Fed chair Jerome Powell definitely is speaking with a hawkish tone as his two day Senate testimony continues. Weeks ago, I told readers that the market action in bond yields and the Fed rhetoric was potentially mispriced. Either the markets were wrong, or the Fed was wrong. You generally don’t want to bet against the Fed so it became clear what side was wrong. It turns out that the Fed pivot/pause trade will have to take a backseat.
Much of the market thought inflation was tapering and heading down, however January 2023 CPI came in higher than expected which will see the Fed continue to raise interest rates.
Jerome Powell yesterday said that interest rates are ‘likely to be higher‘ than previously anticipated. The Fed’s battle to tame inflation isn’t done, and rates will have to go higher.
“The latest economic data have come in stronger than expected, which suggests that the ultimate level of interest rates is likely to be higher than previously anticipated,” Powell said in remarks prepared for two appearances this week on Capitol Hill. “If the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes.”
This came to a surprise to most of the market, but contrarians have been saying that this is coming. They say inflation is just beginning. The key takeaways are that 1) the terminal rate will be higher than the previously thought 5.25%, and 2) we may still get large 50 basis points plus rate hikes as opposed to small 25 basis point hikes.
They do have a point. Here’s a key thing to remember:
In no time in economic history has inflation over 5% been tamed with interest rates below the rate of inflation.
This means that the Fed (and other central banks!) have more work to do.
Current market pricing moved higher following Powell’s remarks, to a range of 5.5%-5.75%, according to CME Group data. Powell did not specify how high he thinks rates ultimately will go.
What the Fed wants to do is avoid the mistakes from the inflationary period in the 70s.
Above is the inflation rate from 1970-1980. You will see that inflation first spiked, and then came back down. So we did have a period of disinflation…just like we were initially seeing in Q4 2022. Back then, the Fed began to cut rates too early. This saw inflation remain entrenched and spike into double digits. The Fed then had to raise interest rates to over 20% to tame inflation. This is why Jerome Powell and other Fed Presidents are very adamant in saying that interest rates will have to ‘stay higher for longer’. They do not want to cut prematurely.
“Restoring price stability will likely require that we maintain a restrictive stance of monetary policy for some time,” Powell said. “The historical record cautions strongly against prematurely loosening policy. We will stay the course until the job is done.”
With what is happening now, the idea of a soft landing might be out the window. The Fed’s idea of raising interest rates just enough to tame inflation while avoiding a recession. Currently, the Fed thinks their rate hikes haven’t done damage because employment numbers remain strong. This is why US NFP data coming out this week on Friday will be significant.
The Fed will rely on near-term data and make decisions on interest rates on a meeting by meeting basis.
Powell’s comments on Capitol Hill triggered a 1.5% selloff in equities, according to JP Morgan’s trading desk. Tuesday’s losses saw every sector lower, with financials and real estate logging the biggest declines for the day.
Above I have the charts of the Dow Jones and the Russell 2000. It appears as if the recent rally has been a dead cat bounce. I want to highlight the Russell 2000 because this market tends to lead the S&P 500, the Nasdaq and the Dow Jones. The Russell could be breaking below a major support zone by the end of the trading day today. This would not bode well for the larger US markets.
Bond yields continue to be where the major action is happening. Recent stock market pops were seen when bond yields had a red day. Yields are once again spiking post Powell, and rising yields are hitting the stock markets.
With a hawkish Fed and rising yields hinting at more rate hikes, the US Dollar is beginning to turn. I actually gave a long trigger back when we broke above 103 and confirmed the first higher low. A second breakout has now happened pointing to more US Dollar strength.