I’ve had a few clients ask me about the stock market swings this week. First, we had the 700-point rally in the Dow on Wednesday, and then on Friday the market opened down over 300 points. I’m guessing some of you may have wondered the same thing, so I wanted to share my thoughts.
For most of 2022, the day-to-day gyrations of the market can be boiled down to inflation expectations and what the Federal Reserve said or did, and this week was no exception.
On Wednesday Fed Chairman Powell gave a speech at the Brookings institute, and obviously the market responded well to it…but why?
First let’s back up.
For much of the summer and fall, the Fed has been beating the drum to: “We will continue to raise aggressively. We cannot allow inflation to become entrenched.” The debate about how high the Fed will go led to discussions around the so called “terminal rate” which is the term used to describe where rates will be when the Fed finally stops raising.
But just how aggressive would they be? Well, just a few weeks ago the St Louis Fed President (James Bullard) was out talking about how they may have to raise rates until the Fed funds rate hits as high as 7%. To get that high from the current 4% rate, we’d have to see FOUR more hikes of 75 basis points, and remember- we started 2022 at 0%.
Here’s the argument for +7% Fed Funds rate: the Fed may have doubts about its ability to forecast inflation (see last summer when they kept telling us it was transitory), they keep expecting inflation to subside (and it hasn’t really) and meanwhile the economy keeps chugging along and the labor market (a major source of inflation) hasn’t shown any signs of slowing down enough.
Even though the last inflation report showed inflation trending lower, the rate is still far above their 2% target and so investors and analysts alike have been taking them at their word. In a vacuum, higher interest rates=slower economy=weaker job growth=lower earnings=lower inflation. For investors, lower earnings historically lead to poor stock market performance. I’m obviously simplifying this a lot, but with every rate hike to bring down inflation, economic growth could suffer, and that’s what the Fed wants!
Over the summer, even with inflation roaring, we started to see a shift in mindset with some analysts on Wall Street. Some folks started to say that perhaps the Fed was going to overtighten, meaning they raised rates far TOO high and TOO quick. We know that there’s a lag between when the Fed hikes rates, and when those hikes are felt in the economy. Some believe it could be as much as a 12-month lag. Headline inflation is measured year-over-year, but some of the data (gas prices, for example) showed that inflation was subsiding.
The grumblings in October were that “if” the Fed continues to hike 75 basis points at a clip (as they have been), due to the lag effect of those rate hike impacts, they may crush the economy by over-tightening.
Think about the last time you had a headache, and you took Advil. If, after 5 minutes, you still have a headache, you wouldn’t just go pop another 2-3 pills and then after 10 minutes, do it again. If you did that, you’d be ignoring the lag between the impact of the first dose and feeling better AND you’d run the risk of doing serious damage by taking so many pills in such a short period of time.
Back to Wednesday’s speech. During Powell’s speech he said: “a substantial majority of participants judged that a slowing in the pace of the increase would likely soon be appropriate.” This comment (amongst many others, to be honest) was an admittance that the Fed is considering slowing the pace of rate hikes. It was also an admittance that they are cognizant of the potential risk of over tightening. And lastly, to a certain extent, (given what you may think of the reputation of the Federal Reserve) it’s a sign that they are beginning to think the inflation dragon is being slayed.
This does NOT mean they won’t continue to raise rates. In fact, if I had to guess, I would predict that we will see a 50-basis point hike in December, followed by 25 in January, and then a pause. So, on Wednesday, the market was reading into Powell’s comments with confidence that the Fed should start to slow down on rate hikes, and that lowers the risk of crashing the economy.
With that seemingly good news, then why did the market open down so much Friday morning?
One word: Jobs.
Friday saw the release of the latest jobs report, and we saw that more jobs were added than expected AND the hourly pay data also jumped a fair amount higher than expected. For the average American this is good news: jobs are plentiful and we’re all getting paid more to do them. However, we’re in a period where “good news” for the economy is “bad news” for the market. This hot employment number is a sign that inflation has not been fully tamed. Remember, the Fed wants to see a slower job market. The Fed does not want to see people getting healthy raises, because like it or not, those things feed the inflation beast. So when the Jobs report came out Friday morning hotter than expected, the stock market quickly swooned because at the most basic level “maybe a 75 basis point hike is back on the table” and by extension “maybe the Fed isn’t going to slow down their aggressive stance.”
In my opinion, I still believe the Fed will slow down their rate hikes. The next inflation report will come out on December 13th, which is the start of the two-day Fed meeting. Yes, that means I’m assuming the inflation report shows a continued slowdown with inflation. I think Powell’s speech this week will prove to be the correct analysis. Essentially it was admittance that inflation isn’t dead yet, but it’s on the ropes and the pace of hikes isn’t as warranted anymore. We shall see if I’m right soon enough.
Derek Amey serves as Partner and Co-CIO at StrategicPoint Investment Advisors in Providence and East Greenwich. You can e-mail him at damey@strategicpoint.com.
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