June 12, 2023

Can the Fed overtake its past failures?

Stocks rallied on Friday as traders got themselves ready for this week’s big releases. No negative news paved the way for further gains on the major indexes.

Hop, skip, or jump. If you have been paying attention to my writing… which, I know you have, you must have noticed how many times I have used the term “inflection point” in recent months just prior to Fed meetings. I know that the term implies that it is a singular moment in time which will have an impact on everything thereafter. But alas, the singular moments just keep coming and going. Now, looking back, there have been a series of inflation points that really began less than a year ago after inflation began to recede after peaking at +9% on this very month last summer. By that point, the Fed had enacted 3 rate hikes, a +25, a +50, and a +75 basis-point bump in succession. The latter 2 were referred to as unprecedented at the time due to their rarity. July would see another unprecedented +75 basis-point hike which would take the Fed Funds Rate into the 2 handles. Many economists, prior to that move, considered 2% to be neutral, meaning the rate was neither stimulative nor restrictive to the economy. Besides, the Consumer Price Index / CPI seemed like it had peaked the month earlier. So, would the Fed pivot after the July hike? That is obviously a rhetorical question… we know the answer, but let’s analyze this for a bit.

If we turn the clock back another year to the summer of 2021 the Fed was still referring to inflation as transitory, meaning that it expected it to recede on its own. Any of us non-Fed, non-economist folks who were in the market for… ANYTHING, knew that prices were on the climb and showing no signs of retreat. The Fed must have had access to some secret information that gave them comfort to keep policy accommodative. Sadly, it did not, and the Fed was patently wrong, missing the clear signals. But the central bank eventually got the signal, albeit too late, and found itself in a game of catch-up. In the motorsport world, we refer to this as late-braking. It is a high-risk strategy that allows one to overtake a competitor in a turn… if it works. If it doesn’t work, there is good chance of locking up the wheels and going on an adventure… into the gravel and possibly the wall. Which, is kind-of what happened to the Fed.

Another three big rate-hikes would usher in 2023 and inflation would continue to slow in consecutive monthly declines. As 2023 began, Fed Funds were at 4.5% and the stakes were getting higher for the Fed. The economy was still on its feet, but cracks were emerging. Lots of wealth and buying power was erased in 2022’s capital markets declines, and the Fed was at risk of missing another signal and pushing the US economy into a recession. Remember that the first so-called inflection point was last summer. The Fed, still playing catch-up, hiked again in February, determined to make up for its past failure. Another inflection point would come in March, but this one would be altogether different.

Inflation was clearly trending downward and consumer confidence was waning. Calls for a recession were increasing, and growth projections were being revised downward. Earnings growth was slowing, if not declining. And then the news dropped. SVB Financial failed… right under the noses OF THE SAME FOLKS RESPONSIBLE FOR MONETARY POLICY. Two more banks would fail quickly and many more were left struggling for survival. This would leave the entire financial system in defensive mode. “Defensive” means that credit would be tightened as banks struggled to get their books in order, given the tight monetary environment. That was the Fed’s second major failure since missing the onset of inflation.

After 2 consecutive strikeouts, investors are rightly concerned that the Fed will miss yet again. Rates are clearly restrictive, and the banking sector is as tight as it gets (and possibly getting tighter, as I reported last week). Inflation is far lower than it was a year ago, but it is still too high, and there are signs that its incremental declines are slowing. This has led the markets to believe that the Fed will have to pause its rate hiking in this week’s meeting. The rhetoric from policy makers remains high and the Fed is in a really tight bind with its 0 and 2 track record. That means anything can go, despite what the market believes or even wishes for. Commentary leading up to this week’s meeting have been nuanced to calling for a “skip” rather than a “pause.” “Skip” implies temporary while “pause” implies indefinite. Gone from the narrative is the word “pivot,” which is now considered a 2024 possibility, at best. That all being said, the Fed is very much at an inflection point. Policy along with the words that surround it are going to be critical in determining market direction for the next few months. The Treasury, in the wake of the recent debt ceiling showdown, continues to hit the market with supply, putting even further pressure on the financial sector. We will also get inflation figures tomorrow and Wednesday as the FOMC meets and releases its policy. Imagine what it must feel like to be speeding into a sharp turn going 210 miles per hour (337 kph for my metric readers) and deciding just how long you can wait to get an advantage without ending up in a wall. The Fed knows the feeling, and that wall is coming fast.

FRIDAY’S MARKETS

Stocks ended the week on a positive note as traders eagerly awaited this week’s Fed policy meeting in a slow news cycle. The S&P500 gained +0.11%, the Dow Jones Industrial Average climbed by +0.13%, the Nasdaq Composite Index advanced by +0.16%, and the Russell 2000 Index slipped by -0.80%. Bonds pulled back and 10-year Treasury Note yields added +2 basis points to 3.73%. Cryptos lost -1.67% and bitcoin declined by -0.75% . The S&P500 ESG Index advanced by +0.18%.

NEXT UP

No economic releases today.

The Treasury will auction around $200 billion in notes and bills of various maturities today.

Later this week: Consumer Price Index / CPI, Producer Price Index / PPI, Retail Sales, Industrial Production, University of Michigan Sentiment, and regional Fed Reports. The FOMC will meet tomorrow and Wednesday and announce policy on Wednesday. Please refer to the attached economic calendar for times and details.