Overview
FOMC Chair Powell announced that it is premature to consider pausing the rate hikes. Instead, he would prefer to over-tighten because they don’t know what level of rates would be sufficiently restrictive. The FOMC’s approach means the terminal could continue to increase if inflation does not soften soon.
Powell did not know what the committee would do once it arrived at the Fed Funds terminal rate. So expect the Funds rate to remain at the terminal rate for many months.
This statement and recent data increase the odds of a US recession and corresponding decline in US equity markets.
The US economy created an estimated 261,000 non-farm payroll jobs in October, though the unemployment rate increased to 3.7%. Even the revisions to the prior two monthly estimates added another 29,000 jobs. So the jobs market is showing little effect from Fed tightening.
Key Question:
What kind of progress do we need on inflation for the Fed to stop raising rates? We explore this question below.
Performance Review
We had warned for the last two weeks that the FOMC meeting was a source of event risk for the market. Sure enough, the major indexes declined more than 2% after initially rising about 0.4%. Technology shares dropped the most for the week at the prospect of even higher rates.
The Net Bull/Bear balance turned negative, but not decisively, i.e., traders reversed the recent relief rally.
The longer-term Diversified Trend Index also declined into the neutral zone, which means the uptrend could resume next week since the decline occurred without a significant increase in VIX or a change in the futures curve.
Value strategies have dominated the growth-vs-value debate as large-cap growth stocks suffered a contraction in multiples this year and reported weak earnings last week.
Progress on Inflation
Progress on inflation is the primary source of equity market improvement for bulls. The US Economic Outlook from Northern Trust Bank shows how inflation might evolve in 2023. Their models imply that we need to have a 50%-70% decline in the sub-category inflation rates for a significant drop in overall headline inflation (see below). But even the FOMC is not sure about the timing and magnitude of declines in inflation next year.
CNBC published a survey of manufacturers that shows which factors they think are affecting supply chains. Global political unrest, lack of raw materials, and rising fuel costs were the leading causes, which shows how complicated the FOMC’s campaign to lower inflation has become since they control none of these factors feeding inflation.
As an example of global political factors, the possibility of a reopening in China led to big jumps in the energy markets on Friday. Since China recently completed a leadership reshuffle, traders have been expecting steps to improve economic growth there. As a result, something as simple as approving the BioNTech COVID-19 vaccine in China can greatly impact energy markets since it could help reopen cities from lockdowns.
Richmond Fed President Barkin clarified on Friday that he expects a slower pace of increases but for a more extended period and to a higher level. As a result, we can expect a step down to 50-bp (and then 25-bp) increases, leading to a terminal rate between 5%~5.5%. I expect the terminal rate to be reached by May 2023.
If you want to play defense in this environment, look at the Energy sector ETFs, Commodity ETFs, or managed futures programs or ETFs.
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Wrap-up
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Disclaimer
And now for some housekeeping. This publication is for “edutainment,” education, and entertainment, not for investment advice. Past performance is not necessarily indicative of future results. Our disclaimer at chandeindicators.com is included herein by reference.