The Red Zone
For those that are not football fans, the red zone is the area inside the 20 yard line, where the team is close to scoring a touchdown. When the red zone is reached, the defense is defending a much smaller area on the field, which presents a greater challenge for the offense. It is incumbent on the offense to call the right play to be able to score the touchdown.
The Fed has reached their Red Zone. Although the rate increases in 2022 were large and fast, they were easy decisions. Inflation was running very hot and interest rates were not restrictive. Now, inflation is cooling off and interest rates are at a level that is almost, if not modestly, restrictive. The game is much more nuanced now and pounding rates higher is no longer the easy answer. The Fed needs to call the right play.
The Case for Pushing Harder Against Inflation
- Inflation is moderating, but remains too high.
- Many commodity prices (copper, steel, nickel) are beginning to rise again.
- Wage inflation is too high because jobs are plentiful and unemployment is low.
- The Fed does not want to repeat the mistakes of the 1970’s by stopping rate increases too early.
The Case for Pausing Rate Increases Soon and Easing the Inflation Fight
- The effect of interest rate increases takes time to move though the economy. After the large, rapid increase in rates, now is the right time to pause and wait to see the results.
- The Fed does not want to raise rates too much and push the economy into a recession.
- Most economic measures show the economy beginning to contract. Employment is the key outlier. The Fed needs to trust the preponderance of evidence.
Markets vs. The Fed
The gap between what the bond market expects and what the Fed expects has grown wider. Allow us to explain in the chart below. The yellow bars are the current Fed projections for interest rates. The Fed does not forecast any rate reductions until 2024. On the other hand, the bond market (pink and black lines) expects two rate cuts in 2023, beginning around midyear. Either the bond market or the Fed (or maybe both?) is going to be wrong!
The bond market expects rates to be materially lower than the Fed projections. Our interpretation is that the bond market expects the Fed to call the wrong play and produce a policy error. That error causes the Fed to reverse course and quickly move to reduce interest rates. The most obvious potential policy error is pushing the economy into a recession.
So what changed this week? Why did the market rally? Great question and it’s the same question the pros are asking too.
When the official statement from the Fed was released on Wednesday afternoon, markets got what was expected: statement which contained in this line and was unchanged from the last meeting:
“The Committee anticipates that ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time.” (Our emphasis)
The term ‘ongoing increases’ implies there are numerous rate increases to come and this was briefly perceived as the hawkish tone that markets were anticipating. Thirty minutes later, Chair Powell stood at the podium and made comments to the press and answered questions in a way that appeared more dovish, and markets spiked higher. There are any number of reasons his comments might have been perceived as dovish, but the one that seems to stand out is when one questioner stated that stronger markets have loosened financial conditions and then asked if that is working against the Fed’s goals. Powell essentially punted the question, saying that the Fed concentrated on long term trends. This failure to ‘push back’ on the question appeared to be the spark that ignited the fireworks in markets.
From our perspective, that type of answer was to be expected. The fact is that the Fed may not like that financial conditions have eased recently, but they fully understand that markets go up and down and any reaction by the Fed to a short-term changes would be inappropriate.
But once markets started to spike, it was clear that this market had a one-track mind. Markets were positioned for hawkish comments and now they had at least the perception of the opposite. Traders like to trade and that’s exactly what they did in an attempt to correct their positioning. Here is an example: as we went into this Fed meeting, the hedge fund short interest in treasury bonds was at or near record levels. The dovish comments pushed rates lower (bond prices up) and these shorts were forced to cover (i.e., buy bonds) which only drove prices even higher. In short, the rally became self-fulfilling.
What is fascinating to us is that the stock market appears to be fixated on the kneejerk reaction that lower rates = higher valuations, while ignoring the impact of a recession on equity valuations. Years of free money, which shut down real price discovery, appears to have markets very confused.
We suspect that the reaction to the Fed press conference has been way overdone. As with every Fed meeting, once the meeting is over, the blackout for Fed public commentary is lifted and we would expect those comments to walk back Powell’s dovish tone into a more hawkish tone that is consistent with the written release.
The Fed’s efforts at transparency appear to backfire with some regularity and every syllable is over-analyzed. The Fed would be far better off with a written statement that can be made very clear and would limit the second guessing of the message they are trying to send, but that is for another day.
What We’re Reading
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Bonds, Economic Growth, Federal Reserve, Interest Rates, Jerome Powell, Recession