Since June, the market has rallied on the expectation of a “political pivot” by the Federal Reserve. However, those hopes were dashed each time when Jerome Powell clarified that the “fight against inflation” remained the main objective. Mr. Powell made this point clear after the latest FOMC announcement.
“The question of when to moderate the pace of increases is now much less important than the question of how far to raise rates and how long to maintain tight monetary policy.”
Before the pandemic, the Fed’s scenario was to let inflation soar rather than let inflation stay too low for too long. This makes sense because inflation is easily managed by raising rates and slowing the economy. Deflation is a much different story, as it becomes an ingrained psychological impact that becomes difficult to dislodge.
Today, Powell says the Fed’s concern is entrenched inflation causing pain in the economy.
The reality is that inflation is not the problem.
If the Fed did nothing, “High prices will cure high prices.” The real risk remains a “deflationary” spiral that depresses economic activity and prosperity. Deflation is a much more insidious problem than longer-term inflation.
This is why, over the past decade, the Fed has flooded the economy with cash and zero interest rates to stimulate economic activity. The graph below shows periods when inflation has been above or below the average inflation rate starting in 1982. Since “Great financial crisis” inflation has always been well below this average and even below the Fed’s 2% target rate.
While monetary interventions and zero interest rates failed to generate organic growth above 2% per year, they raised asset prices, inflated asset bubbles and increased wealth inequality.
What is important to note is that since the turn of the century, the results have not been positive every time the Federal Reserve has launched an aggressive rate hike campaign. Notably, the Fed is well aware of this but no longer fearful of creating economic havoc. As Powell recently stated,
“If we tighten too much, we can support economic activity.”
In other words, for bulls hoping for a “pivot,” Powell clarified that a “political pivot” arrived. It’s just a function of time until it becomes clear that something is breaking in the economy and bailouts are needed.
The political pivot arrives
One of Jerome Powell’s interesting comments was the “The window for a soft landing for the economy was shrinking.” This confirms what we already know that the Fed is beginning to realize the risk of a “hard landing” becomes higher and higher.
This leaves only two paths for monetary policy. The first option is for central banks to suspend rates and let inflation run its course. This would potentially lead to a soft landing for the economy but theoretically anchor inflation at higher levels. The second option, and the one chosen, is to raise rates until the economy slips into a deeper recession. Both trajectories are bad for stocks. The latter is much more risky because it creates an economic or financial situation “an event” with more serious consequences.
Although the US economy has absorbed tighter financial conditions so far, that doesn’t mean it will continue to do so. The story is pretty clear on the results of higher rates combined with a rising dollar and inflationary pressures.
Naturally, once the Fed’s aggressive rate hike campaign “breaks” something, the “political pivot” to arrive at. This will happen when it is realized that inflation has now become a “disinflationary” wave in the economy. As Michael Wilson recently noted:
“M2 is now only growing at 2.5% per year and falling rapidly. Given the main properties of M2 for inflation, the seeds have been sown for a sharp decline next year. The implied CPI decline depicted would be strongly off-consensus, and while it won’t necessarily play out exactly, we believe it is directionally correct.. We are closer today [to a ‘policy pivot’] because M2 growth is rapidly approaching zero and the 3-month to 10-year yield curve finally inverted last week, which Chairman Powell noted is important in determining whether the Fed has any does enough.“
Since the surge in inflation was caused by increased demand due to “timmy checks” in the face of a drastic drop in supply as the government shut down the economy, the reversal of these dynamics is disinflationary. Notably, inflation will fall in 2023 much faster than the Fed expects, leading to a “pivot of politicsthe bulls continue to hope.
However, bulls may not like what they get.
Bulls may not like the “pivot”
The bullish expectation is that when the Fed finally makes a “policy pivot” it will end the bear market. While this expectation is not wrong, it may not happen as quickly as bulls expect.
Historically, when the Fed cuts interest rates, it’s not the end of stocks “bear markets” but rather the beginning. This is shown in the table below of previous “The Fed is pivoting.”
In particular, the majority of “bear markets” occur AFTER the Fed decision political pivot.
The reason for this is that the political pivot comes with the recognition that something has broken either economically (aka “recession”) or financially (aka “credit event”). When this event occurs and the Fed initially takes action, the market reprices economic growth rates and lower earnings.
Currently, forward estimates of earnings and profit margins remain high. The gap between the producer price and consumer price indices remains problematic. Historically, this suggests that producers will absorb inflation, eroding profit margins as consumer demand deteriorates due to inflationary pressures.
This is what Michael Wilson also concluded:
“Bottom line, inflation has peaked and is expected to fall faster than expected, based on M2 growth. This could temporarily relieve stocks in the short term as rates fall in anticipation of the change. Combining this with the persuasive techniques, we think the current S&P 500 rally has legs at 4000-4150 before reality decides how far 2023 EPS estimates need to go.”
Once the reversion is installed, the Fed cuts rates to zero and restarts the next “Quantitative easing” program, such will begin the next bull market cycle.
We will definitely want to buy this opportunity when it presents itself.
Our warning is that bulls may try early to “to buy” the first one political pivot.
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