Last week saw the official start of fall – or so we were told. Here in San Antonio, high daytime temperatures still hover in the mid-90s.

The week also felt like a huge pivotal turn in the global central banks’ battle against persistent price inflation. Monetary policymakers added 350 basis points in rate hikes, bringing the total amount of increases in the world’s 10 largest economies to 2,000 basis points so far this cycle, according to Reuters. The only country on hold is Japan, which still faces moderate inflation below 3%.

Of course, the central banks are not close to completion. The Fed expects the rate in the US to be 4.4% by the end of the year, before peaking at 4.6% in 2023. Some macro research firms believe we will see 5%.

The question is: Will this have an effect on inflation? The Fed has historically had to raise rates well above its annual Consumer Price Index (CPI) to make a difference, but that has been tough for Jerome Powell, whose starting point is essentially 0%.

Will higher prices cause a recession?

The danger is that the Fed drug may be ineffective but come with serious side effects. The current interest rate increases likely won’t be enough to bring down inflation, but they could be enough to trigger a recession. Then we deal with stagflation, the toxic combination of high prices and high unemployment. The next CPI report is due out on October 13th, and I hope we’ll see continued slowdown in inflation.

Below is the so-called misery index, which together sums the monthly unemployment rate and the monthly inflation rate. We haven’t hit the levels of the 1970s yet, but the trend is clearly going in the wrong direction. If we’re not already in a recession, this could be as close to being the highest out of an economic downturn as we’ve ever seen.

Cash is king, but bonds look attractive too

With a recession likely, and the S&P 500 sliding another 4.7% last week, investors may be wondering what the next step should be. Taking no action is probably the best way forward for now. It is often said that cash is king in downturns, and today may be no exception. The Bloomberg Dollar Spot Index has advanced more than 14% so far in 2022, compared to the S&P 500, which is down 22%, eliminating the past two years.

Government bonds are also experiencing one of their worst years in recent memory. The iShares 1-3 Year Treasury Bond ETF (SHY), the largest ETF with more than $26 billion in assets, is currently down 4.4% for the year. This puts SHY in its stride for the worst year in its 20-year history.

However, if you know anything about bonds, it is that as prices go down, returns go up. Because of this, Treasuries are starting to look like a potential buy again. The yield on 10-year notes has risen to nearly 3.7%, the highest level since 2011, while 2-year notes are trading at as high as 4.1%, a level last seen in 2007. Either way, that's much higher. S&P 500 dividend yield.

I should pause a bit to point out that the difference between the short-term return and the long-term return is now at its clearest since 2000, around the time of the tech bubble. This reversal indicates that investors are becoming more pessimistic about the US economy over the next two years. Moreover, since 1955, each yield curve inversion has been followed by a slump in subsequent months.

a state of optimism

Having said all that, I still urge readers to remain optimistic, even though almost every sign indicates more economic and financial pain.

By the way, there are many misconceptions about optimism. Some people think that only good things will happen. Others believe that you have to be naive to express optimism, or that only happy people can be optimistic.

I don't think about any of these things. I think optimism is simply the recognition that, while there may be setbacks along the way, some significant, the odds of things eventually working out increase over time.

The ideal analogy is the stock market. Huge selloffs like the one we're seeing right now distorts some people's attitudes about investing. They see the S&P in correction territory and may conclude that the investment is too risky. The truth is that stocks have risen three times out of every four years, historically speaking.

I've been in the game for decades, and one of the most important lessons I've learned is that an optimistic attitude helps you identify opportunities where a pessimist might only see risks. There will always be risks, as we all know. Sometimes it's best to avoid risks altogether. Other times, taking a risk increases your odds of achieving rewards beyond your wildest dreams.

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