All METARs know by now that the Federal Reserve had a meeting on Friday at Jackson Hole, where Fed Chair Powell gave a short, punchy speech. Powell announced that the Fed will stay the course of higher interest rates until inflation is brought down to their target of 2%, despite expected pain for businesses and households. Powell didn’t mention the asset markets but the stock market reacted strongly since speculators had been betting on a Fed pivot away from raising interest rates.
**Stocks’ Pivot Spurs Investors to Shore Up Defenses**
**A pronounced retreat from risk following a strong summer rally points to a volatile period ahead, many portfolio managers say**
**By Matt Grossman, The Wall Street Journal, Aug. 28, 2022**
**Remarks from Federal Reserve Chairman Jerome Powell ended talk of a hoped-for Fed pivot, in which bullish investors bet that falling inflation and a faltering economy would lead the central bank next year to cut interest rates.**
**Instead, it is the stock market that has pivoted. Over two weeks of declines, the S&P has now given up 5.2%, its worst stretch since mid-June. On Friday, bond prices slid, cryptocurrencies fell and every major industry sector posted stock-market losses....**
**Realizing that the Fed is ready to dig in is jarring to investors who were hoping the worst of 2022 was past, analysts and portfolio managers said. Now ahead: more second-guessing of how rising interest rates are likely to hit economic demand, corporate earnings and stock valuations....** [end quote]
Fed Chair Powell said, “We are moving our policy stance purposefully to a level that will be sufficiently restrictive to return inflation to 2 percent. At our most recent meeting in July, the FOMC raised the target range for the federal funds rate to 2.25 to 2.5 percent, which is in the Summary of Economic Projection’s (SEP) range of estimates of where the federal funds rate is projected to settle in the longer run. In current circumstances, with inflation running far above 2 percent and the labor market extremely tight, estimates of longer-run neutral are not a place to stop or pause.”
This key paragraph makes two points that dash cold water over the markets.
The Fed intends to be restrictive until inflation comes down.
Once inflation subsides, the Fed does NOT intend to bring the fed funds rate back to its emergency stimulative level of zero. The Fed intends to return to the historic practice of maintaining a neutral fed funds rate which is 2.25 - 2.5% when the inflation rate is 2%. This permanently shifts the equilibrium back to the historic level, destroying asset values and businesses whose prices were based on the zero fed funds rate (and all the ultra-low rates at other maturities that followed). The Fed is slowly reducing its bloated book of long-term Treasuries and mortgage bonds, which has immediately resulted in a doubling of the 30 year mortgage rate to near its pre-crisis average.
Fed Chair Powell clearly believes that the current inflation resembles the 1970s, which he cited in his speech. “The successful Volcker disinflation in the early 1980s followed multiple failed attempts to lower inflation over the previous 15 years. A lengthy period of very restrictive monetary policy was ultimately needed to stem the high inflation and start the process of getting inflation down to the low and stable levels that were the norm until the spring of last year. Our aim is to avoid that outcome by acting with resolve now.”
It seems that the market is finally beginning to believe what Powell and other Fed officials have repeated over the past 6 months.
**Investors Ramp Up Bets Against Stock Market as Summer Rally Fizzles**
**Net short positions against S&P 500 futures have recently grown, reaching levels not seen in two years**
**By Hannah Miao, The Wall Street Journal, Aug. 28, 2022**
**...“Retail investors are actually pretty optimistic,” said Mr. Hackett. “It’s more likely that in the near term, a period where retail investors get more pessimistic causes the market to drop.”** [end quote]
The bottom may take a while until investors realize that the whole playing field has changed.
The Fear & Greed Index has fallen into mild Fear. The trade is suddenly risk-off, not yet severe.
The Treasury yield curve shifted up in the past week, slightly lower at the long end. Financial stress is neutral, nothing to worry about.
The METAR for next week is stormy. Friday’s drop will continue.