Less hawkish Powell signals end of rate hike cycle is near

WELREX® Director John Longo shares his latest views on US markets and the economic outlook

January Effect in Full Swing

The year started strongly with the January Effect in full swing. The S&P 500 increased 6% last month and Nasdaq had its best start to the year since 2001, up a robust 10.7%. Most international stocks also did quite well with the widely followed MSCI EAFE Index up roughly 9% in January. Bonds started to rebound from perhaps their worst year ever in the U.S., with the Bloomberg Barclays Aggregate up more than 3% in January. Investors resoundingly slammed the door on a largely disappointing 2022 and welcomed in the New Year with gusto.  Would the Fed’s first interest rate policy meeting of the year spoil the party?

The Fed Has “More Work to Do”

In a widely expected move, the Fed raised interest rates 25 basis points on February 1^st, bringing the Fed Funds rate to 4.75%, a far cry from the nearly 0% rates of roughly a year ago. Stocks rallied on the news, with the S&P 500 up a little over 1.0% for the day. The 25bps rate hike was almost a foregone conclusion, but there was some debate about the Fed’s next move.  Pause or no pause? Fed Chair, Jay Powell, said “there’s more work to do” basically putting the debate to rest.  Fed Funds Futures are pricing in virtually a 100% chance of another 25bps increase in March, as shown in the graph below.

Source: CME Group

Futures are pricing in a 63% chance of another 25bps hike at the May meeting, buoyed by an unexpectedly strong unemployment report, discussed further below. So why did stocks rally on the rate hike news? In his press conference on Wednesday, Powell took a sort of a victory lap saying “the disinflationary process has started.”  For those not well versed in Fed speak, disinflation refers to positive inflation, albeit at lower rates.

Hot Unemployment Report Points to “Higher for Longer” Fed Policy

Just as the Fed seemed to bask in the glory of falling inflation and an economy facing the prospect of a soft landing, Friday’s blowout unemployment report threw a monkey wrench into its plans. The U.S. unemployment rate fell to 3.4%, the lowest level since 1969. Inflation was likely to stay elevated well above the Fed’s 2% target simply due to the base effect component of the CPI calculation. The number one factor driving consumer spending, the biggest part of U.S. GDP, is having a job. Consumer spending is likely to remain above recessionary levels fueled by job + wage growth and continued pent-up demand from the pandemic. Hence, the Fed may be faced with the dilemma of living with stubbornly high inflation or, conversely, hiking rates and shrinking its balance sheet to push the economy into a recession. We think the Fed will blink and live with inflation in the 3% range, rather than its desired goal of 2%, a strategy that is likely to keep interest rates higher for longer.  A monetary policy of this sort is likely to result in a coin flip between a mild recession or a soft landing.

What Does It All Mean?

At Welrex, we think most stock and bond indexes will deliver positive returns in 2023, unlike last year. However, we think alternatives generally have the best return/risk tradeoff at this juncture, since there is limited room, if any, for earnings multiple expansion and earnings growth this year is likely to be weak at best. Similarly, strong employment and stubbornly high inflation levels make it unlikely that fixed income securities will deliver very meaningful returns. Granted, yields today are far better than they were a year ago, but on a real, after-tax basis they can be hardly described as mouthwatering.  Alternative investments include hedge funds, private equity, commodities, and a modest allocation to the strongest cryptocurrencies.

John M. Longo, PhD, CFA

Director, WELREX