Don't Count on a Fed Pivot

The market-friendly Fed we grew accustomed to over the last few decades is not driving the ship anymore. Yesterday's investment strategies will prove flawed if a new inflation-minded Fed is at the wheel.

Of course, you can ignore the realities of today's high inflation and take Jim Cramer's ever-bullish advice:

When the Fed gets out of the way, you have a real window and you've got to jump through it. … When a recession comes, the Fed has the good sense to stop raising rates," the "Mad Money" host said. "And that pause means you've got to buy stocks.

Shifting market expectations

On June 10, 2022, the Fed funds futures markets implied the Fed would raise the Fed funds rate to 3.20% in January 2023 and to 3.65% by July 2023. Such suggests the Fed would raise rates by almost 50 basis points between January and July.

Now the market implies the Fed funds will be 3.59% in January, up .40% in the last two months. However, the market implies July Fed funds will be 3.52%, or .13% less than its January expectations. The market is pricing in a rate reduction between January and July.

The graph below highlights the recent shift in market expectations over the last two months.

The graph below from the Daily Shot shows compares the market's implied expectations for Fed Funds (black) versus the Fed’s expectations. Each blue dot represents where each Fed member thinks Fed Funds will be at each year end. The market underestimates the Fed's resolve to increase interest rates by about 1%.

Short-term inflation projections

The biggest flaw with pricing in a stall and Fed pivot in the near term is the possible trajectory of inflation. The graph below shows annual CPI rates based on three conservative monthly inflation data assumptions.

If monthly inflation is zero for each month through the remainder of the year, which is highly unlikely, CPI will only fall to 5.43%. Yes, that is much better than today's 9.1%, but it is still well above the Fed's 2.0% target. The other more likely scenarios are too high to allow the Fed to halt its fight against inflation.

Inflation on its own, even in a rosy scenario, is not likely to get the Fed to pivot. However, economic weakness, deteriorating labor markets, or financial instability could change their mind.

Recession, labor, and financial instability

GDP just printed two negative quarters in a row. Some economists call that a recession. The NBER, the official determiner of recessions, also considers the health of the labor markets in their recession decision-making.

The graph below shows the unemployment rate (blue), recessions (gray), and the number of months the unemployment rate troughed (red) before each recession. Since 1950, there have been 11 recessions. On average, the unemployment rate bottomed 2.5 months before an official recession declaration by the NBER. In seven of the 11 instances, the unemployment rate started rising one or two months before a recession.

The unemployment rate may start ticking up shortly, but it is at a historically low level. At 3.5%, it is well below the 6.2% average of the last 50 years. Of the 630 monthly jobs reports since 1970, there are only three other instances where the unemployment rate dipped to 3.5%. There are zero instances since 1970 below 3.5%!

Despite some recent signs of weakness, the labor market is historically tight. For example, job openings slipped from 11.85 million in March to 10.70 in June. However, as I show below, it remains well above historical norms.

A tight labor market that can lead to higher inflation via a price-wage spiral is of concern for the Fed. Such fear gives the Fed ample reason to keep tightening rates even if the labor markets weaken. For more on price-wage spirals, please read my article Persistent Inflation Scares the Fed.

Financial stability

Besides economic deterioration or labor market troubles, financial instability might cause the Fed to pivot. While there were some growing signs of financial instability in the spring, those warnings have dissipated.

For example, the Fed pays close attention to the yield spread between corporate bonds and Treasury bonds (OAS) for signs of instability. They pay particular attention to yield spreads of junk-rated corporate debt as they are more volatile than investment-grade paper and often are the first assets to show signs of problems.

The graph below plots the daily intersections of investment grade (BBB) OAS and junk (BB) OAS since 1996. As shown, the OAS on junk-rated debt is almost 3% below what should be expected based on the robust correlation between the two yield spreads. Corporate debt markets are showing no signs of instability!

Stocks, on the other hand, are lower this year. The S&P 500 is down about 15% year to date. However, it is still up about 25% since the pandemic started. More importantly, valuations have fallen but are still well above historical averages. So, while stock prices are down, there are few signs of equity market instability. In fact, the recent rally is starting to elicit FOMO behaviors so often seen in speculative bullish runs.

Declining yields, tightening yield spreads, and rising asset prices are inflationary. If anything, recent market stability gives the Fed a reason to keep raising rates. Ex-New York Fed President Bill Dudley recently commented that market speculation about a Fed pivot is overdone and counterproductive to the Fed's efforts to bring down inflation.

What does the Fed think?

The following quotes and headlines have all come out since the late July 2022 Fed meeting. They all point to a Fed with no intent to stall or pivot despite its effect on jobs and the economy.

• *KASHKARI: 2023 RATE CUTS SEEM LIKE `VERY UNLIKELY SCENARIO'
• Fed's Kashkari: concerning inflation is spreading; we need to act with urgency
• *BOWMAN: SEES RISK FOMC ACTIONS TO SLOW JOB GAINS, EVEN CUT JOBS
• *DALY: MARKETS ARE AHEAD OF THEMSELVES ON FED CUTTING RATES
• St. Louis Fed President James Bullard says he favors a strategy of "front-loading" big interest-rate hikes, repeating that he wants to end the year at 3.75% to 4% – Bloomberg
• FED'S BULLARD: TO GET INFLATION COMING DOWN IN A CONVINCING WAY, WE'LL HAVE TO BE HIGHER FOR LONGER.
• "If you have to cut off the tail of a dog, don't do it one inch at a time."- Fed President Bullard
• "There is a path to getting inflation under control," Barkin said, "but a recession could happen in the process" – MarketWatch
• The Fed is "nowhere near" being done in its fight against inflation, said Mary Daly, the San Francisco Federal Reserve Bank president, in a CNBC interview Tuesday. –MarketWatch
• "We think it's necessary to have growth slow down," Powell said last week. "We actually think we need a period of growth below potential, to create some slack so that the supply side can catch up. We also think that there will be, in all likelihood, some softening in labor market conditions. And those are things that we expect...to get inflation back down on the path to 2 percent."

Summary

I am highly doubtful that the Fed will pivot anytime soon. Supporting my view is the recent action of the Bank of England. On August 4,, it raised interest rates by 50 basis points despite forecasting a recession starting this year and lasting through 2023. Central bankers understand this inflation outbreak is unique and were caught off guard by its persistence.

The economy and markets may test their resolve, but the threat of a long-lasting price-wage spiral will keep the Fed and other banks from taking their foot off the brakes too soon.

Inflation will start falling in the months ahead, but it hasn't even officially peaked yet.

Michael Lebowitz has been involved in trading, portfolio construction, and risk management involving some of the largest and most active portfolios in the world. In addition to broad institutional experience, he also built a successful independent RIA allowing him to further extend his experience into the realm of investment management for individuals and family offices. Grounded in logic and common sense, he blends vast trading and investment expertise with economic viewpoints that delivers pragmatic and actionable thought leadership to clients.

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