This week’s showdown between the Fed and markets could decide the fate of the stock rally in early 2023
Let’s get ready to rumble.
The Federal Reserve and investors appear to be locked in what one seasoned market watcher has described as an epic game “chicken”. What Fed Chairman Jerome Powell says on Wednesday could decide the winner.
Here is the conflict. Fed policymakers have steadily insisted that the fed funds rate, now at 4.25% to 4.5%, must rise above 5% and, importantly, remain there as the central bank tries to bring inflation back to its target of 2%. However, Fed funds futures show that money market traders are not entirely convinced that the rate will top 5%. Perhaps more vexing for Fed officials, traders expect the central bank to deliver cuts by the end of the year.
Stock market investors have also bought into the latter political “pivot” scenario, fueling a January rally for downbeat technology and growth stocks, which are particularly interest-sensitive. Government bonds have risen, which pulls interest rates down across the curve. And the US dollar has weakened.
Out on a limb?
To some market observers, investors now appear to be way too big for their breeches. They expect Powell to try to take them down a peg or two.
How? Look for Powell to be “unequivocally hawkish” when he holds a news conference after the end of the Fed’s two-day policy meeting on Wednesday, Jose Torres, senior economist at Interactive Brokers, said in a telephone interview.
“Hawkish” is market parlance used to describe a central banker who sounds tough on inflation and less concerned about economic growth.
In Powell’s case, that would likely mean emphasizing that the labor market remains significantly out of balance, requiring a significant reduction in job openings, which would require monetary policy to remain restrictive for a long period, Torres said.
If Powell sounds sufficiently hawkish, “financial conditions will tighten quickly,” Torres said in a telephone interview. Treasury yields “would rise, technology would fall and the dollar would rise on such a message.” If not, expect the tech and financials rally to continue and the dollar to soften.
Hanging loose
It is actually an easing of economic conditions that has tested Powell’s patience. Looser conditions are represented by a tightening of credit spreads, lower borrowing costs and higher stock prices, which contribute to speculative activity and increased risk-taking, helping to fuel inflation. It also helps weaken the dollar, contributing to inflation through higher import costs, Torres said, noting that indices measuring financial conditions have fallen for 14 straight weeks.
The Chicago Fed’s National Financial Conditions Index provides a weekly update on US financial conditions. Positive values have historically been associated with tighter than average economic conditions, while negative values have historically been associated with looser than average economic conditions.
Federal Reserve Bank of Chicago, fred.stlouisfed.org
Powell and the Fed have certainly expressed concern about the potential for loose financial conditions to undercut their inflation-fighting efforts.
The minutes from the Fed’s December meeting. released in early January, contained this startling line: “Participants noted that because monetary policy operated importantly through the financial markets, an unwarranted easing of financial conditions, particularly if driven by a misunderstanding by the public of the committee’s response function, would complicating the committee’s efforts to restore price stability.”
That was taken by some investors as a sign that the Fed was not eager to see a sustained stock market rally and might even be inclined to punish financial markets if conditions loosened too far.
Read: The Fed delivered a message to the stock market: Big rallies will prolong the pain
If that interpretation is correct, it underscores the notion that Bold “sets” — the central bank’s apparent long-standing willingness to respond to a plunging market with an easing of policy — is largely kaput.
The tech-heavy Nasdaq Composite posted its fourth straight weekly gain last week, rising 4.3% to end Friday at its highest since Sept. 14. S&P 500
SPX,
rose 2.5% to log its highest settlement since Dec. 2 and the Dow Jones Industrial Average
DJIA,
rose 1.8 per cent.
Meanwhile, the Fed is almost universally expected to deliver a 25 basis point rate hike on Wednesday. That’s a deleveraging from the series of 75 and 50 basis point hikes it delivered during 2022.
See: The Fed is poised to deliver a quarter-point rate hike along with ‘one last sting in the tail’
Data shows US inflation continues to slow down after peaking at a roughly four-decade high last summer along with expectations of a much weaker and potentially recessionary economy, the 2023 economy has fueled bets that the Fed will not be as aggressive as announced. But a petrol pickup and food prices could provide a bounce in January’s inflation readings, he said, which would give Powell another nudge to dial back market expectations for easier policy in future meetings.
Jackson Hole redux
Torres sees the setup heading into this week’s Fed meeting as a prelude to Powell’s speech at an annual central bank symposium in Jackson Hole, Wyoming, last August, where he a straightforward message that the fight against inflation meant economic pain ahead. That spelled doom for what turned out to be another of 2023’s many bear market rallies, starting a slide that took stocks to their lowest level for the year in October.
But some question how frustrated political decision-makers really are about the current backdrop.
Sure, financial conditions have loosened in recent weeks, but they remain far tighter than they were a year ago, before the Fed began its aggressive tightening campaign, Kelsey Berro, portfolio manager at JP Morgan Asset Management, said in a phone interview.
“So from a holistic perspective, the Fed feels they are becoming more policy restrictive,” she said, as evidenced, for example, by the significant increase in mortgage rates over the past year.
Still, the Fed’s message this week is likely to continue to emphasize that the recent slowdown in inflation is not enough to declare victory and that further increases are on the way, Berro said.
Too early for a change
For investors and traders, the focus will be on whether Powell continues to stress that the biggest risk is the Fed doing too little on the inflation front or shifts to a message that acknowledges the possibility that the Fed could overdo it and slow the economy, said Berro. .
She expects Powell to eventually deliver that message, but this week’s press conference is probably too soon. The Fed will not update the so-called dot plot, a compilation of forecasts from individual policymakers, or its staff’s economic forecasts until the March meeting.
It could turn out to be a disappointment for investors hoping for a decisive showdown this week.
“Unfortunately, this is the kind of meeting that could end up being anticlimactic,” Berro said.
