Markets are fighting the Fed at their own peril

Investors aren't supposed to fight the Fed. It's one of the most constant aphorisms driven into the mind of any investor that they should never do it. But as 2022 comes to an end, it looks like the conflict remains intense. Jerome Powell and his colleagues at the Federal Reserve told us that they were more hawkish than people realized, and that the projected course of interest rates should be adjusted upwards. The market responded by adjusting its estimates of rates slightly downwards. What gives?

The basic dichotomy between the message the FOMC wanted to communicate and the one the market received can be illustrated easily. In its "dot plot" — in which each FOMC member is asked to give a prediction for where fed funds rates will be in the future — the estimates shot up compared to the last dots published in September. In the chart below, which I enjoyed putting together with the paint function and PDFs from the Fed's website, the thick line through the middle line is 5%, with each dotted line showing a 0.25% increment. The dots on the left are the FOMC's projection for the end of next year, as published in September. The dots on the right are the ones published this week. In that period, during which inflation had shown signs of easing, the FOMC has become sharply more hawkish. Three months ago, none of the members thought rates would finish next year above 5%; now, only two don't think this:

Powell referred to the dot plot several times in the press conference, and often wanted everyone to look at it. On the face of it, the Fed amped up its hawkish rhetoric as much as it possibly could without endangering its credibility. 

Now, here is the fed futures market estimate for where rates will be at the end of the year, as calculated by Bloomberg's World Interest Rate Probabilities function. It starts immediately after the publication of the September dot plot:

Rate expectations scarcely shifted after this news, and are barely higher than they were three months ago. This is directly contrary to the Fed's clear guidance, and suggests traders thought they could safely ignore the dot plot altogether. 

There was more to the hawkish message than the dot plot. Powell took care to emphasize the historical lesson that easing too early could be a terrible mistake, and said he needed more evidence than a couple of good inflation reports before he could consider being less restrictive. He harped on repeatedly about the "very strong" labor market, and produced a model of inflation that implied more tight money was needed. He said his greatest concern was "non-housing related core services," accounting for 55% of the Fed's favored inflation benchmark, which was "really a function of the labor market." 

There had been speculation that the FOMC would fragment as decisions grew harder, but the decision was unanimous, while the dot plot shows a fairly unified front, at least for the next year. Andy Sparks of MSCI put it neatly enough:

Powell emphasized that the Fed needs to see substantially more evidence that inflation is headed towards the central bank's 2% goal before the Fed may consider a less restrictive rate policy. This is tough talk, given the significant improvement in reported inflation in October and November. Chair Powell's remarks today may open the Fed up to more critique from doves, who may argue that the Fed has over-reacted and is pushing the economy into recession with its overly aggressive policies." 

But as it stood, the market response, following Miles Davis, was: "So what?" Stocks were down by the close, but not much, and were even in positive territory for a while during the doom-laden press conference. The dollar weakened, and longer-term bond yields fell a little. The 10-year rate is a little below 3.5%. 

So, what did the market see and hear from Powell and his colleagues to persuade them that he didn't really mean what he was saying? There are various theories:

First, it could be a question of body language; Powell at one point hesitated for a long time before moving on with his notes, almost as though he was in a hostage video. This raised hopes that he didn't mean it, according to some. (Hard for me to judge as I was listening to him while watching the World Cup.) This added to the concern that maybe the talking points were so hawkish, and repeated so robotically, that traders simply didn't take it seriously, but instead put trust in their own models showing an imminent recession and imminent need for the Fed to cut rates. As one strategist put it: "The market says 'you just act macho.' On this account, it wasn't so much that the market didn't believe the Fed, as that it saw the Fed 'acting tougher than required?'"

There is an argument that Powell fatally missed an opportunity during the first question of the press conference, when he was invited to complain that financial conditions had grown too lenient — or in other words to talk down the stock market. He didn't do so, in what some investors told my colleague Katie Greifeld was a critical flub. To quote Katie: "The S&P 500 jumped after Powell responded that financial conditions had in fact tightened over the course of the year, and in any case the central bank doesn't worry much about short-term moves."

It's true that financial conditions, broadly construed, have eased significantly in the last few months, and that this has a lot to do with the rebounding stock market. This is how Bloomberg's own measure of conditions (where lower numbers mean tighter conditions) compares to the S&P 500:

But how strongly could Powell have talked down stocks, and wouldn't whining about share prices have made him look weak? Dan Suzuki of Richard Bernstein Advisors suggested that talking the stock market up or down is dangerous territory for the Fed (even if Alan Greenspan did take aim at "irrational exuberance" more than a quarter of a century ago). Suzuki said: 

He's not going to focus his comments on the stock market, which is extremely volatile. He will continue to focus on the fundamentals, which are that they need to tighten liquidity further, which will continue to put downward pressure on growth. That's hardly a green lights for risk assets.

Most importantly, the market really liked Powell's comments that the speed at which rates rise from here no longer matters so much as the final destination and how long rates stay there. I think Powell was plainly right about this, but for a certain kind of person, most concerned by the short term, this could be construed as preparing to hike by only 25 basis points in February. That might well happen, but that won't make the end of the year any more comfortable if the fed funds really is above 5% by then.

It's also possible to construe a willingness to hike by just 25 basis points next time as showing a lack of commitment to the notion that rates still aren't "restrictive" enough. That point was made very strongly by Steven Blitz of TS Lombard:

"Chair Powell – either you believe your policy stance is "not sufficiently restrictive" or you believe it is close enough that a 25BP hike is on the table for February. You cannot believe both. The markets know that and read through your hawkish pronouncements, inflation dissection, your dismissiveness of easier financial conditions as volatility with no effect, to see your dovish bias. A bias underscored by your strong hint that 25BP is the odds-on hike in Feb. Because all this syncs up with the market's own bias on growth and inflation, markets ignore the hawk and price in the dove. Markets consequently control your narrative, Chair Powell, your best hope is that everyone is right, and disinflation follows regardless of the easing you have set in motion."

Steve Englander of Standard Chartered took a similar view, suggesting that Powell's readiness to contemplate taking rate hikes more slowly revealed weakness or lack of commitment to the entire tightening project:

"What caught the eye was 'We're getting close to the level of sufficiently restrictive, we laid out today what our best estimates are to get there. It boils down to how long we think the process is going to take.' This points to more confidence that policy rates are close to the top while discouraging anticipation of premature easing. The repeated reference to the unimportance of speed leaves the door open to downshifting to hiking 25bps at the next FOMC if the data are supportive."

These are all valid arguments, but a lot has to rest on them. A slowing pace of hikes doesn't help that much, particularly when Powell affirmed that the Fed would keep on with "QT" asset sales, which would further mop up liquidity. The Fed has told us very clearly that it's more hawkish than we thought, and it's inherently very dangerous to ignore it.

The dance of central banks and markets is always complicated. Markets can create their own reality. There is also a legacy of many years in the post-GFC period when the dot plot continually predicted higher rates the markets always bet against and always won. But the problem for everyone remains that serious inflation is back for the first time in four decades, and there is a lack of reliable precedents. With the labor market seemingly impervious to all the monetary tightening that has happened already, it seems easy for the Fed to keep tightening, and dangerous for investors to bet against it. 

In short, I understand the arguments for not taking Powell seriously, but on balance I don't accept them. If the Fed is going to make a mistake it will be raising rates too much, not too little, and everyone should work on that assumption. Now to see whether the European Central Bank and the Bank of England have any better luck getting their messages across…

Look on the Bright Side
With less than two weeks to go until 2023, it's been natural to harp on the potential downside risks to markets. Whether it's a global recession, sticky inflation, or looming black swan risks that no one has yet priced in, investors are positioning themselves for bad outcomes. 

At one level this is just human nature: Expect the worst and hope for the best. But investors seem only to adhere to the former, judging by S&P 500 options and what they're saying about next year. Here's Drew Pettit, director of ETF analysis and strategy at Citigroup Inc.:

The market has definitely put a bigger premium on downside protection than upside risk, and we see that in sentiment indicators. The Levkovich index has been stuck close to panic levels, even after the recent rally. Sentiment is a very hard thing to break. Positioning has changed slightly, it's gotten less bearish, but people are finding comfort in the crowd and that crowd still thinks downside is more likely than upside.

Still, Pettit does note his team sees the tail risks slightly skewed to the upside. Among those is the possibility that the Fed really does engineer a soft landing. So let's focus on 2023's potential upsides which could leave us wishing we'd bought more risk assets. One of Wall Street's most bullish strategists, John Stoltzfus of Oppenheimer Asset Management, has a slightly longer list of upsides (eight) than downsides (seven) for his firm's S&P 500 target and earnings projection next year.

He predicts the S&P 500 will hit 4,400 in the coming 12 months, a more optimistic call than any provided by the strategists Bloomberg regularly surveys. That implies a 10% rise from Wednesday's close. His reasons for baseline optimism include a likely decline in inflation, a successful Chinese reopening, and less aggressive central banks, which all seem reasonable.  

Now, here is his nifty list of upside risks to his forecast, with minor annotations by Points of Return:

• Oil production stateside further increases if the administration pivots to favor domestic US oil producers
• Inflation levels continue to trend lower to a greater extent than currently expected
• Corporate earnings and revenue growth turn out better than forecast
• Real estate proves more resilient amid rising rates
• Supply-chain snarls cool as businesses diversify from one-country dependency
• Commodity prices stabilize or fall, though not to the point of recession
• The US dollar falls even further as geopolitical risks lessen
• More workers return to the workforce as the inflation surge cuts into personal savings

It's worth looking out for all of these. Bloomberg's commodity index hit a peak after the Ukraine invasion, and has since found a lower level — another step down could easily happen, and would contribute to easing financial conditions:

As for the dollar, it also seems to have clearly broken its dramatic upward trend, but there is a lot of room below. A cheaper dollar eases conditions for all countries and companies that finance in dollars, and it could amplify any resurgence in risk assets: 

As Christmas is approaching, Points of Return will not go into detail on the downsides. Don't worry — we'll keep you informed about them. 

And there's also one very important bottom line. There are often times when it is sensible to cut back on equities, or shift into particular sectors. There is almost never a good time to get out of the market altogether, because over time economies tend to grow, share prices grow with them, and stocks tend to beat bonds. None of this is inevitable, but even if you're pessimistic, it's wise to keep a foot in the stock market, just to guard against a pleasant upside surprise. 

—Isabelle Lee

Survival Tips
Let's get back to the bright side. At present, the World Cup has left everyone not from France or Argentina with a pressing need to count their blessings. But quite a game is in prospect for Sunday.  What to listen to in the interim? Argentina gave us the tango and Daniel Barenboim, and the setting for Evita — just a little bit of star quality to look forward to. France offers anything from Josquin Desprez through Debussy and Berlioz to France Gall, while providing the setting for Les Misérables. One of these countries will have a lot to sing about before then: good for them. 

— With assistance by Isabelle Lee

John Authers is a senior editor for markets and Bloomberg Opinion columnist. A former chief markets commentator and editor of the Lex column at the Financial Times, he is author of "The Fearful Rise of Markets." 

Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.