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The Federal Reserve

Wealth Insights | Economy/Politics

Weekly Market Analysis: The Fed Isn’t Satisfied and the Market Isn’t Listening


3 Things to Know

A soft landing may not be coming

To drive domestic sources of inflation sharply lower, the Fed believes it should persist with restrictive monetary policy. The recent rally in financial markets will only compel the Fed to step up its rhetoric and make it more likely to hold peak rates. In short, this is a lot of medicine for the economy to handle. It makes talk of a soft landing look a bit far-fetched.


 

Summary

The recent rally in financial markets will only compel the Fed to step up its rhetoric and make it more likely to hold peak rates. Though the Fed’s next rate hikes are likely to be “only” 25 basis points, the cumulative power of its medicine is still pumping through the economy. Policymakers are insufficiently patient with the present decline in inflation. In spite of many data points showing inflation abating, the Fed’s focus on a “2%” rate of inflation is narrowing their field of vision. More fiscal restraint in combination with an already slowing economy makes talk of a “soft landing” look far-fetched. While CIO doesn’t expect US employment data to fall until later in the first quarter 2023, CIO sees the recent ISM, retail and housing data as being sufficient to presage a recession that can, for a time, further depress asset prices and weaken credit markets.

Inflation is heading downward

We think more progress in the inflation fight is likely, even if the Fed left rates as they are. Fed officials know that inflation measures lag movements in the real economy, but have chosen to largely look at backward data to justify further action.


 

Portfolio considerations

A recession is on its way. CIO sees signs of it appearing with greater clarity month over month. Expect more market volatility in the US as well as market corrections to return before anticipating a lasting recovery. CIO stands ready to position portfolios more positively when it sees greater resolution of these contradictory Fed and investor views.

 

The Fed wants a rise in unemployment

It appears clear that the Fed wants a rise in unemployment, a clear sign of recession. CIO believes the housing market downturn and surge in consumer goods inventories could result in US job losses in 2023, including services positions that support the goods sector. Wage gains are already decelerating and the total hours of work fell in the past two months.

US services prices vs. private average hourly earnings Y/Y%

Source: Bloomberg as of Jan. 18, 2023. Past performance is no guarantee of future results. Real Results will vary.

 

A soft landing may not be coming

To drive domestic sources of inflation sharply lower, the Fed believes it should persist with restrictive monetary policy. We believe the reduction in US credit supply and demand will drive the first decline in broad money supply since 1948. With rapid reductions in lending to the US bond market (Quantitative Tightening) and the end of Covid related fiscal stimulus, US broad money supply (M2) declined over the course of 2022 and is poised to contract further in 2023. The recent rally in financial markets will only compel the Fed to step up its rhetoric and make it more likely to hold peak rates. In short, this is a lot of medicine for the economy to handle. It makes talk of a soft landing look a bit far-fetched. While CIO doesn’t expect US employment data to fall until later in the first quarter 2023, CIO sees the recent Institute for Supply Management, retail and housing data as being sufficient to presage a recession that can, for a time, further depress asset prices and weaken credit markets.

 

Inflation is heading downward

The Fed’s preferred inflation measure known as “Core PCE Deflator” peaked at a 5.4% pace in 2023 and is now at running at 4.5% year/year. Core PCE likely rose at an annualized pace of just 3.2% in Q4 2022 (December data will be reported on Jan. 27). CIO thinks more progress in the inflation fight is likely, even if the Fed left rates as they are. Fed officials know that inflation measures lag movements in the real economy, but have chosen to largely look at backward data to justify further action. The Fed is narrowly focused on getting inflation, however defined, down to their “hard target” of 2%. A slowdown to the 2% pace is most likely to be hit only in 2024 after a drop in US employment. Sadly, the loss of jobs and economic growth will have relatively little impact on inflation. Stimulus and supply disruptions of the past two years were the primary sources of inflation. CIO’s assessment is that inflation will decelerate and bottom at pre-Covid norms in years to come. While new or worsening supply shocks amid geopolitical conflicts remain the larger exogenous risks, inflation may remain more persistent in a few areas of the US economy.

 

The Fed wants a rise in unemployment

It appears clear the Fed wants a rise in unemployment, a clear sign of recession. CIO believes the housing downturn and surge in consumer goods inventories could result in US job losses in 2023, including services positions that support the goods sector. Wage gains are already decelerating and the total hours of work fell in the past two months. US employment measures in January are particularly difficult to rely on because of seasonal adjustments typical at the start of every year. A “head fake” in the January employment data is likely to demonstrate strong reported job gains. In CIO’s view, the January data – to be released Feb. 3, just after the Fed’s next policy meeting – will show near 200,000 new positions, a level the Fed will consider unsustainably strong. False positives in the data could revive concerns the Fed will continue its “higher for longer” path. Investors presently relieved by the positive signs pointing to slower inflation ahead may find themselves challenged. The wild seasonal swing in employment won’t end in January. US employers typically hire more than a million workers in February, including numerous seasonal positions. With construction industries and business services under downward pressure, CIO believes the US employment recovery will end in the months to come.

 

Portfolio considerations

The Fed is not repeating the monetary mistakes of the 1970s by accommodating ever-higher inflation. Nonetheless, the medicine it has delivered in 2022 and now in 2023 is potent and long-lived. While the Fed will likely slow the size of future rate hikes to just 25 basis points, it’s behaving impatiently claiming that progress on slowing inflation is insufficient. CIO disagrees. Recent market action could imply the worst for the economy has passed. Yet, looking just a few weeks ahead, a likely strong jobs report for January may reignite concerns that the Fed will remain aggressive. Short positions in markets at levels above the Great Financial Crisis period create “buying pressure” when bear market rallies gain speed. And with analysts understating earnings estimates to cushion EPS declines likely to come, the current optimism for a soft landing may be short-lived. A recession is on its way. Expect more market volatility in the US as well as market corrections to return before anticipating a lasting recovery. CIO stands ready to position portfolios more positively when it sees greater resolution of these contradictory Fed and investor views.

Note: Past performance is no guarantee of future results. Real results may vary.