Two Steps Forward, One Step Back

Count us among the many who thought Jay Powell got a bit ahead of himself last month when he started taking a victory lap.  Armed with some encouraging economic data in January, the Chairman was mostly optimistic in his February 1^st policy statement and subsequent Q&A.  He didn’t sound too much different a week later when he gave a speech in front of the Economic Club of Washington.  To me, it seemed the Chairman’s overriding message on both occasions was that the Fed’s efforts to bring inflation back down to its 2% target would not necessarily trigger a significant economic slowdown or big spike in unemployment.  Sure, he gave all the usual caveats.  He said it was possible that more hikes (than were priced in by the markets) might be needed to get the job done.  He also outlined his concerns about the non-housing services sector, which is bearing the brunt of the tight labor market.  But he also did very little to discourage investors from assuming that the disinflationary process has begun, it would likely continue, and it very well could run its course with less pain than feared.  It was this assumption that propelled the S&P 500 over 6% higher in the month of January.     

I personally found it puzzling that the Chairman didn’t take a more forceful stance during those two early February appearances.  It is true that the economic data in January was starting to suggest that inflation was coming down.  That data also contributed to the stock market’s gains during the month.  But by February 7^th, when Powell appeared at the Economic Club of Washington, we had just received the January employment report.  That report reveal that a huge 517,000 jobs were created in January, and wage growth was higher than expected as well.  Based on that strong labor report, it appeared as though markets were braced for some hawkish commentary from Powell.  But I just didn’t hear it.  It was more of the same.  Apparently the Chairman was still not concerned about the impact of looser financial conditions (read: higher stock prices) on the Fed’s mission to bring down inflation.    

Fast forward one month and Powell’s tune seems to have changed.  It seems clear from his Q&A in front of Congress earlier this week that inflationary concerns among Fed members increased materially during February.  These concerns follow the release of several economic indicators showing that inflation will not be so easily defeated.  The indicators include strong retail sales, elevated labor costs, and huge numbers of job openings, among others.  In response, it appears that the Fed is now contemplating a 50 basis point hike at its next meeting on March 22^nd rather than the 25 basis points that had been widely expected.  In fact, the Fed Funds futures market is assigning about a 50% chance of the bigger hike compared to just about 25% odds prior to Powell’s testimony.  Looks like Powell is pivoting back to hawkishness again. 

Though the stock market is hanging in there pretty well considering the Fed’s about face, the yield curve is screaming even louder that the economy is headed the wrong way.  On Wednesday, the spread between the yields on the 10- and 2-year Treasury bonds, at 108 basis points, had expanded to the widest level since the early 1980’s.  The spread has since pulled back to around 93 basis points, but it is still a flashing red light.  In the chart below we show the S&P 500 along with the yield spread between the 10-year and 2-year Treasuries.  You can clearly see that the incoming economic data turned problematic in February after some encouraging signs in January.

One thing has become abundantly clear, to me anyway.  The Fed talks too much.  If you don’t have the confidence to make predictions, then don’t.  Let the markets figure out things for themselves.  We don’t need 5-6 different Fed officials responding to every new economic release each week.  Having said that, it is still not at all clear to me that the Fed hasn’t done enough already in terms of rate hikes.  The effects of monetary policy decisions take 12-18 months to materialize and so the bulk of the Fed’s action to date is not in the data.  The economy is facing interest rates that are multiples of the levels seen over the past 15 years.  How can that not have a dramatic impact?  Where does that leave us?  It leaves us with a high degree of uncertainty that the markets are starting to sniff out, regardless of Fed posturing.  So, my advice to the Fed is that when faced with uncertainties of such magnitude, why make public speculations at every turn!?