Powell’s sharp tongue

Stocks took a beating on Friday after the Fed Chairman failed to toe the stock bulls’ line. A second inflation gauge showed that prices pulled back moderately last month.

Hold your tongue! Look, the man was simply doing his job. To be clear, Jerome Powell did not wake up last Friday morning and say, “today, I am going to see how badly I can freak out stock investors with my speech.” As we now know, the Chairman did, in fact, freak stock traders out on Friday. Here is your quick guide to what in the world happened to the markets last Friday.

The Fed Chair spoke at The Jackson Hole Symposium for central bankers, policy makers, and economists. Leading up to the address, quite a bit of tension built in the markets. By Thursday night, it was clear that no matter what Powell said, markets would react strongly. At 10:00 AM Wall Street Time, the Fed Chair took to the lectern, and sure enough, markets took the cue. Did Powell say anything new to cause markets to sell off? I will let you decide before I chime in. Powell said that inflation is still bad, and that the Fed had to continue to fight inflation with higher rates in order to restrict the economy. He recognized that the higher, restrictive rates would cause discomfort, possibly even weaken labor markets. These are necessary sacrifices for longer term prosperity… lower inflation. NOTHING NEW YET. In recent weeks, some have been speculating that the Fed would actually stop raising rates and possibly even lower interest rates sooner than expected. THIS WAS PURE SPECULATION, as the futures markets, which are used to predict Fed Funds rates in the future, changed very little in the weeks leading up to Friday’s speech. There was, however, quite a bit of underlying tension in the equities markets with the recent rally off the mid-June lows. Volatility, as measured by the VIX index, had been declining since June and was hovering just below 20, which by recent history, is relatively low. In other words, the market had become a bit complacent given the long list of risks that are still present. In one passage of his speech Powell said, that there is a history of the Fed mistakenly lowering rates too early. That was the pivotal admission that caused stocks to ultimately tumble. It was interpreted as the chair saying that we can expect rates to remain high for a longer period of time. Hopes of rate cuts were quickly shattered and interest rate sensitive stocks (growth and tech) took the brunt of the selling pain. Indeed, the selloff was broad and ultimately stocks of all ilk suffered.

Bonds on the other hand, responded to Powell’s speech with a “meh.” Bond traders are more practical and tend to have a “show me” attitude toward the Fed. The bar is high for bond traders when it comes to predicting rate policy. Sure, there is some room for speculation, but for the most part, bond yields must sync up to where rates are expected to be in the future, specifically shorter maturities. By Friday’s close, 2-year Treasury Note yields barely budged in the session. Those notes attempt to predict where interest rates will be in 2 years, and they are more closely tied to the Fed than any of the other notes on the yield curve. Longer-term Treasury notes are a better predictor of what traders are expecting for the economy in the longer run. Many traders use the 10-Year Treasury Note yield as a proxy for that and yields of those notes also barely budged on Friday. Fed Funds futures markets were too, unphased by the Chairman’s comments.

Powell did acknowledge that there have been some positive signs from the economy but warned that there was not yet enough to justify material changes to policy. We knew that already, as well. Prior to the speech, the PCE Deflator, the Fed’s favored inflation proxy, came in lower than expected with a decline to +6.3% from the +6.8% posted in the prior month. Powell also admitted that the aggressive hiking would have to slow at some point…based on the numbers, of course. So, all in all, the Chairman added nothing new to our understanding of rate policy in the near future. For that small group of unrealistic speculators who believed that the Fed would significantly soften rate policy in the near-term without significant data, well…let’s just say that their parade was rained on.

So, what’s next? Asia and Europe had a chance to digest Friday’s data and selloff, and not surprisingly, futures were down overnight as China continues to experience an economic slowdown and Japan struggles with its own inflation problem. In the EU, speculation on the path of its rate hikes began. Though statutory rates are not strictly tied together, central bankers are under pressure to respond to the policies of big trading partners to avoid big swings in currencies, which we know can cause economic hardships for global traders. Traders, now having digested all of Friday’s data and commentary and at least partially digested yesterday’s Sunday dinner, are now positioning for the week ahead. The bond markets have responded with higher yields, as expected. Yields on the 2-year Treasury note are higher by +6 basis points and are currently at their highest since 2007. Longer maturities have gained in yield as well. This will serve to put further pressure on interest rate sensitive stocks, though the incrementally higher yields are very small relative to the jumps over the past 9 months. Fed Funds futures continue to predict a +50 basis-point hike next month with a 71% chance of an additional +25 basis-point increase. That is roughly around where it was on Friday. Fed Funds are expected to end the year at around 3.70%, which is about +20 basis points higher than in mid-August. If you like to think of rate hikes in +25 basis point chunks, that means 5 more by the end of the year (that is +1.5 percentage points higher). What stock traders are likely to be looking at in the days ahead are Fed Funds Futures for next May. That is the point at which traders expect rates to begin to come down. Right now, there is a low probability of that (only 17%), but that will surely change over the next few days as traders continue to respond to Friday’s speech and the raft of important economic data that is due to be released in the coming days.

FRIDAY’S MARKETS

Stocks sold off on Friday in response to Fed Chief Jerome Powell’s not-dovish speech. The S&P500 fell by -3.37%, the Dow Jones Industrial Average dumped -1008 points (-3.03%), the Nasdaq Composite Index dropped by -3.94%, and the Russell 2000 Index declined by -3.30%. Bonds fell and 10-year Treasury Note yields gained +1 basis point to 3.04%. Cryptos traded lower by -6.47% and Bitcoin sold off by -4.61%.

NXT UP

• Dallas Fed Manufacturing Index (August) may have improved to -12.7 from -22.6.
• Later this week: more housing numbers, Consumer Confidence, JOLTS Job Openings, ISM Manufacturing, and the monthly employment situation. Check out the attached calendar for times and details.