If you’re waiting on a sustained rebound for risk assets (like stocks), you might be waiting for quite a while.
Or at least that’s the conclusion one draws when juxtaposing Fed speak, market pricing for policy rates and Monday remarks from JPMorgan analysts including Marko Kolanovic, who said that “in order to have a sustained asset recovery, the Fed would need to start cutting rates.”
That’s problematic if you’re betting on Q4’s nascent equity bounce to persist. Because even on the market’s timeline (which is more dovish than the Fed’s to the extent policymakers are keen to push back on the idea of easing late in 2023), rate cuts are seven or eight months away at the earliest. That’s not long in the grand scheme of things, but it’s sure going to feel like it to battered, bruised and weary market participants.
Mary Daly on Monday talked about taking a “judicious” approach to additional rate hikes to avoid overtightening, but nevertheless reiterated that she sees rates peaking around 5%. “We want to go far enough that we get the job done, but not so far that we overdo it,” she said, explaining a “resolute and mindful” approach to tightening during a speech to the Orange County Business Council. “Resolute and mindful are not in conflict,” she insisted, but conceded there’s “tension” between them.
The issue for markets is just that no Fed official has indicated anything like a willingness to pause before delivering another ~100bps worth of hikes. So, all of the “we’re mindful,” “we’re not going to overdo it,” “we’re cognizant of lags” banter doesn’t really change much, hence rangebound terminal rate pricing (figure above).
For now, an uneasy truce finds the Fed and markets agreeing on at least 5% when it comes to what counts as “sufficiently restrictive” in the context of putting sustained downward pressure on inflation. There are plenty of caveats, though. Jim Bullard wants more, for example, and the market expects a quick pivot once terminal is achieved, while the Fed insists such an outcome is very unlikely.
“While we find it encouraging that the peak in the market pricing for the Fed has been hovering around the 5% level since mid-October, any idea that the peak is behind us still lacks high conviction,” Kolanovic and co. said Monday. “Despite the downward surprise in the October US CPI release, few clients are convinced that core inflation would decline enough in 2023 to make the Fed stop the rate hiking cycle without a material retrenchment in the US labor market.”
Of course, the odds of that (i.e., the probability of a sudden deterioration in the jobs market) are low, or at least if you go by weekly claims and also JOLTS. The latter comes on a significant delay, but between job openings still loitering near record highs and jobless claims showing virtually no sign of stress, it’s very difficult to make the case that a labor market inflection is imminent. Between that and the mathematical impossibility of inflation receding anywhere near target before mid-2023, analysts (and here I mean everyone, from JPMorgan to Morgan Stanley to Goldman to Barclays to Nomura and on and on) is almost universally lined up behind the notion that the Fed is going to achieve something like 5% come hell or high water, and will be extremely reluctant to cut rates in the absence of a serious economic slowdown or some manner of credit event (and no, crypto doesn’t count).
Rate cuts “will likely happen at some point next year [but] it is not likely near-term,” Kolanovic said Monday. “As long as central banks raise rates or keep them at current high levels, we believe assets will be rangebound with a more pronounced downside risk,” JPMorgan went on to say, adding that “catalysts for a proper pivot (cutting rates) are likely some combination of increased unemployment, declining inflation and something breaking in financial markets” and because “an increase in unemployment is not likely to happen very soon, markets will be on edge between waiting for better inflation data, a slowing economy and earnings, and rising risks of a financial accident.”
Later, Daly told reporters that 5% is a “good starting point,” but suggested the Fed could go higher. It’s “way too early” to call a turning point for inflation, she emphasized, before describing herself as “on the hawkish side” when it comes to what the Fed needs to do.
Historically speaking, from negative slopping yield curve to positive slopping yield curve (i.e. cut), asset price tends to fall significantly. Old cliche goes, be careful what you wish for.
i think the causality is opposite, typically only after asset price collapse do fed ease the pedal which cause the positive slopping yield curve.
Your are correct! That’s what I recall happening over the last 45 years.
As our esteemed author wrote in “Burn the Playbook,” a lot of how you view the current situation depends on your perspective. The period from March 2009 to February 2020 may indeed have been an aberration. My perspective dates back to late 60s, and 5% rates seem more reasonable than outlandish. And in the broader context of Western capitalism, 5% is still on the low side. Until recently the idea that investors would buy government bonds at negative interest rates was unthinkable. And being driven out the yield curve and down the credit ladder to get income hasn’t been very palatable. Now that inflation has popped, rates need to go back to “normal” (from a long term perspective) and stocks must be repriced accordingly. Of course, as our author points out, markets may break in the process and repricing may turn chaotic. We all hope that doesn’t happen, but 5% in itself doesn’t seem like an outlandish goal.
It could easily be years until inflation is down to 2%
No one knows for sure, including Jerome.
Stepping back, it’s commonly stated that earnings drive share prices. That assumption underpins many of the forecasts our Dear Leader has been sharing with us.
But over what time periods does the correlation hold? Quarters? Years? Market cycles? If the time period covers years, how useful are they when it comes to forecasting equity price movements over the next six months?
As well … is the correlation CAUSAL or reflective? So many of the models investors and the Fed rely upon may well be built on foundations of sand.
Not that most strategists would care to even countenance this observation from some old crank.
Good morning, Derek. Your crankiness is valuable, and you’re not the only market aficionado to question and complain. Notwithstanding the cold water being splashed on the economy the Fed, this too shall pass.
I am expecting that investments I make during this downcycle will yield real earnings after the slop washes downstream. I’m not saying I can take it to the bank when I wish it to be so. But I’m here to gain a return and invest in good companies with realistic plans for success. In the meantime, anything can happen. Who knows. Putin may invade Europe. But I don’t expect it. The dust will settle at some point, and I hope to capitalize when that occurs.
My first real (grad) finance prof had a saying that applies here (IMHO); “Something is always better than nothing and if you can’t make 6% on your money, drink it (apologies). Even if there are no positive reals, 6% >4% and 8% > 6%. When I can get a higher current income, even at a negative real level, given level(ish) risks, I’ll take it. Right now one of the best things I own is a biggish amount of Vanguard’s TIPs fund (VAIPX) yielding 8.3%. The income I get from this one position is equal to my SS payment. The price is below my basis but a loss is only a loss if you take it. I won’t do that.
Interesting. I don’t know what the weather will be over the winter. But I can pretty well guess it will be cold here in Chicago, and it will warm in the spring. I’m an older guy, and I should be attracted to a Vanguard fund with such a yield, but I don’t like going that route.
How we perceive risk varies. Some are conservative. My perception of risk is based on a life-experience of recessions (which is not necessarily saying much). I’ll hold BAC or VZ, but at the same time I consider other choices when stocks are underwater.
I believe if I invest in a young company that’s growing its earnings but has been unnecessarily beaten down due to macro issues, it can yield returns, depending on the business come springtime. Of course, there’s also a swath of variables to consider and evaluate in these investments.
I’m no swami. I pay the price of patience, not interest. And the returns are usually multiples of two, three, or more on the initial investment for small caps. That’s just reality. I’m still kicking and finding opportunities. Not for the cautious. Can’t worry about it.
I did that stuff 30 years ago. I’ll be 80 soon and I’ve got no time for young companies any more. I go for income and give 25% of it to those in need. That’s a luxury I’m glad to have. In the last 13 years I’ve given away the equivalent of all the money my wife and I made in the first 30 years of our life together. When I can make 8% with virtually no risk, I’ll do it. BTW, born on Ontario Street in the early 1940’s. The hospital charged my mom $3 a day for herself and 50 cents for me. My dad was on Guam and I didn’t see him until after the war. When he came in the door at my grandparent’s house I spoke my first words, “Hello father, we’re glad you are home.”