The Federal Reserve on Wednesday raised interest rates by another 75 basis points despite acknowledging that economic growth is clearly slowing. The central bank, under Powell, reiterated that the path of least resistance is well-represented by the so-called dot plot: More hikes ahead — all the way to a fed funds rate of 3.75%!
And yet, the stock market has staged a humongous rally, led by the most valuation-sensitive and risk-sentiment-driven asset classes: Nasdaq stocks COMP, +1.08% and crypto.
So … what the heck?!
It all boils down to how one single sentence was able to affect the probability distributions that investors were projecting for different asset classes.
Does it sound complicated? Bear with me: it’s not!
Why did stocks rally?
When the FOMC’s press release was published, it looked like business as usual: A well-telegraphed 75-bp hike with the only small surprise represented by an unanimous vote despite clear acknowledgment that economic growth is softening.
But not even 15 minutes into the press conference, the fireworks went off!
In particular, when Powell said: ‘‘We are now at levels broadly in line with our estimates of neutral interest rates, and after front-loading our hiking cycle until now we will be much more data-dependent going forward.’’
This is very important for several reasons-
The neutral rate is the prevailing rate at which the economy delivers its potential GDP growth rate — without overheating or excessively cooling down. With this 75-bp hike, Powell told us the Fed just reached its estimate of a neutral rate and, hence, from here they aren’t contributing to economic overheating anymore. But that also means any further increases are going to put the Fed in an actively restrictive territory. And the bond market knows that every time the Fed became restrictive in the past, they ended up breaking something.
Until Wednesday, you could be completely sure that the Fed would have just pressed on the accelerator — inflation must come down; no space for nuance. So journalists asked questions to find out something about the ‘‘new’’ forward guidance. It went roughly like this:
Journalist: ‘‘Mr. Powell, the bond market is pricing you to cut rates starting in early 2023 already. What are your comments?’’
Powell: ‘‘Hard to predict rates six months from now. We will be fully data-dependent.’’
Journalist: ‘‘Mr. Powell, due to the recent bond and equity market rally, financial conditions have eased quite a lot. What’s your take?’’
Powell: ‘‘The appropriate level of financial conditions will be reflected in the economy with a lag, and it’s hard to predict. We will be fully data dependent.’’
He did it. He totally ditched forward guidance. And what happens when you do so? You give markets the green light to freely design their probability distributions across all asset classes without any anchor — and that explains the gigantic risk rally — as well as the jump in the broader S&P 500 SPX, +1.21%.
Let’s see why-
If the Fed is so data-dependent, and there is basically one data they care about, it all boils down to how inflation will evolve in the near future — and the bond market has a very strong opinion about that. Using CPI inflation swaps, I calculated the one-year forward, one-year inflation break-evens — basically, the expected inflation between July 2023 and July 2024, which is represented in the chart above and sits at 2.9%. Remember that the Fed targets (core) PCE, which tends to historically be 30-40 bps below (core) CPI: Essentially, the bond market expects inflation to slow very aggressively and roughly hit the Fed’s target in the second half of 2023 already!
So if the Fed is not nearly on autopilot anymore, and markets have a strong opinion on inflation and growth collapsing, then they can also price all other asset classes around this base case scenario. It starts to be more clear now, right? This is what my Volatility Adjusted Market Dashboard (VAMD — here’s a short explainer) showed soon after Powell enunciated that one single sentence.
https://www.marketwatch.com/story/the-fed-vowed-to-crush-inflation-with-higher-rates-then-the-stock-market-rallied-heres-why-its-not-good-news-11659037159?mod=home-page
