The three things investors should know this week:
The Fed surprised markets by performing a double cut while being optimistic about inflation. This optimism was not echoed by other central banks.
It will have a limited impact on the economy but it has significant implications for investors, who can now stop monitoring the Fed’s comments (unless they are very important) in between meetings.
We believe the US central bank may be taking another conscious step towards returning to the Old Normal, reducing its post-GFC impact.
Do as the teacher says not as the teacher does, an old saying goes.
The exact opposite of that should apply to keeping up with the Federal Reserve. We have reached a point where we need to monitor the Fed’s actions ex-post, much more so than the narrative and justification for those actions or any comment about future intentions.
The world’s most important central bank, and purveyor of the global reserve currency, is the most important x-factor for financial markets. Over the long term, earnings and economic growth will always drive valuations. But over the shorter term, markets care mostly about the cost of money. And none as important as the cost of money for the US Dollar. Where the Fed goes, the central banks of America’s biggest trade partners are compelled to follow.
Aiming to restore faith in markets after the collapse of Lehman Brothers in 2008, the Fed began to communicate its intentions clearly and well ahead of schedule. A market so nervous and volatile in the wake of the global financial crisis needed no surprises.
But there’s a toll in over-communicating. A whole generation of traders has learned to rely on that. Analysts have Fed-watched for over 15 years. Every word of every official is dissected analysed and fed into a mental or even a quantitative model. The Fed has often used this to its advantage, as it could “talk” rates up and down, well before having to move on them. “Forward guidance” was a useful tool, as it could move long and short-term yields quickly without having to make policy decisions, and reduce volatility.
Inflation, however, began to upend this. A notoriously erratic macroeconomic variable, it has gradually turned the Fed more unpredictable in the past few years. Throughout the latest rate tightening cycles, the Fed delivered much sharper hikes than markets anticipated. Last week the Federal Open Markets Committee, the Fed’s rate-setting body, decided to reduce interest rates by a half percentage point. While traders buying bonds en masse ahead of the cut gave credibility to the narrative that “the market was positioned for it” it was really not the case. Only 9 out of 113 economists interviewed by Bloomberg believed that a “jumbo cut” was coming. Equity markets rallied after the event and bond yields plunged further. In terms of impact, it is estimated that for the next few months, this will affect no more than 5% of Americans whose loans, or whose business loans, are up for renewal.
To be sure, we never really know what the market is collectively “thinking”. “Implied expectations” is a technical measure of bond futures, suggesting where the rate should be to justify current pricing. A narrative is created, to be sure, on the back of it, but it is by and large an exaggerated one. Saying that “markets expect higher/lower rates” as a result of a futures curve calculation is the equivalent of saying that “markets are expecting higher earnings” after an equity rally.
Now that we have established that the Fed didn’t do what the markets expected, let’s focus on what it said:
The Fed told us a number of things last week, along with the jumbo cut, which taken together don’t necessarily match:
That economic growth is solid, BUT it worries about the jobs market
That inflation has been beaten, BUT that this cut is an adjustment and we should not discount further such cuts
The narrative of strong growth and inflation under control does still justify rate cuts, to be sure. What it does not justify is the shift in the dot plot, the Fed’s unofficial internal survey, which saw one cut by the end of the year just six weeks before, and now sees four. Neither did any of the Fed’s spokespeople who spoke before the FOMC meeting.
There are thus three alternatives:
a. The Fed is right and the data justify a jumbo cut
b. The Fed sees risks of recession or something breaking in the market that investors are not pricing in
or
c. The move was simply political
Let us examine them.
A. In a previous note, we said we didn’t see the urgency for big rate cuts. That conclusion still stands. Labour data have been revised down, to be sure, but it has often been noted that the uptick in unemployment (at 4.2% improved from the previous month’s 4.3%, it is significantly below the average of 5.7%) is mostly a supply issue. Meanwhile growth, as economists tell and the Fed tell us, is robust enough, expected to at 2.5% average in 2024 (albeit slowing to 1.8% in Q4). Inflation has been coming down, to be sure, but mostly because of goods, the result of China’s overcapacity deflating certain parts of the inflation basket. Services inflation remains too high for comfort. So the data we have in front of us don’t justify the urgency. It is important to say that the ECB and the BoE didn’t echo the Fed’s victory lap against inflation.
B. The Fed sees risks that we (the market) do not. This is entirely possible. But it is very difficult to do a double cut and say “It’s all good, don’t worry about it”, while a “recession “ narrative is building up.
Bloomberg- stories with the word “recession per week”. JP Morgan’s Jamie Dimon reiterated his view that he’s sceptical about the “soft landing” narrative after the double cut. Even if that is not the case, the fact that the Fed didn’t make a solid case for the double cut, while at the same time keeping growth projections highs (a nearly impossible feat) now leaves room for doubt.
C. While we would often prefer to live in a “West Wing” type of world, where institutions respect each other’s boundaries and collectively conscientiously work for the improvement of citizen’s lives, our shared reality more often resembles the “House of Cards”, where transactions take place in silent corridors of power. A political move would explain Michelle Bowman’s first board dissent in nearly two decades. After all, there is significant political value for the incumbent government to be able to declare a win on inflation and growth at the same time just six weeks before an election while boasting an all-time high stock market.
What it means for investors
The reality is, a few days after the double cut, we are none the wiser about what the Fed is going to do next. And while the US central bank may prefer it that way, as investors we need to think what this means for our portfolios.
To be sure, we can still safely assume that the important functions of the Fed are still there.
The “Fed Put” an unspoken promise to calm markets when volatility surges and throw money at serious issues when they arise is still in effect.
It will still be a lender of the last resort to good borrowers
An inflation fighter
A steward of growth (through its unemployment mandate) are still there.
But where those targets compete (around turning points for inflation and growth) we simply don’t know what they will do. As it chose not to warn investors of its intentions, it means there’s no need to monitor every word going forward, as opinions may simply change. The bond market is currently pricing in three more cuts until the end of the year, one more than what the Fed itself now predicts. It matters not. The Fed may again change its mind.
So what can we do? We need to stop trying to position for the Fed’s next moves, and instead focus on what we do know:
Macroeconomic data (growth, inflation, jobs, money velocity etc) for the bond markets
Earnings and momentum for the equity markets
The Dollar and demand conditions for gold (supply is more or less stable)
We have often said that the US central bank has strived towards a world where its role is more limited to its core functions and less “guiding the markets”. An old normal, of sorts, the kind investors used to experience before the ascent of Alan Greenspan and Ben Bernanke’s expansive monetary policy.
This may just be it.