On Tuesday, Jerome Powell gave a speech in Boston during which he downplayed the risk that the Phillips curve might suddenly snap back to life, leading to a surge in inflation that catches the Fed behind the curve.
That’s one risk for the Powell Fed, but it’s hardly the only thing they need be concerned about.
Persistent Fed hikes and the perception that Powell is inclined to be more data-dependent (and thus more hawkish given the economic backdrop in the U.S.) than his predecessor, have pushed the dollar higher since April, with deleterious effects for emerging markets.
In addition to burgeoning crises in some developing economies (particularly where external funding needs are high and FX borrowing is seen as excessive), Powell’s relative hawkishness is also playing out against a steady grind flatter in the yield curve and is seen by some as perhaps misguided given the likelihood that recent euphoria in the U.S. economy will prove ephemeral.
On that latter point (that the sugar high from expansionary fiscal policy will soon wear off), it’s important to note that Trump’s stimulus is deficit-funded, which means the gains in the economy mask a deteriorating U.S. fiscal position. The read-through for the next downturn appears to be that with fiscal policy exhausted, it will fall to monetary policy to rescue the economy, and that raises serious questions about the feasibility of cutting rates aggressively at a time when the fiscal position is on par with that of Italy.
The point of all this is simply to say that not everyone is convinced that Jerome Powell isn’t heading for a policy mistake.
Well, according to a new analysis by JPMorgan’s Marko Kolanovic, the market’s reaction to Powell speeches this year suggests traders and investors are inclined to believe the Fed chair is indeed tempting fate.
Marko divides Powell speeches into post-FOMC pressers and “Testimonies and Other Speeches” and here’s what he finds:
- FOMC Press Conferences – average negative return -44bps, 3 out of 3 negative
- Testimonies and Other Speeches – average negative return -40bps, 5 out of 9 negative
“While we acknowledge that it is not possible to attribute the market impact of each speech with certainty, simple math indicates that ~$1.5 trillion of US equity market value was lost this year following these speeches”, Kolanovic writes.
What accounts for Powell’s apparently abysmal market record? Well, as alluded to above, one explanation is that market participants think he might be underestimating the risks.
“Specifically, the equity market likely implies that the Fed is underestimating various risks, and hence is increasing the implied probability of the Fed committing a policy error in the future”, Kolanovic goes on to write, adding the obvious, which is that “a higher probability of a policy error translates into lower equity prices on the news.”
Marko goes on to suggest that Powell may be overstating the case when it comes to multiples being stretched, with the effect of spooking markets. After noting that forward P/Es are on par with the average of the last quarter century, Kolanovic says that “by repeatedly stating that valuations are high, the Fed may be causing equity markets to re-price the risk of a policy error higher.”
As far as the Fed’s ongoing effort to emphasize the necessity of more rate hikes, Marko offers this:
Equity markets see tightening of financial conditions and increased risks in 2018 compared to 2017: the USD is higher, market liquidity is lower, volatility (e.g. VIX) is higher, oil prices are higher, and political risks around trade wars, EM and Europe are all significantly greater. From an equity market perspective, these developments would not warrant higher interest rates.
Finally, Kolanovic suggests that the Fed’s penchant for focusing on “sustained” equity selloffs indicates that policymakers do not fully appreciate the evolution of modern market structure.
“If fundamental investors start questioning the cycle, a technically driven selloff could be more violent and more likely to deliver a knock-out punch to the economic cycle”, Marko notes, adding that “the new microstructure of financial markets would not leave enough time for the Fed to react.”
Whether or not Powell will become a better “listener” going forward remains to be seen. With that, we’ll leave you with a quote we use often from Deutsche Bank’s Aleksandar Kocic and do note that this description was penned to describe the Yellen years…
Through their communication with the markets Central banks, and the Fed in particular, have become “good listeners” with their decisions and actions made with markets’ consent. After years of this dialogue, the markets have gradually surrendered to the ever shrinking menu of selections that converged to a binary option of either harvesting the carry or running a risk of gradually going out of business by resisting. Not much of a choice, really. In this process, Central banks have reached a point of enormous power and control where market dissent is practically impossible. We believe that such levels of market control remain uncontested with anything we have seen in recent history and that the markets’ dynamics have never been further from that of the free-markets. Low volatility is a perfect testimony of that.