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Markets – In this article you’ll find:
- Fed gets what it wants VS Market gets what it wants
- US labour market remains tight
- Central banks continued raising rates
- Financial Condition have loosened
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The Fed wants to keep rates high; the market is increasingly convinced that is not going to be the case.
Expectations of rate cuts are forming, and asset prices are rallying accordingly.
The FOMC statement acknowledged the quickening pace of disinflation and the fact that substantial tightening has been implemented already.
It follows from this that the ceiling for the terminal rate is capped and might well be hit in the next FOMC meeting.
In his press conference, Chair Powell delivered a relatively balanced message, recognising that the cycle is not entirely over,
but that there are emerging risks to the central bank’s preferred softlanding scenario (housing market and bank lending weakening).
Bottomline, the Fed is ready to pivot late this year, subject to price and jobs developments.
Central banks are stumbling into a nuanced phase of policy tightening after major macro events last week.
Lower energy and goods prices are pulling down overall inflation.
Yet tight job markets should keep wage growth above levels needed for core inflation to fall to 2% targets, reflected in a 54-year low for unemployment in the U.S.
BlackRock sees central banks close to pausing hikes: Major economies will see mild recessions but lingering inflation.
We like short-term bonds and credit.
Fed gets what it wants
This would entail annual average inflation easing to below 3% this year, but Fed officials are not convinced that it comes down to 2%.
As real interest rates rise, the labour market would soften, but only modestly.
In accordance to DBS Group Research rising real rates would also push down real GDP growth,
but there would be no recession, especially as consumption gets some support from continued rise in real wages.
Money markets remain orderly even as quantitative tightening continues.
Around this benign scenario, Fed funds rate is held at 5% during 2Q to 4Q.
This scenario is not being bought by the markets presently.
If this was considered seriously, longterm rates would be higher, and equity markets would be under sustained pressure.
Another possibility in this scenario is that the Fed keeps the option to raise rates and tighten financial conditions again if inflation doesn’t come down to 2% and growth/jobs surprise on the upside.
This development would, without doubt, be negative for the markets.
The US labour market remains tight
Nonfarm payrolls that just came out add to the confusion and dissonance in markets but point toward a still tight US labour market.
There was a massive positive surprise of more than 500k new jobs being created in January and the unemployment rate came in at 3.4%, the lowest since 1969s.
Moreover for Nordea Team Research annual revisions resulted in an upward adjustment of last year’s employment by some 813k,
so the labour market in the US has been even tighter than previously thought.
A word of caution is that the January report is the most noisy report of the year.
Among other things, the January reading has the largest seasonal adjustments as well as revised population figures which add to the noise.
But overall, it is clear the labor market in the US remains still too tight for comfort which is why the Fed needs to keep at it.
The market gets what it wants
The deeply inverted yield curve and declining inflation expectations, based on market-based indicators, suggest a very different outlook held by market participants.
The scenario entertained is that of unemployment rising, growth falling, and inflation becoming a nonissue this year.
A sharp Fed pivot would be warranted under this scenario as the monetary authority would be compelled to counter tightening financial market conditions.
Quantitative tightening would be stopped, and policy rate cuts would begin either in 4Q23 or 1Q24.
The pricing now is for over 150bps in rate cuts next year.
Central banks continued raising rates
Central banks continued raising rates this week, with markets hoping the final phase of the rate hike cycle is near.
Both the ECB and the BoE raised rates by 50bp, to 2.5% and 4% respectively while the Fed wound down the hiking pace to 25bp,
bringing the Fed funds rate in the range 4.50-4.75%.
The Fed and BoE will likely continue with 25bp rate hikes ahead, while the ECB signaled at least one more 50bp rate hike in March before likely stepping down to 25bp hikes.
Fed’s Chairman Powell specified that “a couple of more interest rate hikes” are on the cards,
while ECB President Lagarde would not commit to forward guidance beyond the March meeting.
Financial Condition
Markets cheered at the more balanced approach and lack of concrete signs by central bankers.
Remember that these were meetings without new economic projections so some vagueness was to be expected,
and became more convinced that central banks will soon take a break from raising rates.
Stock markets rallied, with the interest rate sensitive NASDAQ up more than 3% yesterday while yields fell 10-20bp across the curve both in the US and Europe.
As such, the outcomes of this week’s interest rate meetings was probably not what central bankers wanted to achieve.
Central banks want tight(er) financial conditions to dampen price pressures in the economy.
If the loosening of financial conditions continues, central banks could be forced to step harder at the brake and raise rates by more than markets currently envisage.
Hence, just like most parties, the better they are, the worse participants feel the day after.
The cheerful mood in financial markets is driven by dissonance among the incoming economic data prints, central bank’s actions and speeches, and investors’ perception of it all.
The good news is that goods disinflation is finally here, which has given markets hope that high inflation is behind us.
Service rent inflation will also likely moderate.
The bad news is that these two components amount to less than 50% of core PCE, while the long fight remains against service inflation, which is closely linked to wage growth.
Join the conversation with your own take on these topics in the comments below.
About the Author
Alessandro is a Financial Markets enthusiastic and he loves learning from articles/papers on many financial topics.
In doing so he shares with you the most interesting charts and comments.