Control Panel: Don't fight the Fed? Or don't fight the market?

All METARs are familiar with the sensation of nearing the end of a long airline flight. About 1/2 hour before landing, the vibration changes as the engines slow. Our ears sense the change in pressure, even in a pressurized cabin. The plane begins a gradual descent to a soft landing.

The Federal Reserve is trying to engineer a similar soft landing for the economy. They are trying to bring inflation to a long-lasting equilibrium of 2%. They have announced their intention that the Fed should maintain a “neutral” fed funds rate that would neither stimulate nor slow the economy, which is a dramatic shift from their stimulative actions over the past 20 years.

They have said that they expect some “pain” in the economy. This means that the Fed will not cut the fed funds rate if a recession occurs. (Barring a financial crisis which would threaten the system.)

The news last week supports the hypothesis that the Fed’s policy is working as they intend it to. GDP growth in 4Q22 was 2.9%, slightly below the previous quarter but still healthy. The job market is still tight. Inflation is moderating.

In the chart above, Core Services ex-housing is 4%.

The Fed’s economists use mathematical analysis to predict inflation. Their models are trying to predict a “natural” rate of unemployment that won’t be inflationary along with the “neutral” fed funds rate.

Fed Debates Whether Wages or Low Unemployment Will Drive Inflation

Easing price, wage data are at odds with concerns that the job market is too tight and the economy is operating above capacity

By Nick Timiraos, The Wall Street Journal, Jan. 29, 2023

Stubbornly high inflation is finally easing as supply chain disruptions fade and interest rates at 15-year highs put the brakes on demand. Now, Federal Reserve officials have voiced unease that prices could reaccelerate because labor markets are so tight…

The Fed is likely to raise interest rates on Wednesday by a quarter percentage point to a range between 4.5% and 4.75%, slowing increases for the second consecutive meeting. That would give officials more time to study the effects of earlier rate rises…

Their projections for interest rates and inflation in December suggest they think the natural rate of unemployment has temporarily shifted up to around 4.8%…The Fed’s economic staff saw this output gap [between actual and potential output] persisting until the end of 2024, a year longer than they projected just a few weeks earlier. …

If wages continue to grow at their recent rate of 5% to 5.5% that would keep inflation well above the Fed’s 2% inflation goal, assuming productivity grows around 1% to 1.5% a year. … [end quote]

Fed Chair Jerome Powell is determined to keep the Fed funds rate high enough for long enough to be sure that inflation will not pop back up as it did in the 1970s. Although goods inflation is subsiding, labor cost inflation is continuing.

The “soft landing” of the Fed will involve higher unemployment. A WSJ poll of economists showed that about 2/3 of them expect a recession in 2023.

The 10-Year Treasury Constant Maturity Minus 3-Month Treasury Constant Maturity spread is the most negative since 1980. This correlates 100% with recessions.

The Conference Board Index of Coincident Indicators is still rising but the Index of Leading Economic Indicators (LEI) has been falling for months. That’s like being at the peak of the first hill of a roller coaster. The Conference Board has a web page titled, “Navigating the Economic Storm: Your Indispensable Guide Through the Global Recession.” Hmmm…that doesn’t sound very encouraging.

Meanwhile, the stock and bond markets had a good week. Stock indexes and internals rose. The Treasury yield curve fell and became even more inverted. The trade was risk-on as stocks and junk bonds rose faster than the UST. The USD fell. Gold, copper and oil rose. Natgas continued to fall. Junk bond spreads fell slightly, an indication that the market thinks that zombie companies have less risk of default.

The SPX pattern since January 2022 has been lower highs and lower lows. Only time will tell whether this pattern will continue. Last week, the market gained.

Short Sellers Feel the Pain in Stock Market’s 2023 Rally

Highly shorted shares are beating the S&P 500 this year, and short sellers are down by $81 billion

Signs that inflation is cooling have stoked bets among investors that the Federal Reserve will pivot from raising interest rates to cutting them as soon as the second half of the year. That has helped risky assets across the board rise. [end quote]

Again, the market is ignoring the Fed! The Fed may pause the fed funds rate increases in 2023 but they will NOT cut it in 2023. They have repeated this many times.

I’ll bet you a quarter (my maximum bet) that the stock market will pop when the Fed raises the fed funds rate 0.25% at their next meeting as expected. That’s like kids jumping up and down and yelling “Christmas!!” even though they know exactly when Christmas will arrive.

So…don’t fight the Fed? Or don’t fight the market?

That depends on your style of investing. A short-term time line would focus on the market. A long-term time line would focus on the Fed.

The METAR for next week is sunny. There are no black swans flying in. The market is in a good mood. The short-term news is encouraging, right on the Fed’s flight path. The longer term news will be recessionary but that’s a tale for a later week.