Jerome Powell delivered the much expected 0.75% hike yesterday and affirms the Federal Reserve's resolve to fight inflation. This is what he says.
My main message has not changed since Jackson Hole. The FOMC is strongly resolved to bring inflation down to 2%, and we will keep it until the job is done.
His message is indeed a reinforcement of what he conveyed back in Jackson Hole. But that said, the Federal Reserve have shifted their stance dramatically and the tempo has been increasing since 2021 when inflation first reared its head. From the initial brushing aside of inflation as transitory, they are now aggressively playing catch up. With thePCE price index (YoY) change, Fed's gauge of inflation, now at 6.3% as of its last print, it is not hard to see why.
US PCE Price Index (YoY) Change (Source: Tradingeconomics.com)
Fed Funds Rate Outlook From Here
Fed Funds rate were still near zero at the beginning of this year, and now it is 3.25%. And we are not done yet for the year, another 1.25% hike is in the pipeline - 0.75% in November and 0.5% in December. This will bring the year-end Fed Funds rate to 4.5% which is 0.75% higher compared to a month ago.
Fed Funds Rate Expectations (22 Sep 2022)
As for 2023, the rate hike outlook is still rather murky. At the moment, the market is just pricing in the possibility of another 0.25% in February bringing the rate to 4.75% and that is going to stay pretty much for the bulk of the year. But of course, when we look that far ahead anything can change and Jerome's message do leave him a lot of room to maneuver either way.
How Did The Market React?
US Stocks Tank Big Time
The stock market didn't take what happened too well yesterday. The US stock market went on a roller coaster ride yesterday and ended the day down in a sea of red. Both the S&P 500 and Dow Jones Industrial Average were down more than 1.7% in a broad based sell off. If it was just a hike of 0.75% without any change in future plans, things might have been different as that is already priced in. But the Federal Reserve just upped the game a notch higher by adding in more quarter point hikes to the plan. They have openly declared that they are willing to see a deterioration in the economy to bring inflation under control. This signaling seems to be getting more and more like the norm based on the past few FOMCs.
US Treasuries Finally Rallied
Longer term US Treasuries, on the other hand, did much better. Both the 10-year and 20-year Treasuries were up. We finally saw its "long-lost" safe haven properties kicking in. Under the twin hammer of inflation and rising rates, bonds have came under immense pressure since hitting a peak in 2021. The 10-year and 20-year Treasuries suffered a record drawdown of 18% and 35% respectively from its high then. But, bonds were also trading at record low yields then before inflation stares down at us. Today, nominal yields have climbed much higher with the 1-year Treasuries trading above 4% and the 10-year above 3.5%. Real yields have also went back into positive territory this year. So if we look at this positively, the appeal of bonds may be coming back as we move out of the low-interest rate era.
The Yield Curve Shifted Up But Inversion Deepens
The spread between the 10-year Treasuries and the 1-year, 2-year Treasuries deepens to a record for the year even though the entire yield curve shifted up higher. We can attribute the shift up to the Fed's push on the Fed Funds rate to combat inflation which will flow down and affect across the entire yield curve. As for the deepening inversion, this is an indication on the increasing risk of a recession.
Deepening Yield Curve Inversion
The Good Out Of These Pain
Despite all these pain in the markets we see today, there is some glimmer of good. This long decade of easy money have distorted behaviors and expectations, in particular, with newer generations who entered the markets after the Great Financial Crisis (GFC) in 2008. These participants have never experienced a real extended crisis and may be conditioned into thinking that the economy and markets will always recover quickly from any corrections. Because that have always been the case after the GFC. Such behavior encourage excessive risk taking, builds potential bubbles and can hinder the efforts of the US Federal Reserve to cool demand off.
With an unprecedented amount of money sloshing around and record low interest rates then, asset prices have been heading north. Stocks, bonds, real estate, then after that came the cryptos and more. In a way, cryptos absorb some of these excess money which would have otherwise pushed up your traditional asset prices to even more bubbly levels. But wages, on the other hand, have been left in the dust. While that was not the primary intention behind money printing, the most prominent effect ended up becoming that of boosting the wealth of the rich who owns an overwhelming majority of these assets and thereby widening the rich-poor divide.
So this withdrawal of liquidity is already way overdue. Without a major crisis, these resources cannot be redistributed and interest rates cannot be restored to levels for monetary policies to function properly in the future. And here we are with one and the central banks is not going to bail the businesses out this time, or at least not now. There will be pain in the mean time, but we should emerge better after this.
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