Crypto News: ‘Don’t fight the Fed’ will be Powell’s message

The Federal Reserve seems destined to downshift its rate hike cadence, confirming the market view that the central bank will get even more dovish as 2023 progresses. But that interpretation of the coming Federal Open Market Committee meeting is a mistake. The Fed may prove more determined on inflation than markets expect — which means the easy gains are already behind us for the year.

When we polled investors last week, more than half agreed with DoubleLine Chief Investment Officer Jeffrey Gundlach that they'd rather watch the bond market than listen to what Fed officials are saying about the central bank's path. Since the bond market is suggesting monetary policy will be a lot easier than officials are, we have a classic case of financial markets fighting the Fed.

I expect Fed Chair Jerome Powell to push against that narrative tomorrow in his post-FOMC press conference. The question, though, is whether he pushes hard enough. Will markets believe him now, if they haven't believed him yet? My answer is no — which ultimately means that only a Fed staying the course in the back half of 2023 will get markets to come around to the Fed view.

The tricky part in all of this is the data. After an unprecedented worldwide pandemic work stoppage and probably the largest government stimulus during peacetime, we have no idea what lies ahead for growth and for inflation. That's what will drive Fed policy. In the meantime, after only one month, I think the easy gains for 2023 are done. Both stock and bond markets will have a much tougher time from here.

So far this year, equity investors have been gleefully betting 2023 will be a banner year after last year's slump. It's not just an earnings story either, but a shift in sentiment due to positive economic data.

Tesla has gained over 30% this year, even after yesterday's 6% rout. And if you look at a lot of other high-beta shares it's the same or better. Coinbase is up 59% while debt-strapped Carvana has more than doubled. Even amongst large-cap tech, we've seen eye-popping gains — Netflix, Amazon, Meta Platforms, Micron Technology and Nvidia are all up more than 20%.

The interesting bit is long-dated Treasury bonds have had a stellar January too. The 10-year yield fell from 3.87% at the start the year to 3.51% early Tuesday. Fed funds futures are pricing in two rate cuts before the year is out. That might seem like a portend of recession — which is bad for earnings. Still, equities are trading on the reduction in discount rates, not the recession signal. Despite the Fed's promise of more rate hikes, financial conditions have recently been the easiest in nearly a year.

That's the power of expectations, overriding policy and confirming what Jeffrey Gundlach is saying about believing markets over Fed officials.

The easing of financial conditions is what makes this coming Fed meeting and press conference so important. Financial conditions have been easing since October on the back of what can be called peak hawkishness. Long-term yields peaked when the Fed stopped surprising markets with the promise of tightening and began pledging to stay the course they had already mapped out. But it was only in January that peak hawkishness flipped to easy financial conditions, with the Bloomberg US Financial Conditions Index moving into positive territory three weeks ago.

Now, at the coming FOMC, we're at crossroads in understanding what the Fed is trying to tell us. On the one hand, the market is up so much it means the Fed is actually easing policy. On the other hand, we learned early this year in the Fed minutes from December that central bank officials were concerned about "an unwarranted easing" in financial conditions, especially if driven by a misperception by the public of the committee's reaction function. They said that "would complicate the committee's effort to restore price stability."

If the Fed steps down to a 25-basis point rate hike today, as is universally expected, it will effectively endorse the so-called "unwarranted easing in financial conditions" we have seen that has pushed up all asset prices including stocks, bonds, commodities, and crypto. No wonder people are fighting the Fed.

16%

The gain from the October 2022 lows in shares of TLT, the ETF tracking gains in the longest duration Treasury bonds

I'd argue you can forget all about what Powell has to say Wednesday. It won't matter. Sure, it could have a minor short-term effect. But the market has proven impervious to previous hawkish Fedspeak. And, with the Fed likely to endorse the market view of a step-down despite easy financial conditions, why would that change?

I think it changes over time. And the basis is through two highly uncertain variables — employment and inflation — which the Fed is watching to calibrate its policy. Right now, the employment picture looks good. The unemployment rate is at a five-decade low and initial jobless claims are running below a meager 200,000.

But we get benchmark revisions to all the data from 2022 on Friday. That could change the picture. What's more, even though initial claims for unemployment insurance are low, bolstering the view of a strong employment picture, continuing claims have surged by 300,000 in the last three months. We could be on the cusp of a fading as the job cuts in the tech industry weaken the broader economy and seep into employment weakness elsewhere.

On the inflation front, inflation is coming down, particularly in the price of goods and housing. But the Chinese re-opening should add additional price pressure on goods. And core services inflation outside of housing remains sticky. Bloomberg Chief US Economist Anna Wong recently noted that Powell watches core services excluding housing rents as the metric that tells him where inflation is headed. In a note on Dec. 27, Wong noted:

It rose 0.3% in December (same as prior), corresponding to an annualized 4.1% pace. On an annualized 6-month basis, it has been steady at about 4% for the past 12 months, in comparison to an average of 2% before the pandemic.

That tells me inflation remains too high for the Fed's liking while employment looks pretty good. Unless that basic picture changes, the Fed is unlikely to lower interest rates. Instead, as officials have repeated ad nauseum, they will raise rates a few more times and hold to observe the impact of the large cumulative tightening.

What moves the Fed from that view to the market's view? I don't think it's employment given how low the numbers are. To give us a sense of how much unemployment would have to rise, let's think about recessions. Outside of the Great Financial Crisis and the pandemic, the greatest six-month increase in unemployment was 1.6% in 1980, a deep recession. That would take us to 5.1%. But in the early 1990s and early 2000s, the rise maxed out at 1.2%. An equivalent rise would take us to 4.7% unemployment. I question if that is high enough to get the Fed to lower rates in the absence of declining inflation.

As for inflation, we are running at a 4% annual pace on core services excluding housing. That's double the Fed's 2% target. Only a spate of deflation gets us to that target anytime soon. Say we had a recession and that number got down to 3% while the unemployment rate rose to 4.7%. Would the Fed cut with inflation well above target? I doubt it.

Either the Fed has a lot lower inflation hurdle than I suspect or the market has gotten way ahead of itself. I expect the Fed to raise rates to 5 or 5.25% and then hold through 2023. And I expect the market to slowly come to that conclusion as the data come in, confirming core inflation remains too high.

Let's remember that the penalty for the bond market's being wrong on rates is not severe. We're talking about a half percentage point here. That's a lot less than the rate hikes the market had to digest in 2022. The bigger question is for equity markets because of both earnings and discount rates.

The S&P 500 began Tuesday just over 4,000. That's a level that will come under threat as margins erode due to still high inflation (think Caterpillar) and revenue growth challenges (think Microsoft and Intel). And then you have the marginally higher discount rate on top of it.

Nothing about the Fed's policy announcement prevents the market from eking out a few gains in the coming weeks and months. But the easy gains were in January. Investors we polled actually expect the S&P 500 to retest lows under 3,600 later this year. Let's wait until 2024 for the all clear.

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One more thing since I wrote you last week on tech. The sector's layoffs in the US have already topped 100,000. Do you agree with Bank of America analysts, who say that the sector is still bloated? What about the impact of AI, especially systems like ChatGPT — is that a threat to white-collar jobs, or a good investment opportunity? Share your views in our latest MLIV Pulse survey.

"Powell wants to write his own page in the history books as someone who, unlike Burns, did not blink and reverse too soon, and, unlike Volcker, did not intentionally cause a recession"

Vincent Reinhart

Chief Economist at Dreyfus - BNY Mellon

Powell doesn't want to be either Burns or Volcker.
On the inflation front, lower house prices should help.
But some think the next big inflation threat is looming in China.
At Davos, the taboo word was stagflation.
Morgan Stanley thinks this year's rally is a reflection of seasonal effects and short covering.
We're only now back to 50% office occupancy. That's crazy.

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