Written by: Tim Pierotti, Chief Investment Officer
There are those who think the Fed should cut and those who think the Fed should hold rates right where they are. Lately, as evidenced by near-term Fed cuts being priced out of the market, the latter view is winning. The risk-on equity (and crypto) rally, tight credit spreads, a retreat in long-term rates and other indicators of “animal spirits” are telling us that “financial conditions” obviously aren’t in any way tight. The Fed should cut camp argues that Fed Funds rates held so far above the current rate of inflation will surely upend this economy any day now, but markets have grown dismissive of the idea that those monetary lags are going to impact risk assets soon or ever.
The chart below shows that financial conditions have fallen dramatically despite the Fed maintaining Fed Funds well above the rate of inflation.
Index Values since November 2021
In January, we saw a spate of data that suggested we could be seeing a change in the trend of inflation. Both CPI and PPI came in hotter as did import prices and the prices paid subcomponent of several regional PMI’s. According to the NFIB, more businesses are planning on raising prices. So far, amid AI mania, the market has shrugged off the indicators of an inflation reacceleration, but a new study from the San Francisco Fed tells us we should be hyper-vigilant as new inflationary data comes available.
Monetary Policy and Financial Conditions authored by Zoë Arnaut and Michael Bauer published on Monday makes the following key points:
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Markets front-run the Fed.
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It is rapid changes in the perception of the direction of inflation that drive financial conditions.
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Investors should focus on the data likely to impact the drivers of Financial Conditions not the activity of The Federal Reserve.
The authors wrote, “We provide new evidence on the drivers of financial conditions, using event studies of monetary policy announcements and inflation data releases. Our analysis shows that monetary policy has significant direct effects on financial conditions, as evident from the response to monetary policy surprises. In addition, monetary policy also has indirect effects: Macroeconomic news affects financial conditions in part by shifting perceptions about the likely course of future policy. Financial market participants appear to be especially attuned to recent inflation data releases, which has led to unusually strong responses in financial conditions.”
The chart below illustrates the author’s commentary. The market is going to respond faster than ever to changes in inflation data.
Goldman Sachs FCI since 1998
The authors go on to conclude, “Short-term rates are not as relevant for economic activity. Instead, financial conditions tightened mainly because of higher long-term interest rates, lower stock prices, and a stronger dollar.” In other words, don’t worry about the Fed’s next move, focus on the data that will impact the long-end of the curve, because if long rates start trending higher, stocks are likely to weaken and spreads are likely to widen.
We, at WealthVest, have been in the “Higher-for Longer” camp since late in the second quarter of 2023. We have believed in the sustainability of the economy for two reasons: massive fiscal support and the secularly tight labor market that has supported wage growth. In our view, the first reason is with us for the foreseeable future and the only risk to the latter is an acceleration of inflation data that moves the 10-yr back toward 5% and thereby upends the housing market. We will be watching and assessing the inflation data very, very closely.
Related: PCE and Jobs: The Potential for Higher and Longer Trends