The Fed Owns This Stock Market

On December 19, Jay Powell stepped to the microphone after the Federal Reserve had raised short-term interest rates and began his press conference. The market was concerned. The two-year rate on government bonds was at 2.65% and was higher than the 5-yr (2.62%) and inching perilously close to the 10-yr at 2.76%. The Fed typically inverts (raises short-term interest rates above long-term rates) the yield curve when it wants to slow the economy because inflation has begun to rear its ugly head. Just one problem. In December 2018 there was no surge of inflation. In fact, the TIPs market said inflation would be below the Fed’s 2% for 10 years.

All of this begged the brilliantly on-point query by Jeanna Smialek of Bloomberg, and I paraphrase: “If you haven’t achieved your two percent inflation goal for 10 years and you don’t see it overshooting, what’s the point of raising rates again at all?” Powell hedged and said policy at this point “does not need to be accommodative”. The market basically crashed for the next week as everyone took that to mean we will continue to raise rates and shrink the balance sheet. Or to paraphrase Ben Bernanke: “We the Fed will murder this economy!”

The Bloomberg Financial Conditions Index, which measures the overall level of financial stress, plummeted. All risk assets were harmed- equities, credit spread products, and commodities. Market participants, including myself, were shocked that the Federal Reserve would “murder” an economy showing no signs of inflation. The Fed was, in fact, achieving its sometimes-contradictory dual mandate – strong employment and stable prices. Instead of smiling and taking a victory lap, Powell felt the need to get way ahead of the data. Fortunately, it wasn’t a plan. It was a rookie mistake.

So how do I know for sure? Immediately after the pre-Christmas debacle, all the Fed governors, including Chairman Powell, walked further rate increases back and, furthermore, even hinted at slowing or stopping the pace of balance sheet shrinking. This culminated in his January 30th press conference where he stated, the Fed is now in “a wait and see approach” and the case for “raising rates has weakened”. I have followed the Fed for a long time, and I can never remember a bigger 180-degree turnaround in one month. The risk markets have noticed. The stock market is on an upward tear along with high yield bonds and other risk assets.
Unfortunately, some damage was already done, and we now see some weakness in the US economy, perhaps from foreign economic weakness, or from a December stock market chill that affected Main Street. The Citi Economic Surprise Index, which is at -23.6 and falling, is near a two-year low and may presage a weak 1Q GDP report. Earnings for Q1 will likely be down year-on-year and full year estimates are rapidly approaching flat. Interestingly, while stocks have had a memorable rally, it has not created losses on long-term government bonds as they are up as well.

So, how do we know the Fed owns this market? In 2018, The real GDP was up almost 3%, inflation as measured by the Core PCE, was sub 2%, and S&P 500 earnings were up 20+%. Despite all this the market fell because of Fed tightening. Now in 2019, the economy is weaker, earnings are flat and, presto, the stock market is unstoppable. The markets are now predicting the Fed will cut interest rates. The Fed owns this market and now they know they own it. We, as market participants, are spending more time than ever parsing their various speeches and meetings!
Addendum- Why did they miss inflation clues so badly? I will cover this in my next column but there are a couple of things to think about. For example, market participants like Powell and others my age, are colored by the 1970’s and 80’s inflation experience. Also think about the following VERBS and their effects on inflation- To Frack, To Uber, To Google, To Amazon and To Stream. Got you thinking?