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How Do We Land This Thing?

Markets Think Jerome Powell's Fed Has the Right Stuff

"What do you mean 'auto-pilot' doesn't include 'auto-land'?"

The Federal Reserve left interest rates unchanged, signaling their satisfaction with the current trajectory of inflation and growth. That there would be no rate increase in June had already been priced in by markets, so the announcement did little to impact prices at first. What seemed to come as a surprise was that the Fed's 'dot plot', or the board members' estimates of future interest rates, indicated that they expect another two interest rate increases of .25% in 2023.
No rate cut for you.

That would bring the Fed Funds Rate, the interest rate banks charge each other, to 5.5% - 5.75%, the highest rate since just before the bursting of the Dot-com bubble in 2000. Significantly, it also shows that most members believe rates will be between 4.5% and 5.0% in 2024. In his testimony before the House Financial Services Committee yesterday, Federal Reserve Chair Jay Powell offered that an additional half-point of interest rate increases in 2023 is a 'pretty good guess'. Markets are getting caught up to the view that interest rates will remain above 5.25%, and likely higher, for the balance of the year: the yield curve now largely reflects this expectation, with rates of 4.0% forecast out to five-year issues. This is what we are talking about when we talk about 'higher for longer'.

The yield curve has adjusted to reflect the Fed's views on future rate policy

Inflation expectations have gone from moderate to collapsed. One-year expected inflation has halved over the past month, while five-year expected inflation has fallen below the Federal Reserve's target rate of 2%. That's a pretty big movement and signals confidence in the Fed's ability to bring down inflation.

Inflation expectations have cratered

The S&P 500 has been on a tear recently, reflecting the confidence that new share buyers have in equity market. The index is now 21% higher than its October 2022 trough--although it bears to mention that this performance is largely due to the relative outperformance of a handful of popularity stocks. Time will tell if the outsized valuations these companies are receiving are justified by their operating performance. If the economy were truly expanding, then we would expect to see small capitalization stocks keep pace with their mega-cap (titano-cap?) brethren, but that has not been the case. More likely, equity investors are choosing 'quality' stocks as a place to hide while they wait for events to develop.

Mega-cap stocks are almost 10% higher since October 2022 troughs

Meanwhile, equity volatility has fallen dramatically in a sign that investors are seeking to hedge less against downside risk.

Expectations for volatility are markedly reduced

With stocks reaching higher highs, and volatility plumbing lower lows, it would appear that we're in a new greed cycle--interesting since it seems like we just exited the last one. The problem with this narrative is that growth is not particularly robust. Productivity growth continues to come in around 1%, so the economy doesn't seem poised to enter recession--however, it also doesn't seem to justify a 21% runup in mega-cap stock prices and low volatility.

Further, leading indicators are beginning to soften, which could spell trouble ahead for the 'everything's okay' crowd that is driving pricing at the moment. We see this not only in the yield curve--which remains highly inverted--but also in credit conditions (deteriorating), consumer expectations (lower), new orders (lower), and inflation (unchanged). While we don't see reasons to believe that a change in equity market sentiment is immediately imminent, the storm clouds are gathering. It certainly seems as though the debt markets have gotten the memo, and are accordingly repricing risky debt. Bond volatility is also elevated, though not yet achieving the highs it summited in October of 2022.

It is for these reasons that the Federal Reserve is taking a wait-and-see approach to interest rate policy. Growth is positive, inflation is no longer rising, and the financial system has stabilized since March's regional banking crisis. However, in order to push inflation down toward the 2% area, the Fed will need to keep raising rates to try to slow hiring and make a dent in the resilient labor market. We continue to believe that higher rates are on the way, and will stay high until wage growth cools and the unemployment rate returns to a level consistent with the natural rate of unemployment (somewhere between four and five percent). So far it has looked like a soft landing, but there's a reason why pilots fear wind shear upon landing the most.

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