By Sonal Desai
Remember the saying, “Don’t you fight the Fed?” It was a central tenet of financial markets folk wisdom for so long, passed down from the more experienced traders to the younger; a mantra repeated in countless media interviews. If the Federal Reserve (Fed) signaled that they were going to do something and you bet against it, the wisdom goes, you would lose money.
It now seems as if this wisdom no longer applies. It was unquestionable when the Fed signaled its commitment to loose monetary policy. But now that the central bank is signaling its intention to keep policies hawkish for quite some time, most investors are quite willing to bet against it.
Markets are currently pricing in significant rate cuts – more than a percentage point by January next year. US Treasury bonds rallied again, even in response to an April consumer price index (CPI) inflation report that showed headline and core measures are broadly stable at around 5% and 5.5%, respectively (4, to be precise). 9% of headline inflation).
During this tightening cycle, markets have often battled the Fed, whether by forecasting a lower interest rate base, an earlier turn to loose monetary policy, or deep rate cuts. Are the markets correct?
This tug of war between markets and the Fed also reflects the very high level of uncertainty that we at Franklin Templeton Fixed Income have been warning about for some time – uncertainty about both the macroeconomic environment and the policy response.
Also read: Financial markets appear to have returned to their old game of predicting a dovish Fed
I see three key elements of uncertainty that will ultimately determine whether investors chose the wrong fight.
First: The growth prospects. If you expect the economy to slide into a very sharp recession, it makes sense to bet on significant rate cuts by early next year. I still think this is an unlikely outcome. Yes, the economy has been hit by ongoing headwinds: higher interest rates, the inflation-related loss of purchasing power and, most recently, the turbulence in the banking sector.
But overall, the US economy insists on showing impressive resilience. Above all, consumption by private households remains robust; The labor market is continuing to recover and the unemployment rate was 3.4% in April, which together with January was the lowest level since May 1969.1
And the employment rate for people of prime working age (25-54 years) is close to the highest level on record. As for the outlook for US companies, neither the stock markets nor corporate credit spreads appear to be expecting a collapse.
Clearly, the recent banking turmoil has increased the risk of a worsening credit crunch affecting growth, and that risk should not be dismissed; However, the clearest sign of danger right now is a sharp drop in regional bank stocks.
While worrying, this does not necessarily imply a full-scale credit crunch; In fact, the Senior Loan Officers Opinion Poll still shows only a gradual tightening of lending standards. A deep recession would justify a quick Fed turnaround – but it doesn’t seem likely and it doesn’t appear to be what risk markets are expecting.
Also Read: Fed Rate Hikes and Chairman Powell’s Message to Markets
Second: Inflation and the real interest rate. Suppose inflation falls faster than expected. This could warrant a reversal, but inflation would need to come down significantly and quickly to allow for the kind of rate cuts the market is pricing in. In March economic forecasts, the Federal Open Market Committee (FOMC) saw key personal consumption spending ( PCE ) spending between 3.5% and 3.9% by the end of this year and forecast a corresponding benchmark interest rate of over 5% (5.1% to 5.6%), close to its current level of 5.00% to 5.25%.
The most recent core PCE (March) was 4.6%. Even accounting for a slightly looser stance due to the banking turmoil, core PCE would need to fall sharply and quickly below 3% for the Fed to feel comfortable cutting rates by more than a percentage point. Again, not impossible, but improbable in my opinion. The just-released April CPI report confirms that the pace of disinflation remains unbearably slow: both headline and core metrics rose 0.4%m/m and both fell just 0.1% to 4 .9% and 5.5% respectively.
Inflation in core non-housing services showed a more pronounced decline, as falling prices in categories such as hotels, airfares, dining out and household furniture showed that consumers may be slacking off somewhat. But it’s just a data point, and on the other hand, core commodity prices continue to rise. At this rate, it’s a long, long way back to 2%. Also note that the policy rate is barely above headline inflation on these numbers. Yes, the real rate should be calculated using expected inflation, which is lower, but previous successful disinflation all required the policy rate to be above current inflation, and we’ve only just achieved that goal. Again, this suggests that the Fed should be in no rush to cut rates, even as disinflation progresses slowly.
The third element of uncertainty concerns the Fed’s persistence in fighting inflation. Over the past decade and a half, the Fed has consistently taken a very dovish stance; This could lead investors to believe that once the inflation scare subsides, the Fed will resume dovish policies to mitigate risks to growth and asset prices. The Fed’s own communications throughout this rate-hike cycle have at times given reason to believe that this may indeed be the case.
However, times have changed. Inflation fears have already proved more severe and enduring than the Fed originally anticipated, and the recent turmoil in the banking sector is a sober reminder of the risks to financial stability that can build up as a result of overly loose monetary policy. Overall, there is much broader acceptance of the sensible idea that monetary policy should not return to the dire straits of the post-global financial crisis and pandemic, even if inflation returns to target.
bottom line: As some of the macroeconomic uncertainty fades, I believe we will see further evidence that the economy is beginning to slide into a mild, rather than deep, recession and that progress on inflation control will remain painfully slow. If that’s the case, financial markets might find they chose the wrong fight and should have listened to their own old wisdom: never fight the Fed.
(Author is CIO, Franklin Templeton, Fixed Income)
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