Doesn’t Fed policy matter to stocks anymore?

Interest rates right now are well into restrictive territory; they’re well above neutral…we’ve said for some years that we would start restoring the federal funds rate to a more normal, almost neutral level. We’re far from neutral now.

Former Fed economist Claudia Sahm argued in a blog post that the first rate cut will occur in July, which is later than consensus expectations. That’s because Powell doesn’t want any dissents on the rate cut decision, and he is unlikely to manufacture such a consensus in June. However, inflation is decelerating and Fed officials will have six months of PCE data by the July meeting.

Currently, core PCE is 2.8% year-over-year — well below its high of 5.5% in 2022. By this summer, even with some bumps and a slow grind down of shelter inflation, core PCE should be undeniably close to 2%. Six months of good data on top of the six months in 2023 should give the Fed more than enough confidence to start cutting. And even the hawkish commentators should see it, too. Time to RSVP.

The January data blip

The January data on CPI, PCE, retail sales and employment were all unusually strong. As a consequence, market expectations began to push out the timing of the first rate cut. As February’s data starts to trickle in, it is beginning to appear that the strength of January’s figures was a data blip.

Similarly, the ISM Services report showed a cooling in both services employment and prices, which is also another sign of deceleration in inflation.
 

The February Payroll report dramatically revised the January nonfarm payroll upside surprise down by an astounding -157,000 from 353,000 to 229,000, and December was revised down -43,000. These revisions cast a dovish tone on the February headline employment beat of 275,000 compared to an expected gain of 205,000. Moreover, February’s average hourly earnings gains were below expectations. Leading indicators of job growth, namely temporary employment and the quits to layoffs rate from JOLTS, are also showing signs of deceleration.
 

In addition, productivity improved in Q4, which allows for a goldilocks scenario of non-inflationary wage growth.
 

A focus on earnings

In short, the risk-on response of the stock market in the face of a higher-for-longer monetary policy has been entirely rational. The market has been looking through the unexpected strength in the January macro data.

Even though valuations, as measured by forward P/E, are elevated, stock prices can advance if earnings growth continues. Valuations are not bubbly by historical standards, and stock prices have further room to rise, especially if my hypothesis about the AI-driven bull is correct (see The Path to Magnificent Exuberance).
 

This fundamental view is consistent with my technical view of a long-term bull. If history is any guide, long-term multi-month equity bulls begin when the monthly MACD histogram of the NYSE Composite turns positive.
 

As well, major market tops are characterized by excessive speculation, as measured by margin debt expansion. The latest readings show that while margin debt is rising, they are nowhere near crowded long levels. The public is not all-in and stock prices can continue to rise from here.
 

In summary, I began by rhetorically asking if Fed policy matters to stock prices. They do, and the current market advance is consistent with a growing economy and the expectations of rate cuts this summer. The market’s focus has pivoted away from interest rates to forecast earnings growth, which is positive. This stock market is tracking market behaviour during a mid-cycle expansion that’s driven by P/E expansion while earnings estimates rise and catch up. Valuations are elevated but not frothy, and if my thesis about AI-driven gains is correct, stock prices can continue to rise.