Fed Chairman Jerome Powell and investors aren’t on the same page…
In fact, the disconnect between what the Federal Reserve boss has openly stated and what investors have been pricing in has never been greater.
Last week, Powell said inflation remains stubborn but interest rates are sufficiently restrictive to keep it from rising again. That implies the Fed will likely halt raising rates at its next meeting in June.
However, Powell was quick to quell any sign that the Fed would cut interest rates in the near future. As he put it, if the Fed’s forecasts are correct, it won’t cut rates any time soon.
The market disagrees.
Based on the fed funds futures market, investors are betting the Fed will begin cutting rates in July. And it’s projecting it’ll cut rates a full point by the end of the year.
Powell called the banking system sound and resilient. This came as regional bank stocks like PacWest and Western Alliance fell as much as 72% and 62%, respectively.
The Fed chief then downplayed the possibility of a coming recession, saying, “The case of avoiding a recession is, in my view, more likely than that of having a recession.”
That’s in stark contrast to economists’ and Wall Street’s projections.
According to economists surveyed by Bankrate, the U.S. economy has a 64% chance of entering a recession by the end of 2023. And Bloomberg’s U.S. recession probability model is indicating that there’s a 100% chance of a recession within the next 12 months.
When the world’s most powerful central banker is out of whack with the world’s largest market, it puts investors in a bind.
One way or another, one side will have to give.
Today, I’ll give you some clarity about what’s going in the market… and what you can do about it.
What the Fed Gets Right
Last Wednesday, the Fed raised its federal funds rate by 25 basis points – increasing the rate range to 5–5.25%. It was the 10th rate hike in 13 months.
That’s the fastest the Fed has hiked rates since 1981.
As I mentioned above, Powell believes interest rates are at a sufficiently restrictive level to tamp down inflation. That implies the Fed may stop raising rates in June.
However, the market doesn’t believe the Fed will just pause rate hikes – it’s betting the central bank will begin to cut rates.
You can see that in the chart below…
The market is forecasting that the Fed will cut rates a full percentage point by January 2024.
This is divorced from reality. Powell, for the most part, agrees with my view. That’s because inflation remains persistently stubborn.
Although it has come down from its record highs, the rate of inflation remains stagnant.
The Fed’s preferred measure of inflation, the Core PCE Index, rose by 4.6% in March relative to a year ago… the same pace it hit in December 2022.
On Wednesday, we found out Core CPI rose by 5.5% in April relative to a year ago. That means it has barely moved so far this year.
This is due to the stickiness of categories known as core services. They include medical and personal care, insurance rates, and education.
Powell pointed to this category as a clear sign that inflation remains a problem.
As Powell said: “We on the committee have a view that inflation is going to come down not so quickly. It’ll take some time. And in that world, if that forecast is broadly right, it would not be appropriate to cut rates, and we won’t cut rates.”
Ultimately, the Fed believes talk of rate cuts is too premature.
Meanwhile, the jobs market remains strong.
The April jobs report exceeded economist forecasts. The U.S. added 253,000 jobs in April, 37% more jobs than the forecast of 185,000.
The Fed has never cut rates with U.S. unemployment this low.
Not only is the labor market strong, but wages in April rose at their fastest pace since March 2022. That’s good news for workers but bad news for the Fed.
The faster wages rise, the more relative spending money for consumers, and the longer prices will remain elevated.
Why It Will Pay to Be Patient
So let’s once more lay out the environment we’re in.
Inflation remains stubbornly high, with some signs that it’s reaccelerating. The job market remains extremely tight.
Yet despite everything to the contrary, investors believe all of that will change in the next two months… And the Fed will be forced to begin cutting rates quickly.
As the market digests the real possibility that its expectations are off, we’ll see downward pressure on stocks.
That’s because the higher interest rates are for longer, the lower the fair value of stocks.
A stock’s fair value is commonly determined by the current value of a company’s future cash flow. To find the current value, you’d discount that future cash flow by what’s known as a “discount rate.”
The higher the discount rate, the lower the current value. As investors price in rates that remain elevated for longer, the fair value of stocks will drop.
Bottom line: If you want to buy stocks right now, I suggest you remain patient.
You’ll likely see better entry points over the coming months as the market finally absorbs what Powell has been repeatedly telling it: Rates will remain higher for longer.
In the short term, I’m anticipating the S&P 500 to dip to its 200-day moving average of 3,972, which would be a 4% pullback. That’s represented a meaningful level of resistance over the past year.
When the S&P 500 dropped below that level in March 2023, it snapped back by 8%. So it offers a good risk-reward setup.
In this current market environment, it’ll pay to be patient.
Regards,
Michael Gross
Analyst, Palm Beach Daily
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