Investors call the Federal Reserve bluff. They are right to do so.
At first glance, and with a great deal of relativity, last week’s updated summary of President Jerome Powell’s economic projections and commentary marks a hawkish turn. Officials have signaled that rates could rise in 2023, earlier than previously wired. And at his press conference, Powell first acknowledged that inflation may turn out to be hotter and more persistent than the Fed anticipated – not a small change for someone who has pushed the idea of transient inflation, said Tom Porcelli, head of the United States. economist at RBC Capital Markets.
But when you step back, the Fed is about as accommodating as ever. When the consumer price index stands at 5%, it is hardly hawkish to say that there is a chance that the price acceleration will be faster and last longer than expected. This is already the case, and it has already been done.
Powell, like former Fed chiefs, told investors to take officials’ so-called dot plot of economic projections with a big grain of salt. But as far as the dots are useful for reading the internal debate, they still show that only three members have changed their minds to hike rates in 2022, not enough to push the median forecast of 0.125% down. How bellicose can all of this really be if, all things considered, the most skeptical members plan to hike rates by 0.5% in 2023? Moreover, the 2023 points message goes against the Fed’s own updated economic forecast. He still sees inflation just above 2% in 2022 and 2023, despite the new tolerance for above target inflation, and he predicts a significant slowdown in growth after that year.
Stocks and bonds were first sold on Wednesday after the Fed policy meeting, but recovered quickly. the
The index, full of expensive growth stocks, closed just off a record Thursday and suffered the slightest weight from Friday’s sell-off after St. Louis Fed Chairman James Bullard said he expects the first increase at the end of 2022 (Bullard is a voting member next year). Still, Friday’s declines are hardly a tantrum and the yield on 10-year Treasuries was lower on Friday than it was before the Fed news. Even more interesting is how the 5-year / 5-year overnight index swap traded.
The 5-year / 5-year OIS captures investor expectations for the peak of the fed funds rate in the business cycle, said Joe LaVorgna, chief economist for the Americas at Natixis. When long rates sold off earlier this year, the gauge rose to around 2.40%, he said, suggesting traders assumed the next round of tightening would look like the last one overall. After the Fed’s meeting on Wednesday, the gauge dropped 1.94%. As of going to press on Friday, it was 1.71%, the lowest yield since early February.
“We don’t believe you,” the futures market effectively tells the Fed, “and says it loud and clear with a megaphone,” LaVorgna says.
Recent history has sided with the market, not policymakers, he says. He points to the long-term equilibrium fund rate, which the Fed has had to continue to downgrade against a backdrop of falling 5-year / 5-year OIS. Once estimated at around 4%, the Fed’s long-term rate estimate is now between 2-3%. The high end of this range still seems far too high if the 5yr / 5yr OIS is a guide.
It makes sense. The sensitivity of financial markets to monetary policy has never been higher. The Fed’s balance sheet has doubled since the end of the 2008 financial crisis, now 40% of gross domestic product. By buying massive amounts of bonds, the Fed cut rates and used asset prices, especially stocks, as its primary monetary policy tool. It’s through the wealth effect, or the tendency of consumers (who make up two-thirds of gross domestic product) to spend more as their assets grow. Any correction in stock prices would negatively affect economic growth and thus limit the Fed’s ability to tighten, according to logic.
Less discussed: the prospect of further budget spending would itself make reducing bond purchases difficult. The Fed has become such a dominant force in the bond market and is likely to continue buying additional debt as the Treasury commits it. (The Biden administration has proposed a budget of $ 6 trillion for 2022).
This is part of the argument that the Fed will not be able to tighten significantly. Another is the debt side of the economy. While the Fed was unable to raise rates above 2.5% in the last tightening round and had to cut rates in several meetings before the pandemic triggered its emergency actions in the early last year, why would it be able to increase now? Since then, American households, businesses and the federal government have only taken on more debt.
“When an economy has a debt-to-GDP ratio of 100% or more and growth is debt-driven, it’s very difficult to raise rates,” says LaVorgna. “The Fed is in a box and I don’t think it can get out of it.”
The result ? The easy money will likely flow well beyond 2023. For now, that would translate into continued market gains, especially in rate-sensitive areas like technology. What this means for the US economy is another question, and what it means for longer-term markets is another.
For LaVorgna, this all probably leads to what he calls secular stagnation. A euphemism, perhaps, for stagflation.
Investors worried about inflation are nonetheless worried. The Fed has tiptoed that the current policy doesn’t match reality, but it hasn’t really made a difference, said Peter Boockvar, chief investment officer at Bleakley Advisory Group. “I’m someone who thinks the Fed did 200 miles per hour in a 50 mph speed zone. I saw Powell slow down to 175.
Boockvar remains the longest zones that resist best during periods of rising inflation, including energy and agricultural stocks, precious metals, and Asian and European stocks. “Inflation is now a high street story,” he says. “I grit my teeth and stick to it.”
The same is apparently true of the Fed. He may have no other choice.
Write to Lisa Beilfuss at [email protected]