I pointed out two weeks ago the strong disagreement between technical analysts, who were bullish because of strong price momentum, and macro investors, who were bearish because of concerns over hawkish central bank policy and a slowing growth outlook (see “Price leads fundamentals”, or “Don’t fight the Fed”?). In the wake of the market reaction to the Fed’s Jackson Hole symposium, it seems that macro investors have won the argument, at least for the time being.
In Fed Chair Powell’s speech
, he underlined that tight monetary policy will “bring some pain to households and businesses” but vowed to “keep at it until the job is done”, which was a signal that there will be no dovish pivot until inflation is beaten. The only exception to that rule is a financial crisis. Historically, equity markets haven’t bottomed until the St. Louis Fed Financial Stress Index has risen to positive. While the index has begun to turn up from a very low level, stress levels are still very tame, indicating that financial crisis risk is still relatively low.
The hawks at Jackson Hole
The speeches at Jackson Hole were, on the whole, brutally hawkish. Powell’s speech
, which contained 47 instances of the word “inflation”, began with a stark warning about the effects of Fed policy:
Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance. Reducing inflation is likely to require a sustained period of below-trend growth. Moreover, there will very likely be some softening of labor market conditions. While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.
Powell went on to outline the extent of the Fed’s hawkishness: “With inflation running far above 2% and the labor market extremely tight, estimates of longer-run neutral are not a place to stop or pause.” He went on to discuss how inflation expectations ran out of control during the 1970’s.
During the 1970s, as inflation climbed, the anticipation of high inflation became entrenched in the economic decisionmaking of households and businesses. The more inflation rose, the more people came to expect it to remain high, and they built that belief into wage and pricing decisions.
A San Francisco Fed study found that “wage inflation is sensitive to movements in household short-run inflation expectations but not to those over longer horizons”. The latest ADP report shows that job stayers saw annual wage gains of 7.6%, while job switchers saw gains 16.1%. Fed officials will undoubtedly be closely monitoring wage gains and short-term inflation expectations. Powell concluded, “We must keep at it until the job is done.”
That was just the appetizer. A closely watched speech
by Isabel Schnabel, who is a Member of the ECB Executive Board, was equally hawkish. She acknowledged that supply shocks are mainly responsible for the latest bout of inflation, which is beyond the control of central banks. Nevertheless, she laid out a case for tight monetary policy as a response.
- Uncertainty about inflation persistence requires a forceful policy response.
- Risks of a de-anchoring of inflation expectations are rising.
- Central banks are facing a higher sacrifice ratio when high inflation has become fundamentally entrenched in expectations.
Schnabel echoed Powell’s sentiments about the risks of allowing inflation and inflation expectations to run out of control.
Both the likelihood and the cost of current high inflation becoming entrenched in expectations are uncomfortably high. In this environment, central banks need to act forcefully. They need to lean with determination against the risk of people starting to doubt the long-term stability of our fiat currencies.
Regaining and preserving trust requires us to bring inflation back to target quickly. The longer inflation stays high, the greater the risk that the public will lose confidence in our determination and ability to preserve purchasing power.
I don’t want to sound like a broken record, but Gita Gopinath, First Deputy Managing Director of the IMF, sang from the same songbook in her remarks
: “Central banks must act decisively to ensure inflation expectations are anchored”.
As well, an important financial market plumbing paper
by Acharya et al about the effects of quantitative tightening concluded that the effects of QT are not a mirror image of QE. Instead, “the shrinkage of the central bank balance sheet is not likely to be an entirely benign process” as QT effects are non-linear.
During quantitative tightening, the banking sector may not shrink the claims it has written on liquidity at the same pace that the central bank withdraws reserves. This may lead to tightened liquidity conditions and the greater possibility of episodes of systemic liquidity stress.
The paper’s discussant, Wenxin Du
, pointed out that the Acharya paper found that “no robust relationship between aggregate reserves and the price of liquidity”, as measured by the spread between the effective Fed Funds rate (EFFR) and interest on reserve balance rate (IOR). However, there is a strong relationship between liquidity and reserves in foreign entities (FBOs) instead of US banks. When QT drains liquidity from the financial system, it raises the risk of emerging market instability.
For investors, the key takeaway from Jackson Hole is hawkish Fed and other major central bank policy for as far as the eye can see.
Subsequent to the Jackson Hole symposium, Minneapolis Fed President Neel Kashkari astonishingly admitted in a Bloomberg podcast
that the Fed wants stock prices to fall: “I certainly was not excited to see the stock market rallying after our last Federal Open Market Committee meeting, because I know how committed we all are to getting inflation down. And I somehow think the markets were misunderstanding that.” Kashkari went on to underscore the Fed’s seriousness in its inflation fight by stating that “a commitment of returning inflation to 2%” is a form of forward guidance.
In other words, if you’re an equity bull, you are fighting the Fed.
Signposts to watch
In light of the hawkish rhetoric from Fed officials, the next important signpost is the Summary of Economic Projections, which is scheduled to be published after the September FOMC meeting on September 21, 2022. Watch for how the neutral rate evolves, which stood at 2.5% in June. As well, watch for how much over and overshoot of the neutral the Fed is willing to tolerate based on its projections for 2022, 2023, and 2024.
At the extreme, the Taylor Rule prescribed Fed Funds rate under “normal assumptions” is 11.4%, indicating that there is enormous upside potential in rates should the Fed turn really, really hawkish. To underline that point, Cleveland Fed President Loretta Mester expressed a preference “to move the Fed Funds rate up to somewhat above 4% by early next year and hold it there.” She added, “I do not anticipate the Fed cutting the Fed Funds rate target next year”.
What does all this mean for investors? Needless to say, most projections are equity bearish. CEO confidence has fallen to levels which makes a recession unavoidable. Historically, recessions have always resolved in bear markets.
of Ned Davis Research found that high inflation and below potential growth is a bad combination for equity returns.
There are few historical instances when the Fed deliberately tightened into a recession. Walter Deemer
invoked the 1969 template.
The other is the Volcker Fed of the early 1980’s. Even Volcker pivoted when the Mexican Peso Crisis threatened the stability of the US banking system.
There is one narrow path for the bulls. Central bankers could wrong about the inflation outlook. Inflation surprises have generally been moderating all over the world.
Markets are forward-looking and yield curves are inverting, indicating slower economic growth ahead. In the past, the peak in the long 30-year Treasury yield has been either coincident or slightly led the peak in the Fed Funds rate. While the signal hasn’t been perfect, those episodes have tended to be bullish for risk assets such as equities, and the long bond yield may peaking today.
The August Employment Report came in slightly above expectations, with payrolls rising at 315,000 (300,000 expected) and significantly decelerating from the July rate of 526,000, Both average hourly earnings and average weekly hours were worse than expectations, which indicate a gradually weakening economy. This report is consistent with the Fed’s desire to cool growth and inflation.
Whatever it takes, or…
In reference to the euro, then ECB president Mario Draghi uttered the phrase “whatever it takes” in 2012. Today, central bankers have taken a “whatever it takes” position to fight inflation at the Federal Reserve’s Jackson Hole symposium.
If you believe the Fed and other central bankers, monetary policy is hawkish as far as the eye can see. However, there are two non-linear and narrow paths forward for equity bulls. One is a financial crisis that forces central bankers to pivot to an easier policy to preserve financial stability. The other is the central bankers have misjudged the inflation outlook and markets are right. If long Treasury yields fall in a convincing fashion, it could be the signal for a market-led dovish pivot.
I recognize the tone of this publication is very bearish. Tomorrow, I’ll discuss the bull case from a technical analysis perspective. Don’t slit your wrists just yet.