Market Dovishness, Meet Fed Hawkishness

Market Dovishness, Meet Fed Hawkishness

Last Friday, the market doves ran into the Fed hawks. The hawks certainly won the first battle, and while markets don’t generally go in a straight line, I would expect the trend to be the hawk’s friend for a while.

What happened that was such a big deal? Exactly what we said last week– the Fed told the market they were too dovish, and they should expect high rates to last potentially until 2024. I’d rush to add that forecasts aren’t reality. It’s just a guidance game. Personally, I doubt there’s no rate cut by the end of next year, but the market had been way too sanguine. The market was way too dovish, and I expect the Fed is currently too hawkish vs. reality, but right now that doesn’t even matter. What matters is the market had its expectations reset, and that should continue.

In more detail, Powell started his brief speech by assuring markets that higher rates were definitely sticking around for some time, meaning there is no Fed pivot. Further, he said their main priority is to make sure inflation goes back down, and that will require a restrictive policy. None of that should be a surprise to anyone who listened to Fed speakers from the last few weeks, but clearly, markets have been very aggressive about pricing in far more dovish expectations.

Where does that leave us? Looking at economic data to see what the newly data dependent Fed sees. I think we can forecast the future better than the Fed is willing to, and the next several months don’t look so great. I think I’ve spent a fair amount of time talking about a lot of this in the past weeks, so I’ll just quickly summarize.

On inflation, I can’t find a historical, postwar, example of a large drop in inflation, like we saw last month, being repeated in short order. In this case, last month’s drop was largely driven by energy, but energy hasn’t repeated that drop in August.

The Cleveland Fed currently estimates August CPI of 8.28% Y/Y. That would be down a bit from last month’s 8.5%, but still well above what the Fed wants to see. The market needs a fast drop, and that’s not fast enough.

On growth, the latest data hasn’t been too bad, which in some ways is too bad for the market, as between that and a strong jobs market, the Fed is being told continuing to hike is perfectly fine. I do worry that leading indicators, such as Purchasing Managers Indexes (PMI’s,) housing, and Leading Economic Indicators (LEI’s) indicate the economy is likely to continue to slow, and potentially sharply.

Lastly, the Fed is planning on accelerating Quantitative Tightening (QT) in September, shrinking the Fed balance sheet at a faster pace. This is the opposite of Quantitative Easing and seems likely to have the opposite effect. We’ve never had a pace of QT like what the Fed plans, and I worry it could cause significant problems.

Putting it all together, on Friday, the market had to admit it had become way too dovish. Looking at the likely data ahead, it seems unlikely the Fed will get the message to slow down much. As such, we should expect more rate hikes and no cuts for a long while.

The first time we could see some form of pause or pivot would be leading up to the Fed’s Nov. 2nd meeting. I think it’s reasonable, but not guaranteed, that the Fed actually could pause then, but that would likely be based on some tough months between now and then. The clearest way to bring inflation down rapidly is recession, and the combination of higher rates and accelerated QT could create that combination.

Ultimately, we primarily invest in companies, and I don’t think we even need to see bad US macro data to stay cautious on stocks. Earnings estimates remain unreasonably high, given the backdrop. Reuters reports about 40% of S&P 500 revenues comes from overseas. Given the strong dollar, doing business in foreign countries gets harder. Additionally, ongoing problems, such as soaring European energy costs obliterating non-essential spending will also hurt.

Bottom line, while I expect our economy will suffer, corporate earnings are likely already on a path to look worse than they are now. There will be a good time to buy, and maybe not even all that long from now, but currently, too many problems still need to be priced in. Continued caution makes sense.