The unfortunate costs of reducing inflation
It was never going to be a good start to the week for risky assets, when the Chairman of the Federal Reserve said that the Fed would direct all its efforts to bring down inflation, which would mean a period of below-trend growth and a softening of labour market conditions. Essentially Fed chair Jerome Powell used his keynote address at the Jackson Hole central bankers’ conference to deliver a tough message, and one that will bring pain to both households and to business. Any prospect of a Fed pivot has now been discarded, and this is best exemplified by what has happened in the Fed Funds Futures market, which is a good proxy for US interest rate expectations. The market is currently pricing in a 66.5% chance of a 75bp rate hike, this compares to a 28% chance a mere month ago. This pivot back to expectations of a hawkish and aggressive Fed is enough to draw a line under the summer of love for equities.
The three lessons from Jerome Powell
Fed chair Powell’s speech was brief, narrowly focussed and his message was direct: how to force the inflation genie back into the bottle. The aim of the speech was to convince the market that the Fed is serious about fighting inflation. He laid out a three-step path of how to alleviate it, based on the lessons of history during periods of high and low inflation over the last 50 years. The first lesson is that central banks should take responsibility for delivering low and stable inflation. Even though the current high rates of inflation are a global phenomenon, Powell stated that high inflation is also a product of strong US demand, which can be targeted by the Fed. The second lesson Powell referenced; long term inflation expectations hold the key to bringing down inflation over the long term. Although Powell said that long term inflation expectations are currently well-anchored, he said that the Fed will not take that for granted, i.e., part of the reason that they will continue to hike rates is to stop the prospect of long-term inflation expectations from moving higher. The last lesson is that the Fed needs to keep up its fight against high inflation and not give up too early. Thus, interest rates will need to stay high for a decent length of time.
The market impact of the Fed’s pivot from the pivot
This is a clear and powerful message, and one that the market took on board. The reaction was swift: US stocks closed lower on Friday, and the S&P 500 logged its worst day since June 13th and it closed lower for the second straight week. Interest-rate-sensitive sectors of the economy were particularly badly hit, including home builders, building products, semiconductor firms and retailers, while the defensive sectors held up best. The US blue chip index is up more than 10% since its lows back in June, however, we think these gains could be further eroded over the coming weeks. The dollar was stronger and continues to make gains on Monday. Although EUR/USD is up 0.3% and is inching its way back towards parity. However, this remains a key resistance level and there are signs that demand for the single currency could weaken as we progress through the week. The reality of higher interest rates from the ECB along with a weakening growth outlook due to the energy supply crisis that is brewing this winter could take the shine off the euro as we move towards the end of Q3.
ECB on track for 75bp rate hikes
One of the biggest shocks in the aftermath of the Jackson Hole conference is that some ECB members want to discuss the prospect of a 75bp rate hike at their meeting on September 8th. This is because inflation is soaring, and with interest rates at 0% after July’s rate hike, they are still stimulating the economy. Some believe that Eurozone rates need to rapidly rise to 1.5% before rates will start to constrict the economy. Like the Fed, some ECB members are worried that inflation expectations will become uncomfortably high, which will cause inflation to become entrenched in the economy. The head of the French central bank said that the ECB should aim to reach the neutral rate of policy by year-end, which could see two consecutive 75bp rate hikes. Although the ECB is powerless to control the price of energy, the soaring costs for power and oil is likely to push the ECB into a deep recession. If you front load rate hikes now, then you don’t need to explain why you are hiking rates when the economy is already slowing, later.
Last minute reprieve for Chinese firms listed in the US
Thus, there are some difficult choices that central bankers on both sides of the Atlantic appear willing to take. Outside of the central bank world, it is worth noting that China and the US have come to an agreement and have agreed to share audits of US listed Chinese firms. This will avoid a swathe of Chinese firms listed in the US being forced off US stock exchanges.
Overall, as we start a new week, there is one theme: central bankers are taking charge and they will use all their power to fight inflation. Thus, the fact that the S&P 500’s indicative opening price for the start of this week is nearly -0.9%, could be a taste of things to come.