It’s one of the oldest rules on Wall Street: Don’t fight the Fed!
Lately, however, that’s all anyone seems to be doing.
The Fed is attempting to rein in inflation by raising interest rates and allowing its balance sheet to shrink. In theory, this should drive asset prices and raising rates on home loans, tightening financial conditions for businesses and households.
While that happened in the early stages of the Fed’s tightening cycle, it has since gone haywire. The S&P 500 rallied 17.2 percent in the 41 days through March 17. U.S. corporate bonds with junk bonds also have gone on a stunning rally, narrowing the spread from roughly 600 basis points to 425 basis points above the risk-free Treasury rate on Friday. The thirty-year fixed mortgage rate has fallen from nearly six percent to 5.13 percent. The market odds implied odds that the Fed will hike another 74 basis points in September have declined substantially.
In short, financial conditions are substantially looser than they were just a few weeks ago.
The most compelling interpretation of these market developments is that investors believe that the Fed will back down from its commitment to bring inflation down to two percent if the current hiking cycle pushes the economy into a recession. Many investors think the economy will enter into a recession but that it will be mild and short-lived—because they think the Fed will not keep hiking into soaring unemployment and a shrinking economy. The idea that the Fed will cut rates next year is practically the consensus.
“We expect the Fed will pivot to easing monetary policy in 2023 as inflation falls back to its 2% target and the need to shore up economic growth becomes a top concern,” said Morningstar’s head of U.S. Economics Preston Caldwell recently.
Now Fed officials are fighting back, apparently warning the market that they are off base when
Minneapolis Federal Reserve Bank President Neel Kashkari—one of the more dovish Fed presidents—said this week that the job of the central bank was to get “very high” inflation down as soon as possible—even if that means triggering a recession. Last week Kashkari said there was a “disconnect” between his view of the Fed’s rate path and the market’s view.
Federal Reserve Bank of St. Louis President James Bullard told the Wall Street Journal Thursday that he is considering support for another 75 basis points.
“We should continue to move expeditiously to a level of the policy rate that will put significant downward pressure on inflation,” Bullard said.
San Francisco Fed President Mary Daly, also considered a dove on interest rates, recently said rate hikes were likely to continue through next year. She warned that the central bank is actively trying to talk the market out of expecting a “large hump shaped rate path, where we’ll ratchet up really rapidly this year and then cut aggressively next year.”
Economists who closely watch the Fed think Chairman Jerome Powell will use his keynote speech at Jackson Hole next week to stress that the central bank is going to bring the inflation rate down to its two percent target even if it means a recession.
The question is: will the market believe him?