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The Big Conversation

Episode 137: Will the Fed pause or pivot?

This week Roger Hirst looks at the possibility of a pause by the Fed and potentially a pivot. A recession should cap prices, but if the Fed eases off too early, prices could rebound again, as they did in the 1970s. Tighten too much, and the US economy could have a significant slump. It will be a difficult balancing act, but the market is beginning to take aim at an imminent pivot.

  • Roger [00:00:00] At the July rate setting meeting, the FOMC indicated that the hiking policy would become dependent on the data. With many forward looking data points, such as the prices paid components of the ISM survey showing a sharp decline. Many in the market have started to look for a peak in rate hikes and a potential pivot from the Fed. But if the backward looking data remains stubbornly strong, will the Fed have to hawkishly surprise the market in order to cap prices? That's the Big Conversation.

    Roger [00:00:31] Although the Fed hiked by 75 basis points in the July FOMC, the stock market continued to rally, with many participants not expecting the Fed to pause or even pivot its rates policy. And this view is gaining momentum. But here, we'll outline why the Fed may still need to shock the market.

    Roger [00:00:48] The equity rally that continued after the July meeting was well underway even before the Fed convened. The interpretation that the Fed may ease back on its policy path was retrospectively fitted to the price action that was going on already.

    Roger [00:01:00] The latest leg in the rally, however, started on July the 14th. It was initiated by a reversal in the US dollar after briefly breaking parity with the euro, but then reversing off the psychological support. The 14th July was also the peak in the US dollar yen rally. This pullback in the dollar gave the market some breathing space and that's because the stronger dollar had been tightening financial conditions. The baton for tightening financial conditions have been handed over from the fixed income markets to the currency markets.

    Roger [00:01:29] The initial sell off in equities this year was largely due to repricing of interest rates and yields, with both the 2-year and the 10-year topping out at about 3.5%. Higher yields were playing havoc with emerging market bonds. Furthermore, higher commodity prices were putting pressure on global growth, especially within Europe, where electricity prices continue to rise.

    Roger [00:01:50] Eventually, this slowdown became evident and the rise of the dollar was part of that process. Global trade volumes were falling, meaning fewer dollars in circulation, which in turn was creating a short term dollar scarcity, driving up demand for dollars and therefore pushing it higher. Even commodity currencies were starting to struggle because higher commodity prices were not being supported by robust volumes.

    Roger [00:02:12] The two largest components of the dollar index are also facing structural headwinds. As mentioned, the eurozone is importing higher energy costs and this has crushed consumer confidence. And these issues are unlikely to stop any time soon. The Japanese yen should also remain weak because of the determination of the Bank of Japan to hold 10-year yields at 25 basis points.

    Roger [00:02:33] The pullback in global yields at the end of July did help initiate a reversal in US dollar yen, which had become overstretched. And this is because when global yields are trending back down, it takes some of the pressure off the Bank of Japan because other fixed income markets at the margin become slightly less attractive destinations. But if global bond yields rise again, then the pressure for the Bank of Japan to dilute the yen will resume.

    Roger [00:02:55] Alternatively, if Japan's CPI continues to rise, that will also increase the need for the Bank of Japan to protect its yield cap, again, diluting the currency. Whilst the peak in dollar yen was around 140, and that may be the peak overall. It is still reliant on many exogenous factors aligning in favour for Japan.

    Roger [00:03:13] So whilst the July FOMC may have helped the equity rally, the wheels have been set in motion much earlier, and much of the late July momentum may have been nothing more than month end activity anyway. Equities have been overdue, a bounce from a very oversold position where sentiment had become extremely bearish.

    Roger [00:03:29] Now the Fed themselves seem unimpressed by the market reaction to the July FOMC. Many committee members have since reiterated that capping price remains their number one priority, even if that's at the expense of some short term growth.

    Roger [00:03:41] What's the market? Pricing of interest rates briefly fell. It remains close to 3.5% for year end, and these are roughly the same levels that prevailed before the FOMC. And it was the rally in the equity market that appeared to create the expectation for a Fed pivot. This saw very little follow through in the short term interest rate markets.

    Roger [00:03:59] So what should we expect if the Fed is determined to tighten more aggressively? Well, the yield curve has already started to vote, with the inversion getting deeper. And the inversion is where the 2-year yield is above the 10-year yield. And this has reached its steepest inversion since 2000. At around about -40 basis points.

    Roger [00:04:17] If the Fed were to tighten in order to cap prices, then 2-year yields should rise more than 10-year yields. But more probably 2-year yields could rise, reflecting sentiment around policy, whilst 10-year yields should fall. Expressing pessimism around growth.

    Roger [00:04:33] Expectations are once again, that the peak in consumer prices is now in. But as we said before, a peak is not sufficient. Prices need to consistently pull back, but this view is not building momentum.

    Roger [00:04:46] The CPI data is out after we finished filming, but the forecast was for a decline in the month on month reading from 1.3% to 0.2%. This would definitely be within the ballpark required by the Fed, but it would need to be consistently followed up by other prints of around this lower magnitude.

    Roger [00:05:03] And one of the problems for the market is this battle between the forward and the backward looking data series. The market has shifted its focus to some of the forward looking surveys, like the new orders component of the ISM survey, which is heading lower. Although none of these are as extreme as either the University of Michigan Consumer Sentiment Survey or the NFIB Small Business Outlook.

    Roger [00:05:24] The Fed, however, will be focussed on CPI data for obvious reasons as well as in employment data. These are both, however, backward looking, in that they are an indication of what has already happened and are also prone to huge revisions and the impacts of seasonality.

    Roger [00:05:38] Take the recent non-farm payrolls data. The figure of 528,000 was a significant beat versus the 250,000 that was forecast. But this is a very volatile dataset. And firstly, last year's data often undershot expectations of the rebound in the US economy, and this year's data is making up for that with consistent beats. Even though more immediate surveys of the employment situation, such as the initial jobless claims, have been edging higher for weeks now.

    Roger [00:06:06] And the details of last week's data were also revealing. The big jobs gains were in the part time sections of the jobs report. Rather than the full time jobs, one person with two jobs is counted as two jobs in the payrolls report. However, in the household report, that same person would be counted as one person with one job. Therefore, the strong payrolls could actually be interpreted as a sign of weakness.

    Roger [00:06:29] But the Fed will still be worried that employment remains tight. One of the best ways to entrench higher prices within the economy is to allow a wage price spiral to get out of control. The Fed will not want that to happen and so may respond aggressively to data that might be weeks if not months old, and then prone to significant revisions in the months ahead.

    Roger [00:06:49] Unemployment in the US is usually at its tightest level just before a recession kicks in so a tight labour market is not really a sign of a healthy economy. Both high and peaking levels of CPI and tight labour markets, are often precursors to recessions or a sign that we are actually already in one.

    Roger [00:07:06] We've already had two consecutive quarters of negative GDP, and although these can be revised higher, it should be no surprise that we are near all within a recession.

    Roger [00:07:16] But the real reason why the Fed needs to remain hawkish, is that a pivot that supports growth will also support prices. Sustainable growth needs prices, which are low and stable. This is because today's high prices are the result of supply constraints and fiscal stimulus.

    Roger [00:07:34] Unfortunately for the Fed, the government has just passed another fiscal package and that will be fighting inflation with more inflationary stimulus. Therefore, the Fed may need to break something if they're going to properly cap prices.

    Roger [00:07:47] Whilst a recession has historically been the best antidote for higher prices, with CPI dropping often precipitously through a recession. A pivot today and a mild recession would just be kicking the can down the road.

    Roger [00:08:00] And that's what happened in the 1960s, in the 1970s. CPI would rise sharply. The Fed would respond with higher interest rates, causing the equity market to buckle. The Fed would then reverse engines, but CPI would then make a new high a few years later. It was only in 1981 when the Fed really pushed interest rates to a level that was significantly higher than the prevailing CPI and then maintained an aggressive level of real rates for most of the next decade.

    Roger [00:08:24] If the Fed allows CPI to rebound, then higher prices will kill growth, before it can even build a head of steam. And that's because the market will reprice the curve in anticipation of yet another Fed flip flop. And this is what happened this year.

    Roger [00:08:40] It was the market and not the Fed that took 10 and 2-year yields to 3.5%.

    Roger [00:08:45] It was the Eurodollar in the Fed funds curve, the price funding levels close to 4% in the middle of next year and not the Fed. The Fed has been playing catch up. In June, the Fed's dot plot briefly surpassed existing market expectations for rate hikes, but was quickly overtaken again soon after.

    Roger [00:09:01] And now people are saying that the Fed is being too aggressive and yet their current interest rates and the dot plot are only marginally above where the market expects interest rates to settle next year. And knocking the Fed is a national pastime. But it's the market that tends to lead and the Fed that tends to follow, although their guidance is absolutely key.

    Roger [00:09:20] If a 75 basis point hike is rewarded with a rallying equity market and then a loosening of financial conditions, which would be more, not less inflationary, then wouldn't this embolden the Fed to tighten by more the next outing? Clearly, looser conditions give the Fed more room for more rate hikes. Therefore, a rising equity market is a double edged sword. It provides relief, but it also provides an opportunity for a more hawkish surprise.

    Roger [00:09:46] Markets currently remain fixated on the policy response that occurred during the era of moderation, where CPI was generally low and stable and tended to rise as a consequence of growth. During that period, which lasted for about 30 years, the Fed was quick to support growth.

    Roger [00:10:01] But when we look back at the 1970s, the Fed had to raise rates to kill growth, and this is why the yield curve continued to invert into recessionary events. And today we should probably expect the same dynamic. The Fed continuing to raise rates even as yields at the lower end are falling, indicating that the policy is hurting growth.

    Roger [00:10:20] Because that's its intention. You need a recession to cap prices. Therefore, the Fed needs to break something rather than reversing course, just because the market is worried that they might break something. The equity market may now need to price an increase in unemployment and a decline in corporate earnings. The Q2 reporting season surprised on the upside. If the large cap corporate world is doing well while small businesses and consumers are suffering, then the Fed should still tighten further.

    Roger [00:10:48] The US yield curve should probably invert more deeply than the precursor to the dot.com recession in 2000. Interest rates may have to be over 100 basis points in excess of 10-year yields to permanently crush prices.

    Roger [00:11:00] On the small head and shoulders on the US, 10-year yield does imply a target of 2%. Tech stocks could outperform, but that may be in an overall down market.

    Roger [00:11:10] The first half declines of the S&P this year were extremely ordered, with few signs of capitulation. Retail investors were adding throughout. Whilst the meme stock frenzy has partially returned, institutional sentiment is far more bearish than actual positioning.

    Roger [00:11:24] And even the short position in non-commercial, often called speculative S&P futures, could be misleading. In 2007, the peak in the shorts took place just before the peak in the market, and there were longest towards the 2008 lows. Sometimes the professionals do actually get it right.

    Roger [00:11:40] And if the Fed does need to shock the market, then we've probably not seen the highs in the dollar. There's no fundamental reason for the euro to bounce off parity. It was a technical event with the fundamentals at 101, the same as they might be at 99 or 95. But it was that bounce that kickstarted this equity rally that then eventually led to expectations for a pivot. But this Fed's probably not for pivoting. At least not yet.

    Roger [00:12:06] And next, we're going to hear from Kevin Loane at Fathom Consulting, and he's going to make a more dovish case for the Fed and why they might be tempted to actually lower interest rate expectations as we go through this year.

    James [00:00:02] So Kevin, welcome to the Big Conversation. Thank you for joining me.

    Kevin [00:00:06] Hi, James. ,Thanks for having me.

    James [00:00:09] Good stuff. So look, what we want to focus on today is the nature of the Fed and it's, what will the Fed do versus what the Fed perhaps ought to do. And things have got a lot more fluid, I think, in in recent weeks. I'd love to get your thoughts on that and what's going on there?

    Kevin [00:00:27] Okay. Sure. I guess what the Fed will do and what they ought to do, hopefully in the medium term do coincide. But then the interesting thing for market participants and investors is thinking about when will the sort of what they should do, you know, when will that get pulled from what they say they're going to do, what they think that they might do? I think an interesting thing to think about is how we got to where we are currently. So the Fed for a long time was saying it wasn't going to raise rates. Investors mostly were buying that story. Throughout most of the pandemic, Fathom was warning basically that this was going to be, in the end, an inflationary shock. And so for us, we're saying what they ought to do is just think about raising rates, you know, much more than what was being priced in and certainly more than what they were guiding towards. Eventually, that's what happened. But interestingly, at this current juncture and in our most recent summer Global Outlook, we're now below where market pricing is in terms of what the Fed will do. That's for both this year and for next year, and that's certainly below what the Fed themselves, themselves say they're going to deal with, the FOMC says, you know, it will do in terms of market pricing. So in our view, I think what they ought to do is probably not increase interest rates as much as they're guiding towards. The principal reason for us in terms of thinking about this is that we're far more concerned about the risk of recession. If you think about what they expect in terms of inflation and what they expect in terms of unemployment, for us, probably what they expect in terms of inflation is broadly going to play out. And so we see a lot of the risks relative to their own forecasts being on the demand side. And since they have a dual mandate, in our view, it makes sense for them to be start, to start worrying a lot more about the about growth and also about the outlook for the labour market.

    James [00:02:16] Now, that's an interesting one. So the, in terms of data points, and you mentioned inflation there, there has, of course, been a series of more hawkish comments coming from the likes of Neil Kashkari and Co since the July rate decision just a couple of weeks ago. In terms of the the inputs or the data that they're looking at and are likely to shape, and are likely to shape their decision ahead of the September meeting, what exactly and what specifically do you feel is is sort of contradicting where positioning and sentiment is currently?

    Kevin [00:02:58] I think in terms of the September meeting, probably I'd say, you know, there's not a huge amount that can happen. We're not going to have a completely different view on the labour market by the time that market, but by the time that meeting rolls around. I guess for me it'll be thinking about how much emphasis are they putting on forward looking indicators. So I'd say at the moment jobless claims probably is one of the key things they're watching. We'll get payrolls. Payrolls are a bit lagging, employment in general is relatively lagging. But I'd say wage growth within the, within the payroll reports will be important for them to watch. But I think more broadly, looking at surveys and sort of more timely measures of spending, perhaps how, you know, even things like gas prices, how gas prices are playing out as that might feed into inflation expectations. And Powell really emphasised that at the June meeting. So I'd say, you know, a mix of different things, but I'd say for September, I'd say 50 basis points is probably quite likely, 50 basis points, maybe 25 basis points if we get a, you know, a bunch of bad data. But I'd say looking forward that's really where the big question marks lie with markets pricing in sort of cuts next year in the Fed and their most recent projections, at least pricing in continued increases through 2023.

    James [00:04:15] And we certainly saw the market react, equity investors and also I think the five year portion of the bond market react to the perceived Fed pivots coming out of the July meeting. It may, according to what you've explained, just there, and according to the Fed's comments themselves, seem a little premature. There are people equally in another camp that are perhaps, or have been calling for a potential peak in inflation. Now, according to what you just laid out there, until we see a correction in gas prices, amongst other things, it seems as though prices, inflation is likely to remain elevated. And you see the terminal rate roughly in line with what the Fed is is aiming for. One of the things that stood out to me, I don't know if you caught this the other day, but the the ISM Manufacturing Survey, the PMI didn't come in perhaps as low as people were expecting and indeed equities were implying. In terms of the pricing, I think they were implying a drop to probably 45 or below 45, depending on which basket you were looking at. One of the things that stood out to me there was the prices subindex fell off a cliff. It dropped 18 and a half points. Now that as a potential lead indicator of inflation, whilst one swallow doesn't make a summer, and there are, you know, a bunch of other indicators out there suggesting that inflation is looking pretty persistent for now, that's one of the things that stood out to me. Do you have any thoughts generally about the ISM in terms of the level it came out at versus expectations, but also what's happening beneath the surface?

    Kevin [00:05:56] I think, yeah, certainly the scale of the drop was a surprise, but I think the broad picture of goods disinflation if not quite deflation yet, that's a story we'd been expecting to play out through the year, and a lot of other analysts have been expecting that too. I think you're starting to see more and more signs of this, and so that, that's really I think, something that will give the Fed some comfort is if you look at shipping prices, if you just look at even used cars prices, I think you can expect them to start to fall off now a little bit. Commodities prices, too, even after what's going on with Russia and Ukraine and with oil prices and copper prices getting really high, those have started to roll off, too. So I think in terms of goods, in terms of a very weak global backdrop, all of that is really going to help at least headline inflation. FOMC has put a lot of emphasis on this. I mean, you know, my way of thinking is they should really be looking at core inflation because that's what the domestic U.S. economy is delivering. But any, any kind of easing in headline inflation will be beneficial, particularly as the key risk has been that inflation expectations will slip their anchor. If something like that were to happen, then they'd be forced into a much more aggressive hiking. The key question, though, as you say, is that price pressures have been broadening and you do see that across services. A lot of that is related to domestic demand. Some of that, things like rents, those are very slow moving forces. And so I do think it will be a mistake for the Fed to wait for all of those things to turn a corner before responding. If they do that, they risk making a similar mistake, but in the opposite direction of waiting for inflation in the data to move a certain way before adjusting. That's what they did, and they probably hiked rates a little bit later than they should have around a year ago. And if they make the same mistake now, they may end up sort of either pausing or even reducing rates too late than what they should do.

    James [00:07:50] So I guess in short then to conclude, we opened with the the question around 'are the Fed doing what they ought to do and what people are expecting?' I think in short, it seems as though, okay, you see the potential for a slowdown, or you do see signs of slowing in the the economic outlook. Inflation may well remain persistent for some time, though, it's important to look at, of course, the leading indicators of that, as well as the business cycle in general. But it seems as though the Fed probably are doing, in your view, what they ought to do?

    Kevin [00:08:28] I'd say for now, just about, although it is hard to to judge that for sure. We had a different piece which was essentially saying the Fed and other central banks are faking it until they make it. So to some extent, they do have to bluff primarily to keep inflation expectations on their side. And so some of this rhetoric that we've seen recently about, you know, we're not even close to being done yet, I think some of that is really just to put some pressure on the markets to make sure that financial conditions don't loosen too much because they are worried that that then could lead to future inflation problems. If that's all that is, then yes, I'd say they're doing the right thing. But if they if they actually genuinely believe that, I think then there is a high risk that they could end up making a policy mistake by basically going too high, and then they'll be forced to cut quite aggressively if they do make that mistake.

    James [00:09:17] Interesting. And that does seem to be what the market is pricing in terms of those cuts. So that makes a lot of sense. Maybe then the July rally could perhaps be an opportunity for for the Fed to press ahead, but whether or not ultimately they end up overloading or front loading their rate hikes too heavily remains to be seen. So, Kevin, thank you for joining me, that's been a fascinating conversation and look forward to speaking to you again soon.

    Kevin [00:09:45] All the best, James. Take it easy.

    Roger [00:21:54] Clearly, timing is everything. If the Fed pivots too soon, they run the risk of pushing prices back up. If they don't pivot, they may create a deeper slowdown than the market currently expects. The data to watch things like the initial jobless claims and the sentiment surveys. But in reality, it's fiscal policy that might be the biggest swing factor for how high or how low or how persistent inflation can be.