A contrarian view is emerging that challenges investors' recent optimism about the Federal Reserve's ability to reduce inflation to 2% without a U.S. recession or a sharp rise in unemployment.
At issue is the idea that Wednesday's unexpectedly dovish shift in policy by policymakers, who have planned three quarter-point interest rate cuts in 2024, could undermine their fight against inflation and create a host of new problems. That's because it reawakens market psychological forces known as “animal spirits” – giving investors more confidence and easing financial conditions in a way that may make inflation more difficult to control.
The resurgence of these animal spirits in financial markets is the biggest risk posed by the Fed's policy update this week, as officials seek to achieve an economic soft landing “by greenlighting a deeper preemptive series of cuts.” “said Charlie McElligott, a maverick thinker. Asset Strategist on the Global Equity Derivatives Desk at Nomura Securities International in New York.
In a note Thursday, a day after the Fed released its update and forecasts, McElligott cited that financial conditions are easing at a time when the labor market remains historically tight. In addition, households and companies benefit from a positive wealth effect through a rising stock market and interest on cash-like investments. The collective impact of all this is that reawakened “animal spirits” could continue to boost consumption and boost inflation, “risking that policy will need to be tightened again in the future,” the strategist wrote.
The Powell Preemptive Pivot is leading to what looks like a “QE/portfolio rebalancing channel trade” in financial markets, said McElligott, who has been warning about the risks posed by animal spirits for months.
For now, he said, there is no reason to try to let the “everything rally” subside until inflation and economic growth accelerate again, which would require “a capitulation in the Arthur Burns tightening cycle,” or until some scenario a “hard landing” occurs with a collapse in the labor market that would require “cuts of over 300 basis points, and fast.” Arthur Burns was chairman of the Fed from 1970 to 1978 and the predecessor of Paul Volcker.
McElligott is not alone in raising concerns about the impact of this week's Fed policy announcement and forecasts. The investment team at Northwestern Mutual Wealth Management Co. in Milwaukee, which had $255.7 billion in assets under management as of September, said it expects it will be difficult to fully suppress inflation and that political Until then, decision-makers would be reluctant to lower interest rates, which will move back to 2% in the long term.
Northwestern Mutual's thinking suggests that a perfect economic landing is highly unlikely and that in that situation, certain investments such as small and mid-cap stocks will perform better than others over the next 12 to 18 months, according to a report distributed Friday Report.
New York Fed President John Williams' comments helped lend credence to skepticism about the central bank's dovish stance. He said officials aren't really talking about rate cuts at this point.
Williams' comments helped the policy-sensitive 2-year yield BX:TMUBMUSD02Y rise 5.8 basis points to nearly 4.46% on Friday. Meanwhile, all three major stock indices DJIA SPX COMP ended mixed. Fed fund futures traders continue to see a high probability of a five to seven quarter point rate cut by the Fed next year.
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