Market momentum is Red. Despite the short-term rally after Jerome Powell’s meeting, it appears that the rally isn’t completely sustainable. Every sector remains under stress, and we’re heading into the weakest day of 2022 tomorrow: Thursdays.
I doubt you need my recap of the Fed’s meeting. The central bank’s policy completely drives the market, so its decision today was all over the news. The Fed raised interest rates by 75 basis points. They’ll continue to sell off $47.5 billion in bonds each month through quantitative tightening. And Esther George was the lone dissenter.
The last time the Fed raised interest rates by 75 basis points was 1994. That was when the Fed achieved a “soft landing” for the economy. They’re trying to play the same playbook – although investors should recognize that a lot of the economic strength we saw was through the expansion of early e-commerce, software applications, and the beginnings of the first Tech expansion.
But there’s one other thing to know about what happened that year. The Fed helped sink the Mexican economy in the process. Whose economy will the Fed sink this time?
Revisiting the Tequila Crisis
In 1994, Mexico experienced a massive economic crisis. The nation’s currency was pegged to the U.S. dollar. But the peso couldn’t keep up when the Federal Reserve hiked interest rates by 250 basis points that year, the peso couldn’t keep up.
The exchange rate exploded. The nation was also dealing with political homicides as the national election approached that year.
The government was trying to keep money from leaving the economy, which pressed it to offer short-term dollar-based debt. They were called “tesobonos,” and they were designed to protect investors against a big drop in the peso.
The goal was to stabilize the currency. But that didn’t happen. Instead, by November 1994, investors pulled about $3 billion from the economy. The worst day was November 18, when investors yanked $1.6 billion from the economy.
The government repeatedly denied that it would devalue its currency against the stronger U.S. dollar. The newly elected government swore that would not happen, but investors didn’t like what they heard—almost another $1 billion flooded from the Mexican economy.
By mid-December, the nation announced that it would devalue the currency by lifting the upper band of the exchange rate by 15%. Within two days, the economy lost another $4.6 billion in capital or half of its foreign exchange reserves. By the end of the month, the currency was devalued by 35%.
In January 1985, the International Monetary Fund had to provide a $7.8 billion bailout package, while the U.S. announced various aid packages to stabilize the economy. This crisis should be a warning to other nations as the Fed takes action.
History of Crises
The “Tequila Crisis” is just one example of U.S. or global problems that have followed rate hikes by the Federal Reserve. This chart from Bloomberg shows that “economic crisis” thrives in the wake of a big move higher by the central bank.
So the question everyone should ask… is who is next?
The United States is likely heading into a recession. Today, the Atlanta Fed Bank announced that second-quarter GDP growth would come at 0.0%. But that’s the least of our issues. Remember, we responded to a massive economic crisis by pouring trillions of dollars on top of everything to paper over the mess.
We did the same with a massive deflationary crisis with COVID-19. So, this should take a while, and it shouldn’t surprise us if we see that number of global assets in negative territory surpass what occurred in 2018 (from the chart above).
Valuation compression will likely remain a theme for this market in the months ahead. So, continue to focus on using puts to aim at expensive stocks like Adobe (ADBE), DataDog (DDOG), and anything else with a price-to-sales ratio over 10.
So long as the Fed is draining money from the economy… and raising interest rates, I will remain bearish. They’re willing to let this economy bleed instead of ripping the Band-Aid off all at once. That’s going to be very tough on retail traders.
We’ll talk about how to find new ideas tomorrow. But, for now, cash remains your friend.