The Big Conversation
Episode 110: Is the fed hiking into a growth slowdown?
This week, Real Vision’s Jamie McDonald examines how Fed policymakers will adjust the course of their signaled tightening cycle if equity weakness continues. At last week’s FOMC meeting, the Fed surprised many by holding strong on hawkish policy and so investors learned that the Fed Put isn’t stuck at a measly 10% down from the highs. So this begs the question: how low do markets have to go before the Fed begins to react, and with inflation now public enemy number one, is the equity market really where investors should be looking anyway?
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Jamie [00:00:00] In last week's episode, Roger Hirst in London, focussed on the recent sell off in equity markets with the big question being: How will fed policymakers adjust the course of their signalled tightening cycle if equity weakness continues? Or, in other words, what is the strike of the fabled Fed Put? And we'll explain that shortly. Today, here in the U.S., it's Groundhog Day, where Legend has it that if Punxsutawney Phil sees his shadow, cold winter weather will persist for six more weeks. Well, now that we've had the FOMC statement, what shadow, if any, has been cast and will we now see rate hikes for the next six months? That's this week's big conversation.
Jamie [00:00:49] At last week's FOMC meeting, the Fed surprised many by holding strong on hawkish policy. So investors learnt that the Fed puts isn't struck at a measly 10 percent down from the highs. So this begs the question: How low does markets have to go before the Fed begins to react? And with inflation now, public enemy number one, is the equity market rally where investors should be looking anyway? After all, if equities continue to bounce higher, then doesn't that give the Fed more room to raise rates faster? Now, I realise that we are talking about many of the same things as Roger did last week, and after all, it is Groundhog Day. But rather than focus on just what is next for equities, we want to focus here on what is next for the real economy and for Fed policy.
Jamie [00:01:38] But before we get too far into the weeds, perhaps we should define what we mean by the Fed Put. Prior to 2021, inflation in the US was a distant memory for central bank policymakers, and their decisions were largely driven by their other mandates. Namely achieving full employment, moderate long term interest rates and what some would argue is their shadow mandate of supporting market prices. Now it's that last one that investors are often referring to. When we talk about the Fed Put. How far do markets need to sell off before central bankers will implement a policy shift to calm investors nerves and support markets?
Jamie [00:02:21] Now, usually, the Fed Put or the Fed stepping in to support markets, means a subtle change of messaging, rather than literally cutting rates or increasing levels of quantitative easing, especially now given interest rates are at zero. So this time, the exercising of the Fed Put would mean a change in their stance on hiking rates in 2022, rather than a cut itself -but so far, we see no sign of it.
Jamie [00:02:45] But before we get too complacent, let's remind ourselves of the fact that on occasion, the Fed Put has simply not been there at all, and they've refused to get pushed around by weaker equity markets. Take 2018, for instance, equity markets fell almost 20 percent in Q4. Yet the Fed followed through on tightening, hiking the target rates up to two and a half percent on December the 20th. In hindsight, this has been largely viewed as a policy mistake, and indeed, the Fed went on to pause its hiking cycle moving forward, eventually cutting rates in the second half of 2019 after economic data started to weaken and equities began to roll over. This, as you might imagine did the trick, as markets then rallied to close the year up almost 30 percent.
Jamie [00:03:34] Now, if your memory only goes as far back as 2020, then you might say that the Fed Put is more than enough to support equity markets. After all, markets rebounded sharply after the Fed stepped in with moves like record breaking interest rate cuts and their decision to step in to the corporate credit market for the first time ever. But in true bear markets like in 2000 and 2008, the Fed's decision to be supportive with rate cuts could hardly have been described as stopping the bleeding.
Jamie [00:04:04] In the early 2000s, the Fed began cutting rates aggressively in January of 2001, only to see equity markets fall another 40 percent before bottoming in 2002. During the GFC, the Fed even began rate cuts and accommodative policy before equity markets peaked. But still, this was not enough to spare the market from an over 50 percent decline.
Jamie [00:04:28] So point one is that you cannot be sure that the Fed will always step in when markets wobble, point two is that in true bear markets, the Fed Put is not always enough to stop the pain, and point three is that this time it is different and it's different because now we have inflation.
Jamie [00:04:47] In recent years, it's been easy for investors to fall back on policymakers to support asset prices when they aren't at all concerned with inflation. But now the Fed's core mandate of price stability is front and centre. How much does the reprisal of their role as inflation fighters, lower the strike of the Fed Put? Well, arguably it lowers it considerably, or at least until the pain in equity markets begins to have knock on effects for growth and employment. But we're still far away from that level.
Jamie [00:05:19] This brings another major issue to the fore. If the equity weakness is hurting growth and employment, we aren't likely to see that play out in the data for a while, because both employment and growth are lagging indicators. Inflation is also a lagging indicator, and even if we have seen the peak in inflation, it will likely take some time before it again reaches levels that allow the Fed to say that they have fulfilled their inflation fighting mandate. In short, if continuing with this hiking cycle is a policy mistake. We aren't likely to know until it's too late.
Jamie [00:05:55] That's why the Fed meeting last week gave us so much information, with many expecting dovish undertones to appease the weak market. The Fed surprised by reaffirming that the strong employment market and elevated levels of inflation mean they will hold the course on tapering asset purchases and begin rate hikes sooner rather than later.
Jamie [00:06:17] And with inflation likely to stay elevated, we would need some weakness in the labour markets or in economic growth, not just the stock market to see a reversal, of course. Investors, therefore, should be focussed on a few key employment data releases this week. Non-farm payrolls and the employment rate both come out on Friday, with expectations of an additional one hundred fifty three thousand jobs. Now we've seen some misses on expectations over the past year of releases, but what is most important is that jobs are being added every month. A large enough miss may cause some reaction by the market. But this is one of those rare occurrences where absolute level might matter more than expectations. The employment number is expected to come in at 3.9 percent after coming in at the same level last month.
Jamie [00:07:08] Although the Fed will certainly be paying attention if either of these numbers come in below expectations or contract, it is important to put them in the context of the longer term trend. We already highlighted that trend for non-farm payrolls. But the same trend is true for unemployment, with the expectation of the April and July 2021 data releases where unemployment ticked up a modest 0.1 percent. We have seen improving numbers for over a year now, with unemployment falling from 6.7 percent to 3.9 Percent. What this means is that one bad month of unemployment data, is unlikely to shift the Fed off course. And so investors need to keep watching these data points throughout 2022. However, should employment weakness persist and inflation remain elevated, at what point does the Fed step away from fighting inflation and start to support growth? Unemployment is 3.9 percent today, but anything north of five percent, and you have to imagine they react. So with the Fed mostly watching lagging data points and likely needing multiple months of confirming data to signal that economic conditions have weakened. Where should investors be looking for more real time indicators to stay ahead of the Fed and determine if they are indeed hiking into a slowdown?
Jamie [00:08:30] The bond market is one area that investors can turn to, at least for real time expectations and there, the yield curve has been flattening. The most important section of the yield curve 2s, 10s, which tracks the spread between U.S. 10 year Treasury yields and 2 year Treasury yields, is now only 60 basis points after hitting a local peak of over 150 in March of 2021. We're still a ways from everyone's favourite recession indicator of yield curve inversion, where this 2s 10s spreads flips to negative, as it did in August of 2019. But flattening alone should be monitored as a signal of slowing growth.
Jamie [00:09:09] Another indicator that you can follow is the Atlanta Fed's GDPNow or 'nowcast'. GDPNow is not an official forecast of the Atlanta Fed. Rather, it is best viewed as a running estimate of real GDP growth, based on available economic data for the current measured quarter. The most recent number released on January the 28th, corresponding with the estimate for Q1 2022, came in at just 0.1 percent. Quite a steep drop off from the final Q4 2021 prediction of 6.5 percent, which was just 0.4 percent shy of the actual Q4 2021 number of 6.9 percent. This means the economic data is already signalling much slower economic growth than we've seen in other previous periods.
Jamie [00:09:58] In the equity market, investors can look at the ratio of industrial stocks to the broader market. In periods where economic growth is strong. You tend to see this ratio rising as these cyclical businesses become the market leaders, whereas in periods of weak economic growth, the broader market, which is increasingly carried by growth tech stocks, will outperform the industrials. We saw this play out from June 2020 to May of 2021, when the reopening economy was at its strongest. But since then, the ratio has actually reversed course and looks like it might be rolling over again after a brief spike in January.
Jamie [00:10:36] So what do we know for certain? Well, the Fed considers fighting inflation to be its key mandate at the moment, barring any major developments. Their asset purchase programmes will continue to taper and eventually halt by early March, and the market has now priced in at least four hikes in 2022, with a 100 percent chance of hiking at the next Fed meeting on March 16th. Should employment remain strong and equities not crash, then it would be fair to assume that the expected number of hikes this year will go up, with even some expecting a hike every month from March to December.
Jamie [00:11:14] What is unclear, though, is how persistent inflation will be, how strong the economy in the labour market will be, and whether this recent equity market weakness is a minor correction or the start of something bigger? All of these factors will determine whether we will look back on this tightening cycle as the moment the Fed regain credibility, as inflation fighters or as a major policy error.
Jamie [00:11:39] Only time will tell if the equity market has further to fall, but we can look at the alternative data points like yield curves, nowcasts and the ratio of industrial stocks to the market, to determine whether we are tightening into a growth slowdown.
Jamie [00:11:55] Well, that's it for this week's big conversation. If you have any questions about this episode, the economy or financial markets, please put them in the comments section or send them to firstname.lastname@example.org