RTX - Powell Is In A Pickle

2023-12-13 09:30:00 ET

Summary

• Stocks have been soaring for the past six weeks, with the S&P 500 and Russell 2000 index both experiencing significant gains.
• The bond market has also seen a recovery, with the iShares Aggregate Bond ETF surging 4.7%.
• Investors believe that inflation will soon fall to the Fed's objective of 2%, leading to expectations of looser monetary policy and rate cuts.
• That has loosened financial conditions dramatically, working against the economic objectives of the Fed.
• Powell will have a difficult time acknowledging progress without fueling the rally, but the Fed's rhetoric is falling on deaf ears.

Stocks soared again yesterday in what has been a six-week melt up like one I have not seen in a long time, and it is no longer a party where just 7 stocks are invited. While the Magnificent ones have held their own, the equal-weighted S&P 500 ( RSP ) has risen more than 11%, and the Russell 2000 Index (RTY) of small cap stocks has soared more than 13%. The bond market has made a miraculous recovery with the iShares Core U.S. Aggregate Bond ETF ( AGG ) surging 4.7% and now showing gains on a year-to-date basis.

I think this reflects an abrupt realization by the consensus of investors that inflation will soon fall to the Fed's objective of 2%, which should allow the central bank to start loosening monetary policy from what Chairman Powell acknowledged two weeks ago is one that is "well into restrictive territory." On the same day, Chairman Powell attempted to throw cold water on the rally that is clearly concerning Fed officials by stating publicly that "it would be premature to conclude with confidence that we have achieved a sufficiently restrictive stance, or to speculate on when policy might ease…" Yet that is exactly what investors have been doing, and rightly so, as Powell also noted that core inflation has run at a 2.5% annual rate over the past six months. The super core is already down to 2.5% on an annualized basis.

This puts Chairman Powell in a pickle like no other today. Investors are no longer buying the rhetoric that Fed officials have used all year long to temper enthusiasm for risk assets until they feel they have achieved their inflation objective. Investors realize that they are very close and will soon achieve that economic outcome within the next six months, which is why rate cut expectations have risen dramatically. Since markets are discounting mechanisms, we are rapidly closing the gap between rhetoric and reality.

Yet the process of closing that gap is also loosening financial conditions in a way that could upend that reality. Bloomberg's Financial Conditions index reflects the loosest level since prior to Russia's invasion of Ukraine in February of last year.

Looser financial conditions work against slowing the rate of economic growth, and the Fed wants that to end as soon as possible. That is what Chairman Powell needs to delicately address today, but I am not sure how he does it. The incoming economic data has been stellar for those who are forecasting a soft landing. Surely, he wants to acknowledge the success in cooling price increases without causing any significant pain in the form of higher unemployment. At the same time, he doesn't want markets to become overzealous in reflecting that fact.

He attempted to thread the needle two weeks ago and failed miserably. The stakes are even higher today. I expect we will see a lot of pushbacks from the more hawkish members of the voting committee in their updates to the "dot plot," which reflects where they each see short-term rates landing over the next several years. We are also likely to see an update to the Summary of Economic Projections that is far less enthusiastic than markets are reflecting. Again, will investors buy into the rhetoric and sell risk assets?

If so, and we do see a pullback to blow off this melt up in stocks and bonds, I think it is one that should be bought for the new year. No matter what Fed officials say, the high-frequency economic data is looking more and more like a soft landing is taking shape. This should lead to new all-time highs for the S&P 500 (SP500) and much broader participation for the stock market at large. My only concern is that this is what most investors are looking for now.

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