Close, But No Cigar
In its first statement of 2023, the Federal Reserve raised its target policy rate by 25 basis points (bps) to an upper bound of 4.75%. This move was again widely anticipated by market participants, but that doesn’t change the fact that we are in the midst of the most aggressive rate-hike cycle since the early 1980s.
That said, the rate-hike cycle is maturing and we are undoubtedly closer to the end than the beginning, but comments from Jerome Powell indicated that as of right now, it’s not over yet. Close, but no cigar.
Whoever Blinks First Loses
One of the great human pastimes: staring contests. The most relevant staring contest going on right now is the one between the Fed and risk markets. So far, eyes are wide open on both sides.
I’m using the term risk markets because it’s not just the stock market staring at the Fed, it’s also the corporate credit market. After a 6% rally in the S&P 500 in January, and a narrowing of investment grade and high yield bond spreads, risk markets seemed to be looking at the Fed as if to say, “prove it.”
One of the most headline-worthy data points over the last month has been the curious loosening in financial conditions despite rate hikes and balance sheet reduction. Some people believe the Fed’s mood and actions are disproportionately affected by changes in financial conditions – I’m not one of them. At least not this time.
Although financial conditions are a piece of the puzzle, they tend to move with markets, and reacting to short-term turns in direction would be akin to reacting to short-term moves in food prices due to a weather incident. Powell’s comments about financial conditions today were flippant, at best.
I don’t think there’s much of an opponent in the staring contest with financial conditions because the FOMC isn’t playing that game.
“We Have to Complete the Job.”
That was a direct quote from Chairman Powell in this week’s press conference and reiterates his commitment to follow-through, and continued hesitance to stop too soon.
Even if the job isn’t complete, I admit I am surprised by how well the process is going…so far. Meaning, inflation has fallen notably, inflation expectations have remained contained (see chart below), and we’re still without major cracks in the labor market. If things continue on this trajectory, Jerome Powell has a chance to go down in history as the first Chairman of the Federal Reserve to ever pull off a nearly impossible victory.
Any sports fan knows that nearly impossible victories happen from time to time and get a lot of attention. Everybody loves a good story and watching history be made.
So You’re Telling Me There’s a Chance?
The soft landing camp still has a chance. Yes. Even Jerome Powell seemed to believe it more this time. Many believed Powell might repeat Jackson Hole and drill the hawkishness into our skulls. That didn’t happen. He didn’t turn dovish, but he acknowledged some satisfaction with the way things were going.
And the market ripped. “Maybe Goldilocks can beat the three bears after all,” it said.
The environment I see as having an increasing likelihood is one where we stay afloat in markets for longer than we expect, and we don’t move materially in either direction. Multiple expansion remains intact.
The fear I have about that scenario is that multiple expansion in the face of a 4.75-5% fed funds rate, draining liquidity, and compressing margins is not sustainable. But for the time being, those of us who remain skeptical at these levels sound wrong. I’m willing to sound wrong for a while instead of forcing myself to turn a blind eye to the pressures I believe are still coming in profit margins and the economy. The light may stay yellow for a long time, and we probably won’t lose much money in the yellow zone, but I don’t feel confident that it’s green.
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