U.S. stock and bond markets ended with a rally in the first week of January 2023. Why?
Over-optimism, based on investors cherry-picking recent labour market data and second-guessing Fed policy. This recurring theme contributed to the three bear market rallies of last year. It may yet contribute to another.
But investors should note the determination of the Fed to bring inflation back to 2% and wait until slack in the U.S. labour market emerges before anticipating any pivot in interest rates. Indulging pre-emptive rallies increases the likelihood of higher interest rates for longer and, therefore, constitutes an own goal.
The labour market continues to tighten
Recent U.S. employment data releases have remained strong in absolute levels, even if there is some ‘rolling over’ from recent highs. Last week’s JOLT report came in stronger than expected, this was followed on Friday with news of unemployment hitting a new 50-year low of 3.5% and non-farm payroll growth beating expectations at 223,000. The Fed’s goal of achieving slack in the labour market has not yet been achieved.
To those who listen to the Fed, this means higher, for longer, interest rates. It means a greater risk of a profit recession and a fall in stock prices -aggravated by increasingly attractive returns from cash. These are not the usual conditions for a stock market rally.
The newly released Fed minutes of the December policy meeting suggest no weakening of intent to squeeze inflation out of the American economy, even as it continues to decline from the autumn highs, so long as employment conditions remain tight. The fear of embedded inflation, particularly in services, arising from strong wage growth, led the policy committee members to predict no interest rate cuts until next year.
In contrast, the Fed Funds futures market is pricing at least one rate cut in the year’s second half (with rates peaking in May). The market is betting against the Fed.
Where are the cherries?
What drives stock, bond and Fed futures markets to believe that the Fed will pivot ahead of its expectations? Where are the cherries that give investors their optimism?
First, Friday’s labour market data dump did show an easing of pay growth to 4.6% annual average hourly earnings in December, from 4.8% the previous month. This is good news, given that the Fed is targeting wage growth. It may prove to be a tipping point in wage growth.
But so long as the labour market remains tight, it is hard to see a trend in falling wages gaining momentum.
Second, there is a good deal of second-guessing of the Fed. An example is the idea that, keen to avoid a recession, the Fed will ease its monetary policy almost at once unemployment begins to grow. We are nearing the nadir in unemployment and, therefore, the peak in interest rates. Unfortunately, this has been forecasted for the last six months.
Another idea is that the Fed, along with other central banks, is toying with raising its inflation target from 2% to 3% or even 4%. This would enable a looser monetary policy than the 2% target demands, supporting growth and company profits (at least in nominal terms).
This may be a sensible plan since 2% is uncomfortably close to zero and the risk of deflation. But now is undoubtedly not the time for any central bank, eager to regain credibility with a sceptical public, to make the inflation target easier to achieve.
Of course, last week’s rally on Wall Street may have been driven by a (still stronger) rally on the U.K. and continental European stock markets last week, as Eurozone inflation data came in lower than expected. However, while moves on Wall Street frequently drive global stock markets, the relationship is much weaker the other way around.
The Fed has warned
Ironically, the Fed has on several occasions mentioned the risk of investors failing to take its commitment to seriously squeeze inflation out of the economy. A stock market rally leads to looser financial conditions through the wealth effect and more work for the Fed.
The following, highlighted by John Authers’ Points of Return on Bloomberg (January 5, 2023), is as clear a message as it is possible to give that interest rates will not be cut this year and betting against this will result in a bloody nose.
‘No participants anticipated that it would be appropriate to begin reducing the federal funds rate target in 2023… A number of participants emphasized that it would be important to clearly communicate that a slowing in the pace of rate increases was not an indication of any weakening of the Committee’s resolve to achieve its price-stability goal or a judgement that inflation was already on a persistent downward path. Participants noted that because monetary policy worked importantly through financial markets, an unwarranted easing in financial conditions, especially if driven by a misperception by the public of the Committee’s reaction function, would complicate the Committee’s effort to restore price stability’
Yet, as discussed in this commentary, the market is pricing at least one rate hike in the second half of this year.
Investors should be wary of betting against the Fed. The downswing of the inflation cycle may prove more stubborn than the market expects -due to the tight labour market – and the Fed has determined to tackle the problem.
When investors bet that the Fed will ease policy sooner than it thinks it will, they are, in fact, goading the central bank to maintain interest rates higher and for longer. A likely own goal.
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