation based on the most recent transaction. Pull support out of the market and then let the paper valuations crash and they make the money disappear. Poof. The Fed printed a few trillions that created tens of trillions in "wealth" and it can reverse the whole process fairly easily. Not without screaming, political threats and a recession, but it can be done.

I doubt the Fed will go all the way. My hunch is they will chicken out part way through the process and structurally high inflation will remain for years. That doesn't matter for the markets now though. What matters is that there are two poles they are working between. One is they fail or inflate. The other is the crush inflation. Then there is the market. What has it priced in? My sense is that the Fed will go further than the market expects and that the market hasn't even priced in a conservative scenario. They are pricing stocks as if this is it and the Fed's going to give up right away.

Additionally, "the market" still doesn't understand that if the Fed stops too early, the stock and bond market will enter a death spiral. The Fed needs to destroy commodity speculation so thoroughly that it can stop QT, rate hikes and even reflate without causing a commodities price spike. If they abort the process too early and speculative money goes into commodities (I will go all in with massive leverage in this scenario, and I won't be alone) then it's game over. The 10-year bond yield is going to double digits and the S&P 500 yield will follow. Do the math on the decline needed to get from a 1.3-percent yield to a 6-percent yield. SPX would go from 4200 to sub-1000. Dividends and earnings would rise in nominal terms eventually, but energy and materials are such a small part of the index today. Initially there will be a huge recession, crashing profit margins, soaring costs. A sub-1000 print on SPX is coming if the Fed doesn't stop inflation and worse, fans the flames.

The Fed can save the bond market, but it cannot save the stock market. If it tries, the bond market dies and takes the stock market with it. Nothing changes until there is a bounce in bonds and a drop in inflation. If that happens, then we can talk about a low in stocks. Long-term bonds are they key though. The Fed wants to see those yields drop because that will tell them their short-term hikes are working. They don't care about recession. They care about killing inflation first. If a recession and lower inflation are expected, bond investors will bid up long-term bonds to lock in higher rates.

The risk to both bonds and stocks, and why I might dump my TLT before the Fed meeting, is that the first move in bonds could be sharply lower if the bond market hasn't fully priced in the impact of the Fed's rate hikes and QT.