Summary
Despite the Fed’s persistently hawkish rhetoric, since the last quarter of 2022, markets have embraced a more positive narrative, mostly on the back of increasingly benign US inflation numbers.
Nevertheless, markets focusing on dissecting inflation numbers are ignoring one basic rule. The question is not ‘where is inflation heading’, but rather, where the Fed thinks inflation is heading.
It is one thing competing against an average consensus of thousands of managers like yourself, and quite a different to ignore warnings from the most powerful central bank in the world. Market consensus can be, and often is, wrong. The Fed has the singular power to reshape market realities to whatever it thinks is right.
And presently, the Fed is telling us it remains hawkish. Not only is it pushing interest rates higher, but also it is draining money from the markets.
Equity markets rallying and bond spreads coming off are actually helping the Fed’s case to remain hawkish. It would take a deep recession or a financial accident for the US central bank to change course, and then probably just briefly like the BoE did in October.
“I’ve spent enough time around Wall Street to know that [markets] are culturally, institutionally, optimistic… They are going to lose the game of chicken, I can tell you that”. Thus spoke Neil Kashkari, President of the Minneapolis Fed and one of the twelve voting Fed members in 2023.
Despite the Fed’s persistently hawkish rhetoric, since the last quarter of 2022, markets have embraced a more positive narrative, mostly on the back of increasingly benign US inflation numbers. Last week’s reading further reinforced the positive narrative, sending the S&P 500 one point shy of 4000 and bond yields lower.
To be fair, plenty of data support the idea that the Fed should back down. For the last six months, the average monthly US inflation was 0.2%.
If that trend persists, then the US economy should be at 2% inflation by June.
One could make an argument that inflation expectations remain anchored. A long running survey of US consumers suggests that while long-term inflation expectations near 3%, they are actually low compared to average 5y inflation.
Or even that all non-services inflation components are dropping fast.
Nevertheless, markets focusing on dissecting inflation numbers are ignoring one basic rule. The question is not ‘where is inflation heading’, but rather, where the Fed thinks inflation is heading.
One of the things that I find astounding about market participants is their persistent search for an ‘ultimate truth’. Up to a point this can be explained as a professional vice. Fund managers spend years digging beyond the consensus to find value where others do not see it. If they don’t they won’t be able to generate ‘alpha’ and distinguish themselves from the pack.
However, it is one thing competing against an average consensus of thousands of managers like yourself, and quite a different to ignore warnings from the most powerful central bank in the world. Market consensus can be, and often is, wrong. The Fed has the singular power to reshape market realities to whatever it thinks is right. If fourteen years of history’s sharpest equity and bond rally against a tepid economic backdrop aren’t enough to convince investors of the power of the US Federal Reserve, then little will. Assuming that the Fed does not see the exact same headline data like the rest of us would just be unintelligent.
And presently, the Fed is telling us it remains hawkish. Not only is it pushing interest rates higher, but also it is draining money from the markets.
If the Fed was looking to return to Quantitative Easing as a natural state of play, then ignoring inflation coming down would certainly be a mistake. However, if it is looking to reduce the size of its balance sheet and disengage from its role as the underwriter of all market risks (i.e. printing money at the hint of volatility), while preserving its reputation as an inflation fighter, then it is probably on course to do that.
Equity markets rallying and bond spreads coming off are actually helping the Fed’s case to remain hawkish. It would take a deep recession or a financial accident for the US central bank to change course, and then probably just briefly like the BoE did in October.
Part of the problem is that we can’t be certain as to how the 17 women and men of the Fed think exactly (minutes tend to be polished). Jay Powell’s comments that inflation was transitory in mid-2021 will follow him for a long time, despite the fact that at the time it was a reasonable estimate. To correct an over-dovish call, the Fed may feel it needs to become overly hawkish. In either case, we don’t have a choice other than to take them at their word. If they choose to focus on falling inflation then so must we. If they choose to focus on sticky services inflation and dangers from China’s reopening, we should follow suit.
When it comes to predicting the moves of the world’s de facto central bank, ours is simply not to reason why. What the implications are if such a powerful institution is wrong, is for elected leaders to dissect. The Fed can plainly choose the backdrop against which we will all operate. Ignoring it may come with some opportunities for the very liquid and the very patient or those who simply don’t have real skin in the game, like commentators. Sure, the Fed might be wrong and the few who called it early (or say they did) can stake their claim as the gurus of the next market cycle.
But for those with a fiduciary duty towards clients, there’s only one rule to which we must submit:
Don’t Fight the Fed.