Fight the Fed if you dare

Stocks sold off yesterday after the Fed signaled a continued aggressive, hawkish stance for the upcoming year. Off-putting comments by the Fed Chair threw cold water on heating bullish sentiment in equities.

Lessons… hard lessons learned. I am going to flip to a well-worn page in my old Wall Street Adages playbook. Don’t fight the Fed, reads the axiom in the center of the yellowing, tattered page. You may have heard this before and I am certain that you have read in my notes if you have been with me long enough. Its meaning is as simple as the text itself. When the Fed is raising rates being a market bull is not a safe bet, and conversely, when the Fed is cutting rates, it is safer to be adventurous.

What is not news is that the Fed is raising interest rates. It has been for the better part of the rapidly fading 2022. If you are following me, you could have assumed that given the poor year to date performance of your portfolio. What should not be news (certain if you are a regular reader) is that the Fed bumped up its key lending rate by a half of a percentage point yesterday. A month ago, traders were placing bullish bets on the event. The bull case was supported by a +50 versus a +75 basis-point hike. It was that potential downshift in the earlier hawkish moves that spurred the recent rally in not only equities, but in bonds as well. Bulls were calling it a pivot. Technically a pivot would include rate cuts, but hey, in the desert even muddy water is refreshing. A few weeks back, Fed Chair Powell dropped the biggest bullish hint in 2022 by signaling a +50 basis-point bump. That is exactly what we got yesterday. The markets promptly celebrated by selling off. “Wait, what,” you ask? A smaller rate hike is supposed to be positive. Yesterday’s selloff was more about the dots and less about the largely expected magnitude of the hike. The dots? Yes, the dots. The Fed’s Dot Plot which details Fed member’s interest rate forecasts going forward. Check out the following Fed Dot Plot from yesterday’s release. It shows that a majority of the FOMC expects Fed Funds to be slightly higher than 5% at the end of NEXT YEAR. With yesterday’s +50 basis-point hike, that means another half percentage point more of hiking in 2023. Only 2 members are anticipating rates will be below 5%. Now that is sending us a clear message that rates will be higher, for longer. In other words, the Fed is not done fighting high inflation yet. That shouldn’t surprise us, but for some reason it caught equity traders on uneven footing yesterday. And there is a reason for that. Keep reading.

The reason is that the market was not expecting it. You may recall that the markets, according to futures, were expecting rate CUTS in the latter half of 2023. In fact, those expectations still exist now, this morning, as you will note by the next chart, below. If you are not into charts, all you need to do is listen to the Fed Chair speak in his press conference yesterday. He was clear that we “have a ways to go,” in his words, a new favorite term for the bankers. He also made it clear that the Fed would not consider lowering rates until inflation was clearly heading back to the central bank’s +2% target. That is a “ways” to go, considering Tuesdays’ core inflation read of +6%. Ok, so hopes dashed for rate cuts in 2023. Is that it? Of course, not, there is more. Keep reading.

The Dot Plot is part of the Fed’s quarterly release of economic projections. Here is how those looked. For GDP, AKA The Economy, the Fed is expecting it to grow by just +0.5% next year. Not only is that paltry, but it is significantly lower than the +1.2% the Fed was predicting in September. On inflation, the Fed is expecting it to end the year at +3.1%, which is higher that its +2.8% projection from September. Ok, at least it is lower than the last PCE Deflator (the Fed relies on this indicator) read of +5.0% (that will be updated next week).

So, to sum up. The Fed attempted to dash all hopes that 2023 will give us some rate cuts in the second half of next year. The Fed also thinks that economic growth will slow next year, and that the unemployment rate will rise. Sounds to me like the Fed is trying to send a message to the market: “curb your enthusiasm!” You can choose to follow the old adage and heed the warning, or you can search for the positives in yesterday's release. To be clear, there are positives, and the Dot Plot represents projections, not policy. Policy, according to Powell’s commentary will be dictated by the numbers in the upcoming year. Of course, this is always the case, but why not underscore it. The likelihood of a recession in 2023 has increased in recent months, and while the Fed is not predicting it, it is certainly acknowledging a slowdown, based on yesterday's release. The likelihood of an earnings recession has also increased in the wake of the last earnings season which was marked by the introduction of “cost cutting” measures and future guidance downgrades. Though the Dot Plots have not been around for long, we can refer to a similar Dot Plot which predicted higher rates as earnings and economic projections were being cut. That was 2018… just before the Fed’s famous dovish pivot… which included rate cuts. Of, course inflation was at 2% at the time, right on target. All this means that we will have to watch those economic releases and earnings even more closely in the year ahead. As if we don’t already.

YESTERDAY’S MARKETS

Stocks ended a volatile session in the red after the Fed made it clear that it is not expecting to cut rates next year. The S&P500 lost -0.61%, the Dow Jones Industrial Average gave up -0.42%, the Nasdaq Composite Index traded lower by -0.76%, and the Russell 2000 Index fell by -0.65%. Bonds advanced and 10-year Treasury Note yields slipped by -2 basis points to 3.47%. Cryptos traded lower and Bitcoin gained +0.38%.

NEXT UP

• Retail Sales (Nov) is expected to have slipped by -0.2% after gaining +1.3% in October.
• Initial Jobless Claims (Dec 10) is expected to come in at 232k, slightly higher than last week’s 230k claims.
• Industrial Production (Nov) is expected to be flat for the month after slipping by -0.1% in the prior period.