Markets may have misread Jerome Powell and the US Federal Reserve

It’s often said that investors shouldn’t fight the Fed but after doing so, the sharemarket looks increasingly vulnerable to a further tightening of monetary policy.

It’s often said that investors shouldn’t fight the Fed but after doing so for the past two months, the sharemarket looks increasingly vulnerable to a further tightening of monetary policy.

While the bond market has viewed the Fed’s tightening as likely to cause a recession, the sharemarket was encouraged – after entering a bear market – by Fed chair Jerome Powell’s post-meeting comments in June that outsized hikes wouldn’t be “common” and his comment in July that “at some point it will be appropriate to slow down”.

More recently Fed officials have pushed back on the idea that inflation pressures will fade enough to allow the central bank to slow the pace of hikes.

Some Fed officials like Neel Kashkari, Charles Evans and Mary Daly – normally classified as neutral or dovish – have sounded more like hawks, as the rebounding sharemarket caused US financial conditions to ease almost all the way back to where they were before the April sell-off.

The US two-year Treasury bond yield rebounded toward a near 15-year peak of 3.45 per cent after the release of June FOMC minutes and US jobs data which showed non-farm payrolls rose more than twice expectations in July, and the 10-2 year spread continued to predict a recession after hitting a four-decade low near 50 basis points this month.

The S&P 500 has risen 19 per cent from an 18-month low in June to a four-month high this week. Australia’s ASX 200 has risen 10 per cent from its June low.

But on Tuesday the S&P 500 shied off its downward sloping 200-day moving average – widely viewed as an indicator of the long-term trend – after touching this line for the first time since April.

The ASX 200 stalled ahead of its downward sloping 200-day moving average as results and guidance from some major companies disappointed.

While reports from US and Australian companies overall have shown some resilience to rising costs and slowing economic growth – the full effects of these forces are yet to play out and rising rates are causing a valuation headwind.

The minutes of the July FOMC meeting were interpreted as slightly dovish.

“Participants agreed that there was little evidence to date that inflation pressures were subsiding”, “many” saw a risk the Fed “could tighten the stance of policy by more than necessary to restore price stability” and “some tentative signs of a softening outlook for the labour market”.

Minutes of the June FOMC meeting saw “many” participants raise concern that longer-run inflation expectations “could be beginning to drift up to levels inconsistent with the 2 per cent objective” and voice a “significant risk now facing the Committee was that elevated inflation could become entrenched if the public began to question the resolve” of the Fed to do what’s needed.

The July minutes also dovishly enshrined Powell’s post-meeting comments that “as the stance of monetary policy tightened further, it likely would become appropriate at some point to slow the pace of policy rate increases while assessing the effects of cumulative policy adjustments on economic activity and inflation”.

But “some” participants indicated that, “once the policy rate had reached a sufficiently restrictive level, it likely would be appropriate to maintain that level for some time to ensure that inflation was firmly on a path back to 2 per cent”.

The message seems to be that unless the US economy slows enough to cause inflation pressures to subside a slowdown to 25 basis point hikes is some way off and rate cuts won’t happen as soon as the market expects.

“Data following the meeting have shown more persistent inflationary pressure, a stronger labour market, and more resilient consumer spending, all of which should keep officials focused on inflation over stagnation risks,” said Citi’s US chief economist, Andrew Hollenhorst.

“Moreover, financial conditions have loosened rapidly since the meeting. This keeps us thinking further hawkish developments are in store.”

Canaccord US equity strategist Tony Dwyer said the recent surge in shares was caused by “an extreme oversold condition and high pessimism; excessive fear of inflation and Fed; and inappropriate fear of economic recession”.

“With inflation and economic fear so high in early June, the market was set up for a ‘bad news is good news’ scenario that has taken place,” he said.

While the strength of the rebound has caused some momentum-based indicators to suggest the worst of the bear market is over, he warned “the macro backdrop of yield curve inversions, real liquidity, and further Fed rate hikes argues the opposite”.

“How the market moves from here historically should depend on whether the economy moves into recession …. the three conditions in place for us to expect a summer rally are no longer supportive.”