Will the Fed blink?

Stocks rallied yesterday as investors became hopeful that a pivot is on the horizon. Bond yields dropped and crude rallied helping energy and tech lead the climb.

Wishing, waiting. Here we go again. We are all collectively hopeful that the economy and the markets will break out of this gloomy pattern. A Fed which talks of a glorious death in its battle with inflation, a slowly cracking economy, a hair-trigger bond market, climbing interest rates, an imploding housing market, geopolitical turmoil, a still-broken supply chain… oh, and high inflation, all make for a very uncomfortable scenario for stock investors… especially ones near retirement. While most of those challenges are cyclical and will ultimately right themselves, the Fed, at the head of the list of worries, is something quite different. All it would have to do is just say THE word. In fact, it doesn’t even have to say THE word, it could merely rearrange its party line to soften some edges and markets would likely react with a relief rally. For simplicity’s sake, let’s just refer to that as a pivot. The last bullish pivot we experienced came in the form of a Christmas gift in 2018 in the wake of the worst December since The Great Depression (with a “D”). Earnings were faltering, consumer confidence was slipping, the economy was losing steam, and the equity markets were in a free fall. The Fed was in a tightening cycle, raising its key lending rate and reducing its balance sheet (aka quantitative tightening). Then and now Fed Chairman Jerome Powell admitted that it may be prudent to ease up on the tightening. Just words, but it did manage to shore up the equity markets. Stocks (the S&P) ended 2018 with a Q4 loss of -13.97%, but the pivot led to a +13.07% gain in Q1 of 2019. It felt good, didn’t it?

Lots has happened since the Fed pivot of 2018… I won’t bore you with the details which I am sure you are aware. But here we are today in a very similar… but very different situation. Similar in that the Fed is in a tightening cycle with no plans of letting up, a weaking economy, and the stock market… well, that is in a more painful state than in 2018. By Christmas of 2018 stocks were off by some -12.9% for the month, making for a swift and steep decline, while this September left us with an almost equally painful -9.34% loss. Still, stocks in 2018 through the pivot were only down by -12% for the year. I used the adverb “only” because stocks today are down by -22.8% year to date. Got the message? It was the Fed’s words, and those alone, which broke the cycle back in 2018. So, it is only natural for us to hope for a similar rescue. There are a few differences between today and 2018, principal amongst them is inflation. In 2018, the Consumer Price Index / CPI closed out the year at +1.9% compared to the latest reading of +8.3%, a level not experienced since 1982.

So, let’s get down to it then. Yesterday’s market is flashing hopes that the Fed will notice the pain and pivot, 2018 style. While futures continue to factor in a 4.2% Fed Funds rate at the end of the year (still almost a full percentage point higher than today), the Fed’s latest dot plot indicates that policymakers are expecting a 4.4% Fed Funds rate for year-end, a roughly single +25 basis-point hike difference. Further, futures are predicting a funds rate of 4% by the close of 2023 while the Fed plot is predicting a 4.6% Fed Funds rate. This divergence indicates that the market is counting on the Fed shifting policy, albeit a slight shift, sometime this quarter. Remember that a shift, or a pivot, can be as simple as a softening of words. Quite the contrary, that has not happened yet with recent Fed language just about as strong as it gets. Unfortunately, it would be in the Fed’s best interest to continue to raise rates as aggressively as the market will allow until a) either inflation begins to pull back, or b) the economy enters a certified recession. It is clear that condition “a” has not yet been satisfied based on the latest inflation figures, but condition “b” appears to be threatening on the horizon. With neither condition being clearly met yet, hopes of a pivot in the near-term may be premature. More hopes abounded overnight as equity futures rallied and bond yields fell further. Unfortunately, it will take more than hope to break the market out of this cycle. Fear not however, the pivot will come, but not until at least one of those previously mentioned conditions are squarely met. You can hear what Fed officials are thinking today, check out the Next Up section of my note. Oh, and because you were thinking about it, the S&P500 is +52.5% higher than it was at the Fed’s last pivot, even taking into account this year’s heavy rout.

YESTERDAY’S MARKETS

Investors broke into the new quarter with optimism for a Fed pivot growing, helped by weaker-than-expected manufacturing numbers yesterday. The S&P500 Index climbed by +2.59%, the Dow Jones Industrial Average rose by +2.66%, the Nasdaq Composite Index traded higher by +2.27%, the Russell 2000 Index advanced by +2.65%. Bonds also gained and 10-year Treasury Note yields pulled back by -19 basis points to 3.63%. Cryptos slipped by -0.94% and Bitcoin gained +1.88%.

NXT UP

• Factory Orders (Aug) is expected to have been flat for the month after declining -1.0% in July.
• Durable Goods Orders (Aug) is expected to come in at -0.2% in line with the prior estimate.
• JOLTS Job Openings (Aug) may have declined slightly to 11.088 million from 11.239 million in the prior period.
• Fed talk today from: Logan, Williams, Mester, Jefferson, and Daly.