The Big Conversation
Episode 138: The Fed's pushback at Jackson Hole
This week Jamie McDonald looks at market developments leading up to last week's Jackson Hole Economic Symposium. An easing in financial conditions doesn't appear to be in line with the wishes of a hawkish Federal Reserve, which has raised the risk of a significant re-pricing in risk assets. With one of the shortest speeches at Jackson Hole by a Fed Chair in recent history, Powell's comments came across firm and direct, as the Fed attempted to set the record straight.
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Jamie [00:00:00] Recently we posed the question, is a rally bad for investors? Now, at the time, this suggestion could have come across as a bit counterintuitive. Rallies are great, right? Well, not if they buy Central Bankers more room to raise rates into a deteriorating economic environment.
Jamie [00:00:19] Now, with a flurry of comments from regional Fed members and the highly anticipated speech from Jerome Powell at the Jackson Hole Economic Symposium last Friday, it appears the debate is over and the Fed is not for pivoting, at least not anytime soon.
Jamie [00:00:37] In what statisticians are calling the shortest Jackson Hole speech by a Fed Chair or Vice Chair since at least 2010, a usually chatty Jerome Powell laid out his intentions right from the start. And I quote "today my remarks will be shorter, my focus narrower, and my message more direct."
Jamie [00:00:58] His message, but more importantly, the implications of it, is this week's Big Conversation.
Jamie [00:01:10] For a bit of context, equity markets have staged a powerful rally from recent lows, with the S&P 500 rising 17.4% over the two months between June 16th and August 16th. The ICE Bank of America high yield option adjusted spread, a popular measure of credit stress fell from a high of 6% in early July to a low of 4.2% in mid August.
Jamie [00:01:36] Now, what's remarkable about this rally in risk assets is that it came at a time when the Federal Reserve raised its benchmark rate by 75 basis points at two consecutive meetings.
[00:01:49] So what fuelled this rally? Because it certainly wasn't better data, nor better than expected earnings. Now, while we can never be certain about all the underlying factors influencing investor behaviour, I think it's fair to say that the foundation of this rally actually began in late May. And it's important to understand the story from May, to understand what's going on right now.
Jamie [00:02:11] For those of you who don't follow Fed communications, St Louis Fed President James Bullard is widely regarded as one of the most hawkish members of the FOMC, and he was one of the first to come out in favour of larger rate increases of 50 and 75 basis points. He's consistently held one of the highest year end targets for the federal funds rate.
Jamie [00:02:35] Now, that hawkishness could explain why his comments in late May. "In years - '23 and '24 - we could be lowering the policy rate because we got inflation under control" seemed to carry greater significance.
Jamie [00:02:49] And in late June, he said that, "We don't have to go as far on QT as it might seem". Again, that seemed to reinforce the possibility that one of the most hawkish FOMC members was beginning to back off the Fed's ultra aggressive fight against inflation.
Jamie [00:03:06] Now, what followed was a slew of deteriorating economic data, like a second consecutive quarter of negative GDP growth, that continued plunge in various leading surveys, and Jerome Powell abandonment of the Fed's forward guidance tool at the July FOMC meeting.
Jamie [00:03:23] Plus, an ever so slightly easing in the year over year growth in the Consumer Price Index. And that's all the market needed to become convinced that the Fed would soon be pivoting towards rate cuts in the middle of 2023.
Jamie [00:03:38] But is this the reaction function sought after by the Fed or put differently? Does the Fed want to see an easing in the financial conditions simply because the CPI fell from 9.06% to 8.52%?
Jamie [00:03:53] Or, as we revisited in the opening, "is a rally bad for investors?" Remember, a rally in risk assets, which is typically accompanied by an easing of financial conditions, can have a circular impact on the Fed's fight against inflation. If this risk on environment is accompanied by a rally in commodity prices, then that can add upward pressure on inflation.
Jamie [00:04:15] If high yield credit spreads remain extremely tight, that might allow corporations easy access to financial markets, which in turn can delay austerity measures such as cutting employee headcount or reducing capital expenditures. There's also the wealth effect where, if investors feel more optimistic because their financial holdings are increasing in value, then they may be prone to spend more in the economy.
Jamie [00:04:40] And that brings us on to today or rather last Friday.
Jamie [00:04:44] With all eyes on Jackson Hole. Jerome Powell sought to squash any ambiguity in the first few paragraphs of his speech, the Fed chair cut straight through the noise with statements such as "the FOMC's overarching focus right now, is to bring inflation back down to our 2% goal", and "Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply in better balance.".
Jamie [00:05:11] Forcefully and sometime. Pretty powerful words from someone who is usually a little more market friendly.
Jamie [00:05:19] Powell then went a step further by stating the historical record, cautions strongly against prematurely loosening policy, while also highlighting important lessons from the past.
Jamie [00:05:31] And just for good measure. Cleveland Fed President Loretta Mester made an encore presentation where she outlined her belief that the Fed will need to take rates above 4% and leave them there. And that last part is crucial because, remember, we were dealing with a market that thought a Fed would do a U-turn reasonably quickly were inflation to come under control?
Jamie [00:05:54] If the Fed was pushing back before, Jackson Hole presented an opportunity for them to come out swinging, which they basically did, if we circled back to my earlier reference of the Euro dollar curve, the initial reaction suggests that the Fed's efforts at Jackson Hole, are beginning to pay dividends. The entire Euro dollar curve shifted higher. But more importantly, the spread between March and December 2023 steepened, which might reflect Mester's comments that rates will need to stay elevated for some time.
Jamie [00:06:24] Now, the interesting part for investors is how this all translates into their portfolios and the broader economy. There are some areas of the market that didn't ever seem to buy the Fed pivot narrative. Take, for instance, the US yield curve, which tends to steepen in anticipation of and through fed cutting cycles. For reference, the 10yr-2yr yield curve has remained deeply inverted throughout this entire risk rally. I.e. not buyers of the Fed pivot story.
Jamie [00:06:53] Other pockets of financial markets like equities, particularly long duration equities such as the Nasdaq that had begun pricing in the Fed pivot may be due for a sudden repricing lower.
Jamie [00:07:05] High yield credit spreads may begin to widen again, putting renewed pressure on highly levered businesses and raising the risk of defaults, which can in turn impact loan portfolios.
Jamie [00:07:15] Bankruptcies may accelerate the recent uptick in initial jobless claims, which could ultimately translate into higher unemployment rates.
Jamie [00:07:23] The point here is that the rhetoric from Powell seems to have changed, but the economy hasn't really. Other than equities being 15 to 20% higher in August than in June, the Fed has been walking a fine line all year, with Powell choosing his words very carefully and leaving plenty of room for interpretation.
Jamie [00:07:42] Well, we stand here today with far less debate amongst investors as to the Fed's intentions. Jackson Hole feels like it was a turning point for monetary policy, and investors need to be wary of those assets that bought into the pivot story and watch for a material retracement in them.
Jamie [00:08:00] To discuss this and more on the markets this week. I sat down and chatted with Mo Haghbin, Chief Commercial Officer and Global COO of Investment Solutions at Investco.
Jamie [00:08:14] Mo. Welcome to The Big Conversation.
Mo [00:08:16] Thank you. Thanks for having me.
Jamie [00:08:18] So, Mo, you are Global CEO of Investment Solutions, is that correct?
Mo [00:08:21] That's right.
Jamie [00:08:22] Good. You sound like a man with a lot of answers then. Now we've just been talking about the fact that the Fed pivot became a story over the summer. And we think it, you know, certainly led to part of the rally in equities during July and August. And now we've had Jerome Powell speak last Friday. So what I want to ask you is how much do you think the Fed pivot story was a part of that rally? Do you think Jerome Powell has changed his stance, given what he said? And do you think those investors who, you know, perhaps believed in the Fed pivot story, do you think that's now off the table for the foreseeable future?
Mo [00:08:56] Yeah, sure. Well, so I think, look, the comments in June really left the door open for a Fed pivot. I think it wasn't as direct and there was some mixed messages being sent. So, you know, the economy had started to slow. We are starting to see weakness in certain sectors. We're starting to see kind of leading economic indicators really slow down sentiment in the markets. Slow down. This is pre the rally, right? So when we kind of heard from the Fed in the last meeting, it was very focussed on, hey, look, if we see weakness in the labour market, if unemployment starts going up, if there's other issues that kind of take us into a recession, we may slow down. That was kind of the message, at least what the market received. I'm not sure that was really the message. That's what the market received. So that did fuel a significant risk rally. You saw kind of from June 15th to August 15th, 15, 17% depending on what index you're using, rally and equity until Jackson Hole. And I think what was interesting about Powell's comments was first time he was very brief, very direct. There was no mixed messages, was a very short speech, and the focus was inflation. We have to get inflation back to 2%. Price stability is important. It's our number one job and that's what we're going to focus on. And what I think was interesting is the way he sent that message to the market was even if we go into a recession and inflation is above 2 to 3%, don't expect us to cut rates. Right. And I think that was a very new message. That was a very direct signal to the market, which you saw the reactions on Friday. Equities sold off, I think 3, 4% depending on kind of parts of the market.
Jamie [00:10:32] So do you think that that rally did buy the Fed a little more room to be stronger on rhetoric? And if I flip that story around, if we now see a big fall in equities, do you think Jerome Powell is now going to get a little bit softer in his language to try and support equities? I mean, basically, the other way putting it is, do, is the Fed looking at equities?
Mo [00:10:50] Yeah, I think that's what you're asking is, you know, how closely is the Fed watching the equity markets and has that feedback loop really, really strong? I actually think the Fed really didn't like that rally, right? It was really not something that they wanted to see. They wanted to see financial conditions continue to be tight because that's really what brings inflation down. They did not want to see borrowing rates get cheaper. They did not want to see risk assets getting stronger bids. They did not want to see exchange rates coming to the effect where really easy kind of financial conditions in the backdrop of a very high inflation number, you know, 9% versus eight and a half percent. Jamie, not a big difference, right? So from the Fed's standpoint, one surprise inflation print for the better is not enough for them to stop. And that's really what they were trying to say.
Jamie [00:11:40] Well, let's talk about market positioning, if we can. But before we get into that, can you talk a little bit about who your clients are? because I really want to talk about some of the discussions you've been having with your clients over the past few months.
Mo [00:11:49] Yeah, so investment solutions were a multi asset team. So we cover both public markets and private markets across the spectrum. Our clients tend to be either intermediary like financial advisors on the retail side as well as large institutional clients. We think insurance companies, pension funds, defined benefit, defined contribution, sovereign institutions, other official institutions, those tend to be the clients we talk to the most.
Jamie [00:12:12] Okay, so this is big money. And I know, I know. I think I'm right in saying you recently went under weight equities, which now looks like a great call. But in those conversations you're having with your clients, how do you think they're repositioning their portfolios, if at all?
Mo [00:12:25] Yeah, look, I mean, so a lot of our clients don't really pay attention to the short term noise. Right. I think one thing that we know about, like, for example, pension funds is the things that drive their decisions are more, you know, demographic and funding ratio driven. Right. So they're thinking about long term liabilities or cash flows and they're matching off those long term liabilities and cash flows with their investments. Today, insurance companies have other considerations, like, for example, regulatory capital constraints. So it's not just risk and return. They're also trying to be the most efficient in terms of capital charges. So it depends. It depends. But most of our clients tend to have a long term view. What I will say, though, is we have been having more tactical conversations recently, just given that run up in equities and really thinking through if there is an opportunity around the edges to reposition the portfolio. And I think what's really attractive, which hasn't been this attractive in a long time, is fixed income, right? I mean, fixed income now is giving you yields that we haven't seen for a really long time. And if you think about it, if you are a, for example, dividend equity buyer, right, because you wanted 4 to 5% income. Well, now you can find that right on the short end of the investment grade. So why would you go into.
Jamie [00:13:35] Without the risk
Mo [00:13:35] Higher risk equities when you can earn the same coupon in in fixed income? So I think those dynamics are at play and those conversations are happening.
Jamie [00:13:44] So do you think it's a given now that the short end were going to get 3 to 4%? Is that what you're feeling?
Mo [00:13:49] Well, I mean, if you look at the forward curve, you know, the market's expecting kind of topping out at three eight and then starting to come down in the fourth quarter of next year, you know, come back down to three five.
Jamie [00:13:59] At the end of 2023 yeah,
Mo [00:14:00] Yeah. I think I think short rates up 4% is very plausible. Very possible. But I don't think that means the long end of the companies moving. So I think we will have a deeply inverted curve, at least for the foreseeable future. And the difference between short rates and long rates could be 100 and 250 basis points.
Jamie [00:14:16] Yeah. Now, Mo, I was actually looking recently I saw this survey, admittedly this is more hedge funds, so it's short interest across the board in equities. S&P 500 was I think is the highest it had been in several years. Do you get the feeling and maybe this is just the so-called fast money, do you get the impression that sentiment is this bearish now in equities as it has been in a long time?
Mo [00:14:37] Yeah, no, the sentiment is pretty bearish, actually. If you look at kind of our risk measures, you know, what we look at, what we look at is risk reward across the spectrum. So starting with money market cash instruments all the way out to the more risky parts of the market like emerging market equities. And what we're looking for is risk taking behaviour by market participants. And what we're seeing is to your point, people are taking risk off right now, not putting risk on. And you have to also consider there's huge elevated cash positions in lots of portfolios. I don't know what the exact number is, but we are running, I think a very large cash overall aggregate cash position for investors that we haven't seen in quite some time. So there is a bearish sentiment in the market and I think, you know, it's hard to read a lot of that because we are over the summer, volumes are a little bit lighter. So you can kind of look at that rally and say, well, how meaningful was that rally in terms of volumes? Right. And how meaningful is that sell off in terms of volumes? Will we get a little bit more information come September, October, when more investors are paying attention?
Jamie [00:15:43] So this big sort of amount of cash, that sort of sitting on the sidelines, so to speak, what do you think is going to be the signal for them to start putting that money to work? Are they waiting for short rates to rise so they can start moving into the shorter end of the yield curve?
Mo [00:15:56] Yeah, look, I mean, that's kind of assuming that someone's sitting on 100% cash portfolio and waiting for an opportunity. That's usually not the case. It's usually the marginal dollar. And where's that going to go? Yeah, but I think some of the things that could be helpful to markets from here is if the supply side. So, you know, the Fed's primary target is demand and kind of cooling demand, demand destruction. They have no control over the supply side. They have no way of easing supply side constraints or bottlenecks in the supply chain. The market in kind of the private sector is going to have to kind of handle those problems. Right. And what we're seeing is that is starting to ease that is actually starting to show signs of improvement. So if, the supply side issues resolve themselves faster than expected and if, employment continues to be strong and, you know, really the economy is stronger than we all maybe think it is, what will happen is the Fed won't have to work so hard to get the demand side balanced because the supply side is going to come into balance and that will slow the Fed down, which will be positive for risk assets.
Jamie [00:17:04] So you brought up the labour market there. And I just find this a fascinating topic because all year I think the labour market stayed stronger than a lot of us expected. And I'd love to hear your views. I mean, actually, my wife works, I won't say the name of the bank, but she works at a bank. And they're certainly preparing for economic slowdown and preparing people for, you know, less bonuses, things like that. Do you feel that people are holding on to their employment because it's just so hard to rehire people? And that, you know, if we do start to see meaningfully worse economic data, even from here, we may see this wall of, you know, a big a big rise in unemployment because so many people are so nervous to make the first move, so to speak.
Mo [00:17:44] Yeah. You know, it's hard to tell, right? Because a lot of the tightening that's already happened, I'm not sure has made its way into the data. So, you know, there is a little bit of a lag here. So, you know, rates have gone up meaningfully. You know, we've had 75 basis point hikes, which, by the way, those are large hikes relative to history and relative to what we've been used to, at least for the last 20 years. And it's not just the Fed, you know, you have the ECB, BOE. Everybody's kind of thinking tightening. Right. And remember, it's not just the interest rate hikes, it's also QT, which is on the horizon. So you have another, let's say, $100 billion of, you know, securities that are going to come into the market every month. Right. For the foreseeable future, just to get that $9 trillion balance sheet back down to a to a reasonable level, that has a different impact. But effectively, it's like a rate hike. Right. So you've got a lot of tightening in the system. Has that made its way into the labour market or are we yet to see the impact of some of that into the labour market? Yeah, look, I think I think we're going to start to see a little bit of that. I think if you look at corporate earnings and earnings calls in the transcripts, some of the senior leaders are starting to say, look, we're starting to postpone some hiring. We're pushing some hiring into next year. We're really looking at optimising a real estate footprint or our headcount footprint so those things could start to trickle into the conversation. I'm not sure it's like the end of the world yet. So I wouldn't I wouldn't say, oh, my gosh, you know, there this big spike in unemployment in the next several quarters. But it's something that we'd want to watch carefully. By the way, the Fed is also going to be watching that carefully, because when they say data dependent, what data are they looking at? Well, one of the biggest things they're looking at is that number, because, remember, they have to balance the inflation number with employment. And so far, this has given them a lot of cover. Right. To tighten a lot. But if this starts to change, you could start to see them have to balance their dual mandate again.
Jamie [00:19:46] Just feels like a lot of things could come at once. Last question Mo typical one to ask you may be looking at the future. Where are you advising your clients to put their money right now, if you can say?
Mo [00:19:55] Sure. Yeah. So today, the portfolio I just gave you, kind of our positioning, underweight equities, underweight credit. We've added a little bit of duration. So higher quality bonds, government bonds within the equity market, we tend to focus on factors, so rather than sectors, we think factors we've gotten very defensive. So think about low volatility factor, quality factors. And you're looking at companies with strong balance sheet earnings power, pricing power so they can kind of pass back some of the, you know, inflationary pressures maybe on the supply chain to their customers. We're also looking at momentum. And momentum is really interesting, right? Because you would you would actually probably say, well, momentum is more of a risk factor, isn't it? It actually is a little bit of a shape shifting factor. It's risk on when the trend is up. It's it's defensive when the trend is down, because all it does is sort stocks based on best and worst performance.
Jamie [00:20:50] We've we've got so used to momentum being the equity story for so long.
Mo [00:20:53] Exactly. So we we think of momentum as a defensive factor.
Jamie [00:20:57] Yeah.
Mo [00:20:58] On the downside, because what you're really doing is investing more heavily in companies that have had the least negative price return.
Jamie [00:21:05] Mo, it's always great to chat with you. Thanks so much for joining us.
Mo [00:21:07] Thanks for having me.