Assessing the new taciturn Fed as the US economy plunged into recession

The US economy is officially in recession after growth fell by 0.9% in Q2 on the back of trimmed business inventories, a weak consumer and a slowdown in the housing market. Due to this backdrop, is it any wonder that the Fed chair Powell kept family quiet at last night’s meeting? Summing up the Fed meeting on Wednesday can be done in one word: brief. The statement set the tone; it did not give much away. Of course, once the Fed raised interest rates by 75bp, as expected, Fed chair Powell highlighted the obvious: growth is slowing but employment is still strong, inflation is surging but the FOMC Committee remains “highly attuned to inflation risks”. The 75-basis point rate hike was approx. 75% priced in ahead of this meeting, what wasn’t priced in was the open-ended nature of the statement and Fed Chair Powell’s press conference. Powell had been expected to lean hawkish at this meeting, but he didn’t, he stayed perfectly taciturn, refusing to bow to the hawks or the doves, instead saying that they will remain data dependent and will adjust policy “if risks emerge” that could jeopardise them reaching their 2% inflation target.

The Fed vs. the market  

This outraged some, who had expected more guidance from the Fed. For example, hedge fund boss Bill Ackman tweeted after the meeting that the Fed had not shown “serious resolve in addressing inflation”, and that Powell is “reluctant” to say that the Fed will do whatever it takes to bring down inflation in the long term. He also asked where Fed Chair Powell’s “mojo” has gone after a superb performance during the Covid pandemic. Ackman’s view that traders ignore Fed dot plots and Powell’s lack of conviction on inflation, might have some merit in the short term. However, we take a more nuanced assessment of what the Fed did last night. Firstly, there are signs that one of the most erroneous elements of core inflation in the US is starting to slow: the US housing market. Housing starts fell 2% in June, and there could be worse to come as the average 30-year mortgage rate in the US is still above 5.5%. This is low over the long term, but it is still one of the highest rates since 2008. Thus, surely, it’s better not to move home until the Fed makes a “policy mistake” and starts cutting rates? Thus, the Fed knows that it is on the right track if mortgage rates remain elevated compared to the last 14 years. Secondly, the market continued to think that the Fed is too “hawkish” in its economic and interest rate projections, for example, Fed Fund Futures remain below the Fed’s own economic projections. At no time during his press conference did Chair Powell rule out the prospect of a 75 bp rate hike in September, however, post the meeting the market is predicting a 72% chance of a 50 bp rate hike. This is not the Fed’s problem, it’s the market’s problem. So, who is right? When Bill Ackman lashed out at the Fed in his Twitter rant last night, he didn’t read between the lines: the Fed is already more hawkish than the overall market, this is why global financial markets have rallied since the last Fed meeting in June when the Fed first raised rates by 75bps. However, by limiting Fed speak and refusing to commit to future policy decisions, Powell and co. are keeping their options open, and not, as Ackman would have you believe, refusing to commit to fight inflation.

Central banks have their wings clipped

The problem for all the world’s central banks right now is that they know they have limited tools at their disposal to slow the rise in oil and gas prices, as they are largely impacted by geopolitical issues, including the war in Ukraine and Opec production. Some argue that the US economy is less exposed to these pressures, and indeed WTI oil trades at a discount to Brent, WTI currently trades at $98.60, while Brent is trading at $103.57, both are higher on Thursday. However, the price of WTI is still high. Oil and other commodities are priced in international markets, and they depend on global supply and demand. Demand for US oil products and other commodities continue to rise due to Europe switching from Russia to other countries to source commodities. Thus, upward price pressures remain for the US inflation outlook, even if the US produces its own oil. Due to this, the Fed can only do so much to target the root cause of inflation.

Will the stock market rally come to an end?

As we look ahead, we think that the market could be out-hawked by the Fed, and we should remain cautious about these bear-market rallies. Already on Thursday, the S&P 500 is expected to moderate, after a strong performance in the immediate aftermath of the Fed meeting. We shall have to see if the 6-week long rally has come to an end. Treasury yields have stabilised after falling post the Fed meeting, however, 10-year US Treasury yields remain below 2.8%. The US yield curve inverted further on Wednesday and is currently at -18 basis points. We think that a reversal in the yield curve will be unlikely any time soon, as we continue to think that the market is under-appreciating the prospect of the US terminal rate ending the year close to 4%, right now there is only a 1.5% chance that the Fed Funds rate will reach 3.75-4% by December this year. Another month or two of higher-than-expected inflation figures could change that.

The dollar stays king

Overall, from a trading perspective, we remain pessimistic on the outlook for global stocks, although we prefer FTSE 100 outperformance due to upward pressure on energy prices as we move into the winter months. We also favour the dollar, which is higher again today. If the dollar index can close the week above 107.20, a short-term resistance zone, then we think a return to the mid-July highs around 109.50 could be on the cards. As we have said this year, watch the FX market for big changes in the direction of risk sentiment. The world still wants dollars, which suggests that the FX market remains wary about the global environment and economic outlook. It is worth noting that the dollar did not fall when stocks rallied in June, this is a sign that one major part of the market was not as bullish as other parts, including bonds and stocks. The demand for dollars suggests two things: 1, the FX market believes the Fed’s own rate expectations and not what the market thinks the Fed will do, and 2, until the global demand for dollars starts to slow, the rally in risky assets will remain shallow.