So Jay Powell made a 1,200-word statement with four footnotes this morning and erased roughly $1 trillion worth of shareholder wealth. There was no real shock here.
Powell knows that there’s another month before he can take his next official swing against inflation. That’s too long a pause for his comfort.
As a result, he reached for the rhetoric, talking tough in order to warn smart actors on Wall Street that we need to check our exuberance. We got ahead of ourselves and now need to cool our wheels.
And the smart money listened. Powell offered us a choice: do this nice and easy now, or endure a rougher ride later in the year.
The Rate Outlook
All Powell really said was what he’s been saying all along. He insists that inflation needs to get back to 2% and I agree with him. To do it, he says, he can’t “pause” or “pivot” while interest rates are in the 2-2.50% zone.
He needs to go all the way to levels where interest starts to restrict the rate at which money moves. That might be above 4% at this point . . . and he suggests that we’re going to get there by the end of next year.
That’s not really news. People have been pretending that next month’s Fed meeting will be the last big rate hike for the foreseeable future, but big money in the futures market tells a different story.
Currently the futures market tells us there’s an even-money chance overnight rates will be a little below 4% by next July. If not, the next-most-likely scenario is that we’ll get at least 1.25 percentage point of tightening along the way.
That’s fairly aggressive. It’s roughly five “small” 0.25 point hikes in the next eight policy meetings . . . or more likely, two big hikes between now and November, and then a possible pause while Powell and company step back and observe the fruits of their labor.
But here’s the thing. Go back to mid-June and expectations were even higher. Back then, two short months ago, the smart money was banking on roughly two additional small tightening moves in the coming year . . . expectations have come DOWN.
The more Powell talks, the less he has to follow up with real rate hikes ahead. Rhetoric is only a drag on sentiment. The yield curve is what actually causes a recession.
Look at what’s happened in the market since June. We survived that rate outlook. From all accounts, we’ve avoided recession.
Maybe we’ll feel differently in November. But for now, we’ve seen that the economy is strong enough to endure interest rates at these levels and even generate significant inflation along the way.
If not for inflation, none of the data points would even point at recession. The job market is as hot as it gets. It needs to cool off. That’s what the Fed is trying to achieve.
Powell says it all. “The labor market is particularly strong, but it is clearly out of balance, with demand for workers substantially exceeding the supply of available workers.”
He’s sacrificed his historical focus on keeping people employed. Inflation is now his top threat. And he isn’t going to stop until unemployment edges up at least a little.
But you can bet that if unemployment surges, he’ll pivot. In the meantime, you need to decide whether you’re more nervous about inflation or recession.
Choose Stagnation Or Inflation
Here’s what I know. Once inflation is back below 2% for an extended period, it’s going to feel really good. We can all breathe easier.
That’s not going to happen before gas prices go negative. And that’s not going to happen before January or February at the earliest.
For inflation to drop from 8% to 2%, perceived “real” economic growth rises about 6 percentage points. It’s going to feel like a boom again, even if it isn’t.
That’s a lot better than living in a boom and not feeling anything but overworked and overheated. But we’re a long way from there.
All Powell can do is cool things off around the oil market. He sees signs of success there. To be honest, I actually thought the Jackson Hole speech was encouraging. He’s making progress.
But it’s going to take time and hard work. We probably won’t know before November. Winter could be hard. After all, winter is the last burst of year-over-year oil shock before current heating prices become the new normal.
I think that’s why the rate outlook essentially peaks out in November. Everything after that is “wait and see.” We might see stagnation. But after that, it’s only another couple of months before energy inflation flatlines.
Three months to November. Two Fed meetings. Maybe the market needs to rewind a few months and try again.
Two months ago, the S&P 500 was 11% below where it is today . . . despite the selling. The NASDAQ was 13% lower. Maybe we went too far.
But the rate outlook was WORSE back then. Maybe it will get a little worse in the coming month. On the other hand, corporate ingenuity will move two months closer to the next earnings report . . . growth will continue, disruption will continue, innovation will continue.
That’s why we invest in stocks, right? Companies get better. They make progress, despite the Fed and everything else that gets in their way. They’re the ones that drive economic growth, and not the other way around.
And here’s the thing. We needed some tough love today to get any hope for the economy at all.
Do the math. If the Fed is committed to pushing overnight rates beyond 4% in the next 18 months . . . or even above 3.50% in the next year . . . long-term rates need to rise in response.
We need to see a healthy yield curve to have any hope of avoiding recession. That means long-term rates are higher than short-term rates. That means long bond yields needed to climb above 3% at least.
But the market is trained to think any move above 3% is disaster for stocks. I don’t think it is. But one way or another, we needed to break that barrier.
Today there’s an inversion in the yield curve between the 3-year rate (3.40%) and the 10-year rate (3.04%). That signals trouble ahead.
A month from now, the short end of the curve will probably hit 3%, give or take a fraction. A year from now, it could easily be above 4% . . . that’s what Powell warned us is coming.
To compensate, the long end needs to come up. Money needs to flow out of bonds. As I’ve said for years, Treasury remains trash until yields are above the inflation rate.
But we don’t invest in bonds. We love stocks here. Dividend stocks for safety and current income. Growth stocks for the long tomorrow.
Don’t get obsessed over the yield curve. Watch your stocks. Nurture your companies.
Let Powell deal with the curve. And if your companies are growing, they aren’t in a recession.
If they’re growing faster than the inflation rate, there’s definitely no reason to look anywhere else. You’re winning in that scenario. Let the rest of the economy tremble.