As Fed Chairman Jerome Powell wrapped up his two-day congressional hearing on June 23, he reiterated his commitment to fighting the . He said:
“We really need to restore price stability…because without it we cannot have a sustainable period of maximum employment where the benefits are very widely distributed. It’s something we have to do, we have to do it.”
As a result, Powell realizes that persistent periods of unanchored inflation are far worse than an impending recession.
Reuters press release
Additionally, he added:
“We don’t have precision tools, so there is a risk that unemployment will go back up, from a historically low level however. A labor market with 4.1% or 4.3% unemployment is still a very strong job market.”
Powell on the prowl
Thereby, Powel is laser-focused on fighting inflation. Remember, I’ve warned many times that letting inflation rage would be the worst long-term outcome for the US economy. In a nutshell: becoming dovish would hurt commodity traders and encourage them to raise prices even further.
As a result, Powell must follow through on his hawkish threats or progress will reverse and he’ll be right back at square one. However, he looks like a man who realizes that fighting inflation is the only plausible path. Moreover, one hike will not be enough to discourage future rate hikes.
Reuters press release
Supporting this argument, Fed Governor Michelle Bowman said on June 23:
“Inflation data shows that after moderating slightly for a short period, motor vehicle price increases resumed, energy prices rose sharply in May and food prices rose. more than 10% compared to a year ago.”
“An important factor that we often emphasize in driving today’s spending decisions and inflation outlook is future inflation expectations (…). If expectations significantly exceed our 2% target, it would be harder to change people’s perceptions about the duration of high inflation and potentially harder to get inflation under control.
“As we see surveys like Michigan’s pointing to higher long-term inflation expectations, we need to pay close attention and continue to use our tools to fight inflation before these indicators take hold. rise further or higher inflation expectations take root.”
Therefore, Bowman expects rate hikes of “at least” 75 and 50 basis points in the next “few” FOMC meetings.
Source: US Fed
Regarding his second point, remember what I wrote on June 16 after the FOMC meeting?
The most important quote from the press conference came when Powell was asked: is 3.8%-4% [federal funds rate] do the job and break the back of inflation?
He has answered:
“I think we’ll find out when we get there. You would have positive real rates and falling inflation. I think you would have positive real rates across the curve.
So Powell confirmed what I’ve been warning about for months: the Fed needs higher real yields to rein in inflation.
The fundamentals of the day were clear:
- The FOMC raised its median rate hike forecast to ~14 in 2022.
- Powell wants higher real interest rates.
- Letting inflation rage is “not an option”.
- The FOMC “widely” wants a “moderately restrictive” policy by the end of 2022.
Therefore, although I have said this repeatedly throughout 2021 and 2022, the fundamental medium-term outlook for Prime Ministers continues to deteriorate.
So, while Powell and Bowman delivered a new dose of reality to the financial markets on June 23, it is the turn of commodities to suffer. On the other hand, interest rates have recovered and short-term interest rates have fallen.
However, billionaire hedge fund manager Bill Ackman, who has been sounding the inflation alarm for months, wrote on June 23:
“Despite [Fed officials’] Coordinated comment, the bond market ignored these statements, leading to a massive drop in short-term rates since the Fed meeting. A prediction: the Fed is serious. Powell and the governors care about the American people, our economy and their legacy.
“Powell doesn’t want to be known as a worse president than Arthur Burns. The Fed will raise rates by 75 basis points or more in July and 50 basis points or more in subsequent meetings and won’t stop until it’s clear and convincing that inflation is back down to 2. %. [Federal funds rate] FF of 5% or more next year is in the cards.
Accordingly, Ackman shares our view that an accommodative pivot would be extremely detrimental to the US economy. Of course, this may provide financial markets with a short-term sugar spike.
However, the long-term consequences of unaffordable food, shelter, gasoline, and other basic necessities would lead to social unrest. Therefore, investors do not realize that they are not the most important variables in this equation.
Tweet by Bill Ackman
With the “bad news is good news” team in full force on June 23, the general stock market rallied. Additionally, equities outperformed as the weaker economic outlook crushed commodities and increased the appeal of high-multiple growth stocks. Additionally, the change in positioning was boosted by a weak PMI impression.
For example, S&P Global released its US on June 23. The overall index fell from 53.6 in May to 51.2 in June. Additionally, as production continues to increase, the report states:
“The decline in the index signaled a further easing in the rate of expansion of business activity at a significantly slower pace than the recent peak in March. Although service providers continued to report an increase in production, this was the smallest increase in five months.
“Weaker demand conditions, often linked to rising costs of living and falling confidence, led to the first contraction in new orders since July 2020.”
However, while the prospect of further rate hikes has rattled US businesses, inflation remains extremely problematic. Therefore, the Fed’s catch-22 is on full display, and Powell rightly determined that actively reducing inflation is the lesser of two evils.
S&P Global Statement
Source: S&P Global
At this point, while old habits die hard, I warned on May 25 that the post-GFC crowd doesn’t realize this time is different. I wrote:
A decade of dovish pivots has left a generation of investors believing that central banking is all talk and no action. However, with inflation at levels not seen in over 40 years, Powell is not out of ammunition, and the Fed kingpin crowd is set to suffer deep disappointment as the drama unfolds.
The bottom line? We’ve officially entered the currency version of The Boy Who Cried Wolf. While Fed officials race to the rescue whenever financial markets show signs of strain, investors are programmed to ignore their hawkish threats. However, while these post-GFC pivots have occurred with inflation hovering near 2%, investors are so confident they are ignoring the climate consequences of unanchored inflation.
Also, not much has changed. Despite six rate hikes (25 basis point increments) and more on the way, the consensus continues to expect an accommodative pivot. As a result, the Cboe Volatility Index () has still not broken through the 40 mark, and the more than 20% decline in the S&P 500 has been relatively orderly.
However, while oversold conditions warranted a short-term rally, the medium-term outlook is much more worrisome.
For example, Morgan Stanley’s chief U.S. equity strategist, Mike Wilson, told clients on June 21:
“With our view of lower multiples and now more consensual earnings, markets are more fairly priced. However, it does not assess the risk of recession, in our opinion, which is 15 to 20% lower, or about 3,000 [for the S&P 500]. The bear market will not be over until the recession arrives or the risk of a recession is extinguished.
So, with Wilson cutting his medium-term target from 3,400 to 3,000, he again cited investor complacency.
The blue line above tracks the equity risk premium (ERP) of the S&P 500. In a nutshell: higher ERP and lower stock prices should coincide with periods of high uncertainty to compensate investors for the increased risks . However, if you analyze the right side of the chart, you can see that the ERP remains relatively weak.
In contrast, the pink vertical bars highlight material peaks that occurred in 2008 and 2020 during their respective crises. As a result, with no real fear in the market, the real panic should materialize as the Fed’s rate hike cycle continues.
The Fed must choose between supporting Americans and curbing inflation or supporting financial markets and raising asset prices. Moreover, while investors are used to the latter, Powell made it clear that higher unemployment will not derail his quest to tame inflation.
Unfortunately, that’s his only option, because short-term economic pain is better than long-term devastation.
Therefore, while investors are hoping that the weakening data points will change its tone, going dovish will only push equity and commodity prices higher and rekindle the flames of inflation.
As such, Powell’s acceptance of reality should push the S&P 500 and PM to lows in the months ahead.
In conclusion, the PM fell on June 23 as economically sensitive commodities felt the wrath of the Fed. Additionally, as the US Treasury yield has fallen recently, so has the US 10-year breakeven inflation rate.
As a result, the real US 10-year rate ended the June 23 session at 0.59%. Moreover, with Powell and Bowman telling us that they want higher real returns, this realization is deeply bearish for PM.