- Fixed Income Portfolio Manager
Asia ex-Japan, Institutional
Change
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“Before you judge a man, walk a mile in his shoes. After that, who cares? He’s a mile away and you’ve got his shoes!” — Billy Connolly
As of this writing, the market is now reasonably assured that the Federal Reserve (Fed) will start its rate-cutting cycle in September, even pricing 85% probability of a 50 basis points (bps) reduction. I am skeptical of such a large cut, with 25 bps being far more likely, and I expect investors to be disappointed by a perceived lack of responsiveness by the central bank. As I have noted previously, I believe the Fed should indeed be cutting aggressively, because the neutral rate for the economy (that which is neither accommodative nor restrictive) is not significantly higher than it was pre-pandemic. What the Fed should do versus what it will do, however, are two different things, with the latter affecting the market to a far greater extent.
Delving into Mr. Powell’s psyche
I believe that even after observing him for six years as Fed chair, market participants still do not understand Fed Chair Jerome (Jay) Powell. Unlike his immediate predecessor Janet Yellen and Ben Bernanke before her, Powell is not an academic economist. Instead, after attaining a law degree and clerking for a federal judge, he pursued a career in investment banking and had a political stint as undersecretary of the Treasury under President George W. Bush. Owing to his lack of academic background, Mr. Powell has a healthy skepticism of economic forecasts and sees the market as a better prognosticator of the business cycle.
In speeches prior to the COVID-19 pandemic, Mr. Powell often said that one could not definitively know the neutral rate for the economy or the lowest level of unemployment that would stimulate inflation. He also opined that the market was a better predictor of the global financial crisis than general equilibrium economic models, which rely on accelerating inflation to determine when the cycle is long in the tooth.
It is this philosophy that led Mr. Powell to make an abrupt policy U-turn in December 2018. At that month’s Federal Open Market Committee meeting, the central bank raised rates to 2.5%. In his public comments, Mr. Powell took a hawkish tone, implying that rate hikes would continue. The S&P 500 Index subsequently sold off 11%. Within two weeks, the Fed noted that its hikes were done and ended up cutting rates by 75 bps throughout 2019. This about-face was largely because Chair Powell believed the market was signaling that policy was too tight.
Taking a different approach?
Mr. Powell’s deference to financial markets evaporated after the pandemic, to the surprise of many participants, including myself. Despite the equity market sell-off that persisted throughout 2022, and the regional banking crisis that challenged markets in much of 2023, the Fed continued to hike rates. One reason for this rather abrupt shift could be that Mr. Powell does not want to be known as a modern-day Arthur Burns. Mr. Burns, who was Fed chair during the 1970s, is infamous for not keeping rates sufficiently elevated to stem inflation and for letting politics influence the bank’s decisions. History might need some revision. Mr. Burns actually hiked policy rates from 6% to 13% in 1973 – 1974, after which the unemployment rate rose from 4.6% to 9%. I’m not sure any Fed chair would have acted much differently at that time. In any event, Mr. Powell almost certainly does not want his legacy to be that of the leader who destroyed four decades of the Fed’s inflation-fighting credibility. To put an even finer point on it, Mr. Powell is unlikely to seek a third term in 2026, so he is probably intent on restoring price stability in the economy by then.
For all these reasons, I doubt that the 220 bps worth of cuts currently priced by the market for the next 12 months will materialize. Absent a sudden financial crisis, economic data tends to deteriorate gradually and linearly. To create their forecasts, economists extrapolate these trends, and forward-looking indicators for the labor market do point to a higher unemployment rate than in the Fed’s current projections. As noted, however, Mr. Powell has long been skeptical of such prognostications. In his most recent press conference, he acknowledged that the resilience of the US economy in the face of high rates has been surprising, and that historic signals for policy tightness (including Treasury yield-curve inversion and the generally reliable “Sahm rule”) have recently done a poor job predicting recession. Mr. Powell prefers actual, tangible data, and while the July employment report was weak, the Fed views the labor market as being in balance with pre-pandemic rates and at low levels historically.
The importance of upcoming data
While Chair Powell did say that a single data point would not determine monetary policy, I believe the next two inflation prints before the Fed’s September meeting are extremely important. If the consumer price index continues to trend lower, the market is likely to breathe a sigh of relief, as it can romance an accommodative Fed. However, if inflation data comes in hot, the market will have to contend with a central bank that may not cut as much as anticipated even though the labor market is slowing and a recession is becoming more likely.
A consensus trade has been to position for a yield-curve steepener, i.e., buying front-end bonds and selling long-end bonds, so as to remain duration-neutral. This trade may work well in a slowing economy with a responsive Fed. But if Mr. Powell sticks to his recent approach, this trade could backfire if inflation comes in higher than expected. I would also note that Mr. Powell is unlikely to respond to recent equity market weakness. The Fed typically pivots when high-yield spreads are above 500 bps, a level that is still a ways off. Rather than trimming by 50 bps, the Fed could end its quantitative tightening program immediately in a nod to deteriorating market liquidity. This move would also likely support the back end of global yield curves.
Monthly Market Review — July 2024
A monthly update on equity, fixed income, currency, and commodity markets.
By
Brett Hinds
Jameson Dunn