Pre-emptive Pivot

The news this week was the Fed (again) with the surprise change of anticipating rate cuts. Nick Timiraos, the so called ‘Fed Whisperer’ at the Wall Street Journal wrote about Chair Powell’s comments:

“Dec 1: ‘It would be premature to … speculate on when policy might ease.’

Dec 13: Rate cuts are something that ‘begins to come into view’ and ‘clearly is a topic of discussion.’

What a difference two weeks can make.”

Chair Powell had been widely expected to maintain the party line of the last few years and push back on any ideas of lowering interest rates any time soon, but that was not to be. Instead, he appeared to project a pre-emptive pivot in interest rates. The Fed is now considering lowering interest rates BEFORE inflation is fully down. He didn’t specifically say the Fed would do that, but the implication was clearly there, and that was perceived as a very significant switch.

Markets Celebrate

As would be expected, stocks and bonds rallied hard on the news as the Fed speak appeared to declare that the economic soft landing had been successfully completed. In our view, we aren’t quite there yet, but if rates start to come down in 1Q24 as Powell implied, recession risk is meaningfully reduced. That leaves us with a market that appears to have fully bought into the soft landing scenario: a stock market approaching the all-time high from 2 years ago, and bonds rallying as rates anticipate the Fed’s next move.

Is it time to back up the truck and buy? Probably not. It’s hard to envision the outlook getting much better than it is today. Complacency is very high (implied volatility in the low 12s) and we may be priced nearly to perfection. Nonetheless, if all that money in high yielding money market funds heads back into stocks, the market could easily move higher. What’s one more bubble among friends?

Does the Narrative Stick?

Chair Powell sounded very convincing on Wednesday, ignoring ample opportunity to walk back his pivot comments. However, on Friday NY Fed President John Williams appeared on CNBC and began to walk back Powell’s pivot comments, saying “We aren’t really talking about rate cuts right now… the question is whether we have gotten monetary policy restrictive enough to ensure that inflation comes back down to 2%. That’s what we’ve been thinking about for the past five months and I think we will be continuing to think about, for some time… We are still in a highly uncertain situation both in terms of inflation, in terms of progress of the economy.” Those comments are a far cry from Powell’s comments on Wednesday.

William’s comments appear to confirm that the market reaction to Chair Powell on Wednesday was not what he, or the Fed, desired. Over the next few weeks, we’ll have to see how aggressive the Fed will, or won’t, be in walking back Powell’s comments.

What Does it All Mean?

For our portfolios, not much. We will stay the course. Diversification remains the best solution because it’s simply not possible to predict what will come next and when it will happen. But here are some things to consider:

Lowering rates sooner rather than later substantially lowers the risk of a recession. The stock market appears to have eliminated any threat of a recession at all. But lowering rates sooner also increases the risk of inflation re-igniting. We are certainly not projecting inflation will re-appear. But it is important to understand that although the Fed has been the primary driver of the stock market over the last several years, other factors beyond the Fed’s control are also at work. The argument against renewed inflation is that the pandemic shortages were the primary inflation driver and those are now largely corrected. The argument for inflation is that we continue on a course of massive deficit spending. The Federal deficit for November was reported this week to be $314 billion, up from $249 billion last year, and well above the $290 billion estimate. Revenue rose $23 billion to $275 billion. Let’s put that into better perspective. Revenue for November was $275 billion but spending was $589 billion, and November was not an outlier. The U.S. has been running massive deficits for a long time. This is important because deficit spending is another stimulus to the economy and potentially a precursor to inflation. Too much money chasing too few goods is an inflationary combination, as we discovered during the pandemic.

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General News

By: Adam