Down the Rabbit Hole

It's a rough time to be a bank... 'A general worsening in asset quality'... Down the rabbit hole... Focusing on the 2% inflation target... It all started on a New Zealand TV show... The problems with averages and targets... Central bankers don't care... [Stansberry Research Logo] Delivering World-Class Financial Research Since 1999 [Stansberry Digest] It's a rough time to be a bank... 'A general worsening in asset quality'... Down the rabbit hole... Focusing on the 2% inflation target... It all started on a New Zealand TV show... The problems with averages and targets... Central bankers don't care... --------------------------------------------------------------- Banks can't catch a break these days... [Two Fridays ago]( I (Dan Ferris) mentioned the recent actions by Moody's on 27 U.S. banks. Specifically, the credit-ratings agency... - Downgraded the credit ratings of 10 small to mid-sized banks, - Downgraded the status of 11 other banks statuses from "stable" to "negative," and - Placed another six banks on review for potential downgrades. Ultimately, I concluded the banks' troubles were a bad sign... I still believe there's a lot more pain to come than the bland little bear market that started in late 2021/early 2022. From peak to trough, the S&P 500 fell 25% and the Nasdaq fell 36%. That's so benign that plenty of folks think it's over already. But even if the S&P 500 or Nasdaq were to hit new highs soon, I don't think we're out of the woods. Bear markets after past mega-bubbles suggest we're looking at something like negative 60% or more for the S&P 500 and negative 75% or more for the Nasdaq. We're a long way from either of those. If I'm right about that, we could now be even closer... On Monday, a Moody's competitor coughed up more evidence that all isn't well in the financial world... Specifically, S&P Global released a new report on 10 banks. It downgraded the credit ratings of five banks, revised two banks' outlooks from "stable" to "negative" (but kept their ratings unchanged), and left three others' ratings and outlooks unchanged. S&P Global's report included two banks that were also on Moody's list... Both credit-ratings agencies downgraded 162-year-old Associated Banc (ASB), which traces its roots back 162 years. But they took different approaches to Truist Financial (TFC)... Moody's put Truist – which formed four years ago when BB&T and SunTrust merged – on review for downgrade. S&P Global kept the bank's rating unchanged and outlook as "stable." The two credit-ratings agencies don't hold the same opinions on each of those two banks. But they generally agree that operating conditions are difficult in the banking industry. And they both named commercial-office-building loans as a risk for regional banks. In fact, S&P Global referred to those types of loans as 'the biggest driver of a general worsening in asset quality'... The report used the term "asset quality" eight times – six in a purely negative context. Bank assets mostly consist of loans, government bonds, and cash. Cash holds its value – in nominal terms, at least. Bonds and loans are the same thing in different wrappers. All else equal, their values fall when interest rates rise. That explains a lot of the asset-quality deterioration that S&P Global mentioned so many times. You can even see it in companies with sterling credit ratings... Some of consumer-electronics giant Apple's (AAPL) bonds don't mature until 2061. They've traded as low as 58% of par value (the amount returned to the bondholder at maturity). And recently, they're at around 62% of par value. These bonds carry a stellar investment-grade "AA+" rating. And by now, everybody knows Apple is the world's most profitable company. It's also the world's largest company by market cap. And yet, due to interest-rate movements, Apple's bonds trade like junk today. (It's more nuanced than that. But if you own these bonds, I bet you don't care about those nuances.) It makes me want to ask if it's reasonable to expect rates to fall any time soon... That would give the banks' asset quality a much-needed boost. And if it's not reasonable to expect rates to fall, then maybe banks' asset quality won't improve for a while – or perhaps it will get even worse. If asset quality doesn't improve, then banks could actually have less capital than they're reporting right now. That would surely generate a lot more credit-ratings downgrades. In its report, S&P Global estimated that banks with protection from the Federal Deposit Insurance Corporation had $550 billion of unrealized losses on available-for-sale and held-to-maturity securities (as of June 30). The 10-year U.S. Treasury yielded 3.85% back then. It's higher than 4% today. So at this point, the banks' unrealized losses are likely bigger than $550 billion. I doubt the Federal Reserve is done hiking rates, either. So more damage likely lies ahead. How can I be sure the Fed's rate hikes aren't finished? Well, as a regular Digest reader, you know me... I don't try to predict anything. But all investors need to think about the market's future risks and opportunities. They need to prepare by considering all types of outcomes that others might not be taking seriously. And higher rates for longer definitely qualifies. Now, to really understand why higher rates for longer is worth a lot of thought right now... We need to go down a big rabbit hole known as the '2% inflation target'... But before we go down this rabbit hole, I must warn you... It's no ordinary rabbit hole. It's filled with serious Alice in Wonderland weirdness. So strap in and hang on. Here we go... For most of the past three decades, a lot of the world's bigger central banks have targeted 2% inflation. They've lowered and raised interest rates, and bought and sold bonds and stocks – all in a quest to make official inflation numbers coalesce around their 2% targets. I expect you already knew that. After all, the people who run these central banks repeat it every chance they get. It's like they're chanting some type of magic spell, just trying to will it into permanent existence. When they talk about the 2% target, you can feel the IQ points draining from your mind. For example, here's what then-Fed Chair Janet Yellen said in September 2015... So let me be clear – 2% is our objective. We want to see inflation go back to 2%; 2% is not a ceiling on inflation. So we're not trying to push the inflation rate above [2%]. It's always our objective to get back to [2%], but 2% is not a ceiling. And if it were a ceiling, you would have to be conducting a policy that, on average, would hold the inflation rate below 2%. That is not our policy. We want to see the inflation rate get back to 2% as rapidly as we can. Yellen never explained why 2% is so important. She just kept chanting "2%" like she's one utterance away from summoning the Dark Lord of the Financial Underworld or something. It's the same thing with Fed Chair Jerome Powell. He cites the 2% inflation target almost every time he makes a public statement. If only we could ask Powell why 2% is so important – and beyond that, how he knows it is... What luck! Nevada Senator Catherine Cortez-Masto actually did ask Powell that question during a March 7 hearing on monetary policy and the economy. Specifically, she asked... Why 2%? Why is getting [inflation] to 2% so important? And Powell answered... Um, so that has become the globally agreed – essentially all major central banks target 2% inflation in one form or another. Um, and uh, it... Then, Cortez-Masto interjected... How does that help my Nevada families? How does that help people in Nevada who are struggling? Powell responded immediately. But, um, uh, his answer really didn't make any sense... I'll tell you how it does. It's, um, I guess it's obviously not, uh, it's not obvious how that is. But, what it – 2% inflation... to have people believe that inflation is going to go back to 2% really anchors inflation there. What? Look, given my track record, I understand if you think I'm being too harsh on Powell. But I'm really not this time. Watch the exchange yourself in [this YouTube video from Forbes](. Powell goes on to explain the "modern belief" that if people "expect inflation to go up 5%, then it will" – as if you can just magically print money by thinking about it. He sounded like a stoned surfer talking about that gnarly wave he totally rocked one time 10 years ago... []Like, it's 2%, man. And we're trying to get back there. And that's what every other central bank is doing, too, so, uh, it's just, like, the awesome 2%-ness of it all, you know, man? But the scary thing is... neither Powell nor Yellen's vapid statements were gaffes. Just today, Powell dropped this pearl of stoner wisdom at the end of his remarks at the Fed's Jackson Hole, Wyoming, symposium... As is often the case, we are navigating by the stars under cloudy skies... We will keep at it until the job is done. Their words represent state-of-the-art understanding of the 2% inflation target. That's all you'll ever get out of them. Deal with it, dude. Maybe I'm asking the wrong question. Instead, what if I worded it this way... Where did the 2% target come from? Who started it? The 2% target isn't rooted in research, historical examples, in-depth studies, or anything you might use to make a momentous decision. The entire rationale is the rough equivalent of a random stock tip you overhear while half-drunk at a noisy cocktail party. You see, the 2% inflation target originated from something then-New Zealand Minister of Finance Roger Douglas said when he was put on the spot on a TV show on April 1, 1988. Back then, New Zealand's inflation had just descended out of double-digit territory for the first time in years. Douglas was afraid that the public wanted easier monetary policy. And he hoped the country's central bank would settle for inflation in a range between 5% and 7%. But when Douglas got on TV, he said he preferred an inflation range of zero to 1%. That off-the-cuff statement implied the central bank's hawkish policy would continue, which would augur more economic pain for New Zealanders. Eventually, New Zealand adopted a 2% inflation target as its official policy. From there, the 2% inflation target spread all around the world... Here in the U.S., it was the Federal Reserve's informal (but still very clear) target by 1996. And it became the central bank's official target under Chair Ben Bernanke in 2012. At first glance, the Fed seems to have achieved its goal of keeping inflation around that level. That is, if you use the central bank's favorite inflation measure as your guide. I'm talking about core personal consumption expenditures ("PCE"). Since 1996, core PCE has averaged roughly 1.93%, according to Bloomberg data. (The blue line on the chart is 2%.) You can see what I mean on the chart below. Take a look... So on average, the Fed has done a great job, right? Not so fast... The problem with averages is that they don't happen often in real life... You don't earn average returns in your portfolio or work for an average salary. You don't live in an average house. You don't have an average day. And you don't have an average life. Similarly, you never seem to experience average economic conditions... You experience good times, bad times, and everything in between – except average. You feel good when it gets better. And you worry like crazy and feel bad when it gets worse. (Check out Sam Savage's The Flaw of Averages: Why We Underestimate Risk in the Face of Uncertainty. It's a detailed discussion of all the stuff that's wrong with averages.) To that point, the past three years haven't felt very average... First, the Fed doggedly pursued the loosest monetary policy in history for several years. That inflated a huge asset bubble. Then, trillions of dollars in fiscal stimulus were added to the mix during the COVID-19 pandemic. That caused inflation to soar. When the Fed finally responded, it embarked on the fastest rate-hiking cycle since 1980. Starting in 2020, core PCE skyrocketed from 1% to 5% in 20 months. Mortgage rates soared, too – from below 3% to more than 7% today. That massive increase suddenly made home ownership impossible for many struggling families in America. We're talking about 40-year inflation highs, 23-year mortgage-rate highs, and the worst year for Treasury debt since 1788. And, of course, stocks weren't immune. Remember, from peak to trough, the S&P 500 Index fell 25% and the Nasdaq Composite Index plunged 36%. Did all that feel average to you? I bet it didn't. And, of course, 5% is way outside the Fed's 2% inflation target. No matter how stable inflation seemed before 2020... The target was always doomed to fail because they generally don't work... Edward Chancellor explained why in his must-read 2022 book, The Price of Time. As he wrote... The mistake in setting targets lies in assuming that relationships between variables – in this case a certain measure of the money supply and inflation – are stationary. In the real world, human behavior responds to attempts at control. But it's worse than that. As UCLA economist Axel Leijonhufvud wrote in a 2007 paper... I maintain that [stabilizing] the consumer price index (or its rate of growth) does not guarantee stability of the financial system. Moreover, under certain conditions, concentrating on year-to-year monetary stability, in the sense of keeping to a [consumer price index] inflation target, can lead you to follow policies that are inimical to financial stability over the longer run. In other words, inflation targets make the financial system less stable – not more. It's easy to see how that could be true... Central bankers kept rates at 0% in a constant attempt to get inflation to stay around 2%. But they were completely oblivious to any potential consequences of a long period of ultra-loose policy (like inflating the biggest financial mega bubble in all recorded history). That's typical behavior from central bankers... In his book, Chancellor documented European, Japanese, and American central bankers' fanatical commitment to "do whatever it takes" (in the famous words of former European Central Bank President Mario Draghi). They were blinded to any effects of their actions. As Chancellor wrote... Asked whether the [European Central Bank's] actions were causing inequality, Draghi replied that his concern was with the target... As Draghi expressed it: "This is not a question of trade-offs. We cannot shy away from implementing a policy that ensures price stability on account of potential collateral effects." The fact that targets don't work means nothing to central bankers... That's because central bankers are human (at least, I think they are). And humans don't handle ambiguities well. Humans need concrete reference points in reality – even if they sound like they've smoked more than Cheech and Chong whenever they try to explain those reference points. In his time as Fed chair, Bernanke was dedicated to preventing the next Great Depression by keeping monetary policy loose enough to hit the 2% inflation target. That policy was maintained until the Consumer Price Index was nearly 8% and core PCE was more than 5%. The Fed didn't start raising rates until a whole year after both measures had exceeded its 2% inflation target. It was "all clear ahead"... "inflation is transitory"... and whatever else the central bank had to tell us (and itself) to maintain the status quo. And in the end, it overshot the target by at least 150%. Likewise, the Fed is doomed to keep rates higher for longer until it has overshot the 2% target to the downside. And banks' asset quality will suffer as rates rise or stay higher. The credit-ratings agencies – late to the party, as always – are only just beginning to figure out this problem. Their recent bank downgrades reflect trends that were in place since at least late last year. The next wave will reflect what has been happening since at least March. So don't be surprised when the next wave of downgrades starts coming in hotter and heavier than anything we've seen so far. Expect it to treat bonds bad – and stocks worse. Get ready... []We're stuck in this 2% inflation-target rabbit hole. And the descent could soon get a lot bumpier. --------------------------------------------------------------- Recommended Links: [The Shortest Bull Market in History]( After soaring 40% this year, the Nasdaq is faltering. And with more bank failures on the horizon – plus the Federal Reserve's relentless push for higher rates – Wall Street veteran Marc Chaikin is ready to share a critical update with you. He called this bull market way back in January and predicted a "run on the banks" five months in advance. Now, he's preparing for one final twist before the end of this year. [Click here for the important update](. --------------------------------------------------------------- [Back by Demand: 'The Perfect Transaction' (94% Success Rate)]( Since 2010, we have logged a 94% success rate with a trading strategy as close to a Holy Grail as anything we've seen. It's a way to target the best companies in the market and instantly collect payouts of hundreds of dollars at a time, without ever touching a single stock up front. By tomorrow, [click here to learn more (includes a free recommendation)](. --------------------------------------------------------------- New 52-week highs (as of 8/24/23): None. In today's mailbag, more feedback on [Morgan Housel's guest Digest]( from Wednesday. As a reminder, if you want to hear more from Morgan, he'll be among the speakers at our annual Stansberry Conference this October 16 to 18 in Las Vegas. [Click here]( for details on our speaker lineup, tickets, and livestream information... As always, if you have a comment or question, e-mail us at feedback@stansberryresearch.com. "Jesus spoke in parables. I've read that one must always have a contrarian on any committee; too many 'yes people' hinder insight." – Subscriber Polly R. "Great article. Quite the eye-opener for me. Probably just saved me 2 hours a day. Thanks." – Subscriber James S. "[Wednesday's Digest had] some quality perspectives! But you do need to trawl through junk to get gems. If you are given too many gems, your brain has a tendency to discard most things, even if all are good! The spoiled child is thus because they are given too many good things, and they lose perspective. "I think also the brain notes how much effort was involved and will remember better things involving effort. If something has a lot of gems, it can be a good idea to just read a small amount and digest those gems. And read more another time... "The idea of asking 'Will I still care about this in a year?' is an excellent idea, and is an example of metalevel action..." – Anonymous subscriber Good investing, Dan Ferris Eagle Point, Oregon August 25, 2023 --------------------------------------------------------------- Stansberry Research Top 10 Open Recommendations Top 10 highest-returning open positions across all Stansberry Research portfolios Stock Buy Date Return Publication Analyst MSFT Microsoft 11/11/10 1,181.2% Retirement Millionaire Doc MSFT Microsoft 02/10/12 1,004.5% Stansberry's Investment Advisory Porter ADP Automatic Data Processing 10/09/08 891.9% Extreme Value Ferris wstETH Wrapped Staked Ethereum 02/21/20 683.4% Stansberry Innovations Report Wade WRB W.R. Berkley 03/16/12 536.2% Stansberry's Investment Advisory Porter BRK.B Berkshire Hathaway 04/01/09 528.2% Retirement Millionaire Doc HSY Hershey 12/07/07 518.9% Stansberry's Investment Advisory Porter AFG American Financial 10/12/12 396.3% Stansberry's Investment Advisory Porter TTD The Trade Desk 10/17/19 317.1% Stansberry Innovations Report Engel ALS-T Altius Minerals 02/16/09 305.2% Extreme Value Ferris Please note: Securities appearing in the Top 10 are not necessarily recommended buys at current prices. The list reflects the best-performing positions currently in the model portfolio of any Stansberry Research publication. The buy date reflects when the editor recommended the investment in the listed publication, and the return shows its performance since that date. To learn if a security is still a recommended buy today, you must be a subscriber to that publication and refer to the most recent portfolio. --------------------------------------------------------------- Top 10 Totals 4 Stansberry's Investment Advisory Porter 2 Extreme Value Ferris 2 Retirement Millionaire Doc 2 Stansberry Innovations Report Engel/Wade --------------------------------------------------------------- Top 5 Crypto Capital Open Recommendations Top 5 highest-returning open positions in the Crypto Capital model portfolio Stock Buy Date Return Publication Analyst wstETH Wrapped Staked Ethereum 12/07/18 1,572.4% Crypto Capital Wade ONE-USD Harmony 12/16/19 1,048.3% Crypto Capital Wade POLY/USD Polymath 05/19/20 1,028.9% Crypto Capital Wade MATIC/USD Polygon 02/25/21 766.8% Crypto Capital Wade BTC/USD Bitcoin 11/27/18 597.1% Crypto Capital Wade Please note: Securities appearing in the Top 5 are not necessarily recommended buys at current prices. The list reflects the best-performing positions currently in the Crypto Capital model portfolio. The buy date reflects when the recommendation was made, and the return shows its performance since that date. To learn if it's still a recommended buy today, you must be a subscriber and refer to the most recent portfolio. --------------------------------------------------------------- Stansberry Research Hall of Fame Top 10 all-time, highest-returning closed positions across all Stansberry portfolios Investment Symbol Duration Gain Publication Analyst Nvidia^* NVDA 5.96 years 1,466% Venture Tech. Lashmet Microsoft^ MSFT 12.74 years 1,185% Retirement Millionaire Doc Band Protocol crypto 0.32 years 1,169% Crypto Capital Wade Terra crypto 0.41 years 1,164% Crypto Capital Wade Inovio Pharma.^ INO 1.01 years 1,139% Venture Tech. Lashmet Seabridge Gold^ SA 4.20 years 995% Sjug Conf. Sjuggerud Frontier crypto 0.08 years 978% Crypto Capital Wade Binance Coin crypto 1.78 years 963% Crypto Capital Wade Nvidia^* NVDA 4.12 years 777% Venture Tech. Lashmet Intellia Therapeutics NTLA 1.95 years 775% Amer. Moonshots Root ^ These gains occurred with a partial position in the respective stocks. * The two partial positions in Nvidia were part of a single recommendation. Editor Dave Lashmet closed the first leg of the position in November 2016 for a gain of about 108%. Then, he closed the second leg in July 2020 for a 777% return. And finally, in May 2022, he booked a 1,466% return on the final leg. Subscribers who followed his advice on Nvidia could've recorded a total weighted average gain of more than 600%. You have received this e-mail as part of your subscription to Stansberry Digest. If you no longer want to receive e-mails from Stansberry Digest [click here](. Published by Stansberry Research. You’re receiving this e-mail at {EMAIL}. 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