One data point at a time
The price action on Friday was quite telling. The September payrolls data was very close to consensus expectations: there were 263,000 new jobs (versus 255,000 expected), average hourly earnings grew 0.3% m/m and 5.0% y/y (as expected), and labor force participation fell to 62.3% and the unemployment rate dropped to 3.5% (both lower than the forecasts of 62.4% and 3.7%). How did investors react to this generally expected news? The S&P 500 was down 2.8%. This reaction is a reminder that there’s a big difference between consensus forecasts and what investors hope the data will actually be. For the payrolls report, that was more evidence of the labor market cooling following the 1.1mn decline in the JOLTS job openings.
The other telling aspect of market performance, on Friday and all of last week, is that the only thing that investors really care about is when the Federal Reserve will pivot by slowing or stopping rate hikes. Every data point or utterance by Fed officials is being viewed through the prism of this singular question.
In one respect, this makes it easier to decide what to write about. But when formulating a market outlook, it’s hard to have an edge in forecasting such a widely-debated issue. Still, there are a number of aspects of Fed policy that may be under-appreciated, yet are vital for thinking about the investment outlook over the next few months and quarters.
First, in mathematical terms the Fed’s current reaction function looks like a constant. Regardless of the data, the response is something like “we’re committed to bringing inflation down and the job isn’t down yet”. For example, Minneapolis Fed President Neel Kashkari said last week: “We have more work to do … We’re not seeing any evidence yet that (wages and service prices) are moving in the right direction.” For the record, average hourly earnings (y/y) declined from a cycle high of 5.6% in March to 5% in September, while housing price appreciation is now negative month-over-month and rents are rising at a similar pace as in 2019, which should lead to lower services inflation in nine to 12 months. Perhaps Fed officials repeat the same mantra for fear that anything else will ease financial conditions. A less generous interpretation is that Fed policy is on autopilot.
Second, this mindset is reminiscent of their approach to hiking rates in 2018, when Fed Chair Jay Powell seemed adamant on getting the fed funds rate to neutral. They did so by hiking rates to nearly 2.5% in December 2018. This happened despite evidence that economic growth was slowing, the US-China trade war wasn’t improving, a government shutdown loomed, and the S&P 500 was already down nearly 8% that month and 13% below its high. With hindsight, we can say that the Fed went too far and by early January was already back-tracking, having realized their mistake.
Third, a Fed focused solely on lowering inflation risks hiking rates too much, and the dynamic between the Fed and investors exacerbates this risk. The last two FOMC meetings illustrate the point. Both entailed 75bps rate hikes, but investors interpreted Powell’s comments in July as dovish, helping to fuel the risk asset rally that eased financial conditions. That led to the September FOMC outcome that forecast more rate hikes than the market was expecting, a rational action for a Fed that wanted to avoid repeating the July response. In effect, the Fed and investors are playing a prisoner’s dilemma game. The
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economy and the markets would likely be better off if the Fed and investors could coordinate on the optimal amount of financial conditions tightening. Because that’s impossible, Fed rate forecasts have to match or exceed market pricing in order to keep financial conditions from easing. The risk is a tit-for-tat escalation of hikes beyond what’s necessary to bring down inflation.
Fourth, the inability of the Fed to credibly pre-commit to keeping rates high for an extended period once they stop hiking biases them to hike even more than the current forecast. The optimal policy may be to hike the funds rate to 4.5%, which they’re likely to do by year-end, and then stay at that level for most of 2023. The result could be below-trend growth for a sufficiently long period to bring inflation back near 2%, and do so without a hard-landing for the economy. The problem is that once they pause, financial conditions will ease as the market starts to price in rate cuts, working against the high rates. Thus, the Fed may think it’s necessary to go further, even at a higher risk of a hard landing, and then start easing sooner.
Fifth, the Fed just stopping its rate hiking cycle may be sufficient for risk assets to begin a sustainable new rally. Last week’s price action and the intense focus on the Fed pivot suggest that there will at least be a substantial market rally when it does happen. That’s not to say there won’t be more pain, especially with earnings downgrades and rising defaults still to come. And it’s true that the S&P 500 didn’t bottom in past bear markets until after the first rate cut. But the dynamic between the Fed and the markets has changed considerably since the global financial crisis. Investors get far more information about the Fed’s intentions from the post-FOMC press conference, the dot plot of rate hike forecasts, and the Summary of Economic Projections. Similarly, market pricing of expected the fed funds rate and inflation is much more readily available and followed today. One consequence is that markets react very quickly to any change in Fed communication, well before concrete actions. Another is that the Fed is increasingly reactive to market pricing when setting policy, given its focus on financial conditions, which means that the markets often lead the Fed, not the other way around.
And sixth, another reason why the Fed pausing could support a sustainable rally is that it would implicitly bring back the Fed put. By ending rate hikes, the Fed is effectively saying that they believe they’ve done enough to achieve their inflation mandate and now are giving equal weight to economic growth. Incremental tightening of financial conditions after that time would make policy more restrictive policy than the Fed now wants, and that would likely engender a response to ease financial conditions. That should limit the amount and duration of market downside after the pause, which would shift the risk-reward skew from negative right now to something more balanced, if not to the upside.
The bottom line: When collectively assessing these Fed policy considerations, three conclusions stand out. First, the risk of the Fed overtightening seems high. Inflation falling and labor market cooling by the start of 2023 may be sufficient to avoid this outcome. But the Fed may also be forced to pivot before the fundamentals warrant it because of another leg down in risk assets similar to late 2018. Second, investors are justified in focusing so much on a Fed pivot. Once the headwind of the Fed wanting financial conditions to tighten is removed, assets will be able to have rallies that last more than a few days or weeks. And third, as we inch closer to the uncertain pivot date, the markets are likely to become increasingly sensitive to each inflation and labor market data point because it may be the marginal one that catalyzes a pivot or puts it off until the next Fed meeting. In practice, that means more volatility and quicker, sharper market swings.