The market doesn’t know what to make of an optimistic Fed. Last week the Federal Reserve’s Federal Open Market Committee (FOMC) met and raised interest rates by 0.25 percent as expected. Then, something strange happened: Jerome Powell started talking and was actually optimistic. The Fed recognizes that the “disinflationary” process has begun. Inflation is still high, but the rate is coming down.
This is happening without the economy going into a recession. In fact, last Friday the Employment Situation Report revealed the economy created 517,000 jobs in January. Powell was clearly stating his optimism that inflation can come down without a job-killing recession. The stock market rose on the news, and if all one ever looks at is the headline index return, then all is well.
However, as I have often stated, the real story is not in the headline number – it is in the action underneath. The stocks that rallied were the large technology stocks that the market now sees as defensive. Traders buy these stocks because they believe the economy will be weak, and these companies are believed to be able to grow even if the economy is weak.
The bond market followed suit, with interest rates on longer term Treasuries dropping. In other words, while Powell gives the most optimistic speech since his “inflation is transitory” talks, the market takes this as a signal that we are heading to a recession. This makes no sense, as the data show the very opposite.
Enter the spin machine. This week the pundits have come up with another story: They now say this market reaction shows that the market believes we are headed for a low interest rate, low-growth environment, and that is why longer rates dropped and tech stocks led the way.
The only issue with that theory is that with all the positivity, Powell was clear on one thing: The Fed is not stopping its rate hikes. “Further Fed rate increases are needed,” he has said repeatedly. We are not about to enter a low-rate environment unless the Fed cuts rates after inflation is back down to its target of 2 percent.
I suppose the idea here is that the Fed raises rates to get inflation under control and once that job is done, they will then lower them back. That makes sense, except it never happens that way. Granted we have had more experience over the last 30 years with the reverse – the Fed lowers rates to fight a recession, and once the economy is growing again, they go back to “normal.” That hasn’t happened – they never go back to “normal.” In fact, that not happening is part of why we are in this inflationary mess: the Fed pulled out all the stops during the reaction to the pandemic and never went back to “normal.” This was after a decade-plus of not going back to normal after the 2008 financial crisis.
If we get the slow-but-steady growth that the pundits are now calling for, then the Fed would have exactly zero incentive to lower rates. They never raised rates simply because the crisis was over; why would they lower them just because the crisis is over? The only way rates are coming back down in the future is if the Fed goes too far and puts us into a recession.
So, what is going on? I can’t really tell you in regard to the bond market; they are usually the smart ones, and their actions over the last week are puzzling. It may be as simple as we tend to read too much into the predictive power of longer-term rates.
The stock market is clearer to me. Tech stocks are the most beaten up, and if people believe we are finally in a lasting rally, then they are likely to bounce back first. If that is the case, then it will not last. What leads the way down almost never leads the next bull market.
It is early yet, but most economists are predicting negative GDP growth this quarter. The Atlanta Fed’s GDPNow, which is based on actual current data, says we are growing at a little more than 2 percent. There is still too much negativity in the market, and they either do not believe Powell or think he is wrong to be optimistic (fair enough, given his track record).
So where does all this leave us? While I personally find this saga fascinating, the confusion and mixed signals are really just reminders that the prudent way to make investment decisions is from the bottom-up. It is much easier to predict a positive future for a specific company than it is to figure out when the next recession will come and what interest rates will be ten years from now.
Still, it is amusing to see the pundits get it wrong and then change their tune as if they had never said what you just heard them say. Markets often act strangely in the short term, but they tend to get it right over time. Powell’s optimism was the only thing that made sense last week. We still have a long way to go, but so far so good for 2023.
Warm regards,
Chuck Osborne, CFA
Managing Director
