Fed turns hawkish, Moody’s turns negative, and a shutdown looms

Last week saw three interesting developments that sparked uncertainty among investors: US long bond yields rose significantly after a disappointing auction of 30-year Treasury bonds(1) and hawkish comments from Federal Reserve Chair Jay Powell that policymakers aren’t ready to declare an end to tightening just yet. Survey data showed that consumer inflation expectations in both the eurozone and the US moved higher. And then last Friday, within days of a possible US government shutdown, Moody’s announced that it had changed its outlook on US debt from neutral to negative, threatening a downgrade to the US credit rating. But while this is all very interesting, I don’t believe it’s very relevant for markets. Here’s why.

Powell’s hawkish comments were not a surprise

I expected Federal Open Market Committee (FOMC) officials to revert to hawkish “Fedspeak” if markets proved too ebullient. To quote Queen Gertrude in Shakespeare’s Hamlet, I believe Powell “doth protest too much.” In my opinion, his comments last week were performative, intended to tamp down financial conditions, but they don’t change anything in terms of my outlook.

Ditto for other recent hawkish Fed comments, such as Minneapolis Fed Governor Neel Kashkari’s recent warning: “We haven’t completely solved the inflation problem. We still have more work ahead of us to get it done.”(2) This is to be expected given that markets have started celebrating a little too early for the Fed’s taste.

Short-term inflation expectations tend to be volatile

With regard to consumer inflation expectations, the most recent reading for the euro area showed a spike in one-year-ahead expectations. This is similar to the recent spike in US inflation expectations for the one-year ahead period reported by the University of Michigan Survey of Consumers. However, it’s important to note that short-term inflation expectations are typically more volatile and are often driven by energy prices.

Last spring, there was a similar spike for both US and euro area one-year ahead consumer inflation expectations, which coincided with a significant increase in the price of crude oil. I suspect the current spike will be relatively brief given that oil prices have fallen significantly in the past few weeks.

And while central banks pay close attention to inflation expectations, they are focused on ensuring that longer-term inflation expectations — not shorter-term (such as one year) — are “well anchored.” Now there has been a smaller increase in longer-term US consumer inflation expectations in the Michigan survey, but it has not shown up in the New York Fed Survey of Consumer Expectations. In fact, the most recent survey results, released on Nov. 13, show a modest decline for median five-year ahead inflation expectations. By the way, the NY Fed survey also shows a decline for one-year ahead inflation expectations, which could already be reflecting the recent drop in oil prices.

Markets seem to be desensitized to credit warnings

When Moody’s lowered its outlook on US debt last week, it cited the perfect storm of higher interest rates “without effective fiscal policy measures to reduce government spending or increase revenues.”(2) The timing of the announcement, within days of a possible government shutdown, does not seem to have been a coincidence. Moody’s explained, “Continued political polarization within [the] US Congress raises the risk that successive governments will not be able to reach consensus on a fiscal plan to slow the decline in debt affordability.”(3)

However, if Moody’s does follow through with a credit rating downgrade, I doubt it will have any material impact on markets. Keep in mind that we have “been there, done that” before. In the summer of 2011, S&P issued a warning and then subsequently downgraded the US credit rating. That warning was shocking and markets reacted powerfully, but since then markets seem to have become desensitized to warnings and downgrades. In May of 2023, Fitch put the US’ credit rating on watch in the face of the debt ceiling showdown. It followed up in early August by downgrading US credit — with little reaction from markets. I suspect a similar market reaction would occur if Moody’s ultimately downgrades US credit.

The reality is that it’s a very tall order for the US to become less dysfunctional and more fiscally responsible. As we learned with the creation of the Simpson-Bowles National Commission on Fiscal Responsibility and Reform in 2010 (a bipartisan effort to cut the deficit), virtually every line item of federal government spending is considered untouchable by one side or the other — and the political environment has become far more divisive since then.

The good news is that there are not one but two levers to pull to ease the US’ debt problems. One lever — the level of rates — is easier to move than the other lever, reducing the budget deficit. While I hope US lawmakers can cooperate to reduce the budget deficit over the longer term, I am realistic; cutting rates is going to be a lot faster and, in the near term, more effective. Hopefully the Fed will get started on lowering rates sooner rather than later in 2024.

Looking ahead: Politicians to take center stage

Turning to this week, we will see attention largely shift from central bankers to politicians, especially in the US. This might cause volatility in the near term because, as Otto von Bismarck pointed out back in 1863, “Politics is not an exact science.” Needless to say, that’s quite a big understatement.

• US government shutdown. The US government will shut down if an agreement to fund the government is not struck by Nov. 17. The new US Speaker of the House seems to be trying an unconventional approach to funding the government. He is proposing a “laddering” of the continuing resolution, so that some departments are funded to January while others are funded into February. It’s essentially a different form of “kicking the can” a short distance down the road. Only in retrospect will we know if it was a brilliant or foolhardy idea. (“Laddering” may work for bond portfolios, but it’s unclear whether the strategy will work for a continuing resolution on the House floor.) The good news is that there seems to be optimism that the US government will avoid a shutdown this week. We will want to follow the situation closely.
• Xi and Biden to meet. The?Asia-Pacific Economic Cooperation Forum?will be held in San Francisco, with?Chinese President Xi Jinping scheduled to meet with US President Joe Biden.?While the relationship between the two countries has fractured over the last seven years, they recognize there needs to be a better relationship and more communication, at least in certain spheres. The goal seems to merely be a stabilization of relations. We will see how much gets accomplished this week.
• Israel-Hamas war. In recent days, we’ve seen an escalation of hostilities at the border of Israel and Lebanon, raising concerns that the war may spread through the region. From the lens of geopolitical crises’ impact on the global economy, the key question is whether the situation is contained or contagious. While thus far the war has been contained, I do worry the odds are increasing that other countries will become involved.

Dates to watch

But it’s not all about politics and geopolitics next week. The US Consumer Price Index (and Producer Price Index) will be released, which will be an important data point for the Fed to consider at its December meeting. I would like to take this opportunity to remind that not every data point will perfectly support the disinflation narrative . However, I firmly believe disinflation is alive and well, and very much underway.

Footnotes:

1. Source: Bloomberg
2. Source: Reuters, “Kashkari: Fed has more work to do to control inflation,” Nov. 6, 2023
3. Source: Moody’s

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