Fed… a classic case of reacting too slowly then doing too much? First 75bps hike since ‘94… was not communicated beforehand and I didn’t think they would surprise like this, but it’s probably the right move, just a little late. Stocks rallied – the Nasdaq rose 2.5 per cent and the S&P 500 was up 1.5 per cent… markets seemed to be saying that being tough on inflation now is good for later… not sure this thesis holds up much but there is a flicker of hope the Fed can get on top of things. Powell’s comments about the next move not necessarily being 75bps but possibly 50bps was taken as a positive – yields down, stocks up. But remember last time he said they were not even discussing 75bps… not a credibility issue for me – credibility comes from making the right policy decisions in the first case.
The Fed is catching up with the market – helpful if the market and the Fed are on the same page as this will reduce volatility and allow for a smoother recovery phase and perhaps an earlier one. European stock markets are sharply lower this morning as the brief relief rally is quickly unwound, crude oil trending lower, rates off the highs from earlier in the week but off their post-Fed lows. US futures have also dropped sharply… yesterday’s rally always looked extremely shaky; stocks should be down on all this CB hawkishness.
The Fed’s dot plot anticipates hitting 4 per cent next year before it pulls back. Is 4 per cent enough? Once inflation goes above 5 per cent it usually needs a lot more, so am not sure 4 per cent gets us there unless there is an horrific recession. The Fed plans on raising rates to 3.4 per cent by year end, whilst also estimate inflation at 5.2 per cent by year end… so real rates are still negative and accommodative… Looking ahead, Powell said that “either a 50 basis point or a 75 basis point increase seems most likely at our next meeting”.
Which leads us to the next question – how much pain is the Fed willing to inflict to get there? Because if it thinks 4 per cent is enough now then can it change its mind and does the market in a few weeks/months start to think ‘hey, actually we don’t think that 4 per cent is enough, we think you need to end at 5 per cent’, then we are back to volatility and downdrafts… right now Fed is hiking fast enough to hit stocks but won’t go far enough to tame inflation… good for gold?
The one thing the Fed is hoping for is that inflation comes down later this year anyway… but that is kind of pinning your credibility on a lot of unknowns… like do we really know how high energy prices could still go? And just how credible is it to say that wages won’t spiral?
Why move more than the 50bps that Powell had guided? One was the hot CPI print last Friday, the other was the jump in UoM consumer inflation expectations – 5yr expectations jumped to 3.3 per cent from 3 per cent. Longer term inflation expectations – as I have consistently warned – are starting to become unanchored. Indeed, they have slipped anchors because inflation is all anyone is talking about and that is hard to combat. They become unanchored not because one CPI print is super-hot, but a cumulative effect of month after month of high, but not necessarily rising inflation; crucially it does not need to keep getting hotter – just get and stay hot – to de-anchor expectations, That, is the new worry for the Fed but it one that has been building for months and been obvious for longer.
The Fed said economic activity has improved since Q1, but the Atlanta Fed GDPNow prediction has fallen again, slipping to 0 per cent for Q2 from 0.9 per cent only a few days ago. As I said a three days ago:
The Atlanta Fed GDPNow model suggests real GDP growth of +0.9 per cent in Q2, down from +1.3 per cent a week ago. Only on May 27th it was at +1.9 per cent, which as I noted last month was low enough to suggest a recession is on the cards since the GDPNow data is always some way out. Four weeks ago it was 2.5 per cent. The initial estimate of first-quarter real GDP growth released by the US Bureau of Economic Analysis on April 28th was – 1.4 per cent, a full 1.8 percentage points below the final GDPNow model nowcast released on April 27th. I think the US is close to recession, defined as two consecutive quarters of negative GDP.
After the Fed statement the spread between 30yr and 10yr Treasury yields inverted for the first time since 2006, suggestive of slow growth for a long time. The Fed acknowledged that taking this approach to inflation makes a soft landing a lot harder. Seems impossible to avoid recession now – and that suggests the earnings pillar that is holding up the S&P 500 will crumble.
It all comes back to the central argument about whether the Fed would suck the liquidity out of the system as quickly as it injected it. The answer was always going to be ‘no’ and that was always going to lead to inflation getting out of hand. They should have started tightening early last year.
And why not just hike all the way to the terminal rate – 3.75-4 per cent in one go, rather than waiting? This would be hugely destructive to a lot of asset classes as liquidity would literally evaporate – markets would convulse. And they’d just need to reverse it soon after – a path of forward guidance is the only credible option.
What does it mean for the Bank of England, which delivers its latest policy statement today? Another 25bps is fully anticipated – anything more has seemed unlikely since the MPC is extremely worried about tightening leading to recession. But… with the bold move by the Fed, there is probably a higher chance we see 50bps – three voted for it last time and a fourth might be enough if the remaining five are split between 25bps and doing nothing. I would not be surprised if the BoE voted for 50bps.
Deutsche Bank is out with a note saying that the ECB’s new anti-fragmentation tool, as underwhelming as it looks right now, will allow it to hike rates by 50bps three times this year… still the tide is going out fast and the naked swimmers are being revealed – QE papered over trouble like high debt-to-GDP ratios. And even if you keep spreads tight, funding costs are still going to rise just as economic growth stalls.
Even the Swiss National Bank is getting in on the action, raising rates by 50bps – the first hike since 2007! Swissy catching bid on the move with EURCHF sinking under 1.02 from 1.04 earlier this morning. Inflation is not the problem in Switzerland that it is elsewhere, but we did think the SNB would use the cover of other CBs raising rates to do the same.
Neil Wilson is the Chief Market Analyst at markets.com