- The Fed Refills the Punchbowl
The Fed Refills the Punchbowl
Well, my head is spinning from that decision (and not from too much punch, I assure you!). The move to cut by 50 basis points (bps) ahead of the election was, well let’s just call it very bold. Typically the U.S. Federal Reserve (Fed), like other central banks, likes to move by quarter point increments, it’s usually taken some sort of crisis to spur a bigger move and, after all there was nothing to stop them from just doing 25bps now, and then potentially following up with 50bps or even 75bps at either of the two remaining meetings this year. But, I suppose I have to take the world as it’s dealt to me, Chairman Powell took charge and apparently led the consensus for this aggressive move.
It seems to me that what the Fed has done is take out a great deal of insurance against the possibility of a downturn, and the price that it has come at is the specter of resurgent inflation. Now, here’s the key point. I agree that the chances of a recession versus higher inflation may be balanced, but I strongly disagree that their repercussions are. In other words, if this dovish move inadvertently allowed inflation to again rear its head, then the credibility of the Fed would be in its worst position since the late 1970s. And I take this point seriously. Central banks rely on that hard won credibility with the bond market and, perhaps as important, Congress. The bond market will care first on depreciating bonds, Congress will care next when they face elections. If inflation re-appears they will have to re-hike fast to levels at or above where they were before. This is a big risk they have taken.
Drilling down into the bond market implications, I am not sure that long-term bondholders (whose investments bear the brunt of inflation) will necessarily agree that it was worth protecting against the downside to this degree. So, I strongly suggest keeping an eye on the 10-year yield to see how that develops. I don’t believe that the cut will necessarily filter through to the mortgage market, and if we have a 10-year yield north of say 4% and a mortgage rate above 6%, we could see problems.
And let’s not forget the deficit. What I think the Fed has done here is effectively said that the fiscal side is not their responsibility. And while that may be officially true, the deficit does still need to be addressed. If we don’t see any tax hikes that target that gap, then I think the yield on the 10-year could certainly go above 4%. And, with the Fed signaling their intention to cut further, and to backstop the economy at a time when recession is still unlikely, then what we have really done is simply move from monetary policy risks to fiscal policy risks. And I think the central bank may have just exacerbated the latter.
Let me make two final points. Firstly, despite all the talk of being data dependent, and less forecast oriented, I am worried this move represents a change in how they claim to operate. Because the data shows that the service components of inflation remain a problem for getting back to target, particularly shelter and healthcare costs. The hiking cycle has neither brought rents, nor home prices, down, and I think healthcare costs, and electricity costs will continue to rise. I am afraid that Powell has really put his credibility on the line here, and, dare I say it, may have succumbed to some “group think” and was, perhaps, overly influenced by what the market wanted. Secondly, there’s an international angle here. With a lower Fed rate, I think that makes the Bank of Japan far less likely to hike at least for many months. If they did, then that could lead to further strength in the yen which would be very unwelcome for their export-oriented economy.
So how do I think about positioning now? Well, in the short term, I think banks and consumers will be beneficiaries of lower rates, and I see that translating into digital sectors, the Magnificent Seven, Healthcare, Utilities, Financials, Capital Goods, and Defense. These are areas which are relatively immune to the tick up in the inflation risks I discuss above. I am underweight Transport, where I think costs make the demand picture questionable, and don’t think now is the time to rotate into Energy or deep value plays.
I hope Chairman Powell knows something about upcoming productivity gains that could offset this sticky services inflation, because the truth is it’s hard to be an investor in this environment of high valuations and persistent macro threats. I don’t think the Fed just made our jobs any easier…parties are fun, but hangovers are horrible.
– David
