QVMS - The Fed Has Freed The Market To Dig Its Own Grave

Summary

• The jobs data surprised to the upside.
• The ISM data surprised to the upside.
• The stock market appears to be grossly mispriced relative to rates.

The most stunning part of the FOMC press conference on Wednesday wasn't at the beginning or the middle. It came at the end. Probably, nobody was paying attention because the market was rising rapidly and everyone believed that the Fed wouldn't push back against the market anymore.

However, toward the very end, Fed Chair Jay Powell was asked about the divergence between the Fed's forecast on interest rates and the market's forecast. His simple answer was:

I mean, I'm not going to try to persuade people to have a different forecast, but our forecast is that it will take some time and some patience and that we'll need to keep rates higher for longer. But we'll see.

The interpretation is that the market is free to do what it wants, and if it wants to fight the Fed, good luck. The chairman's message on Wednesday was no different from what it had been for months, and it seems he's more than happy to let the market determine its own fate.

The first data point in favor of the Fed was the job report data on Feb. 3, which showed that the US economy added 517,000 jobs in January, far exceeding the estimated 188,000. Additionally, the unemployment rate fell to 3.4%, and the labor participation rate increased to 62.4%.

This positive job growth was boosted by a huge surprise in the ISM services report, which rebounded to 55.2 from 49.6 in December after a decrease last month. Furthermore, new orders increased by 60.4% from 45.2, and the prices paid index rose to 67.8 from 67.6.

This data supports the idea that the economy may be slowing down from its fast growth rate of recent years, but it's still performing well. It also suggests that interest rates are too low, the dollar is too weak, and financial conditions are too accommodative. The bond market and the dollar index are reacting as they should, with the Fed Funds futures curve rising sharply from its position following the FOMC meeting. The July Fed Funds future is now showing a terminal rate of 5%, having risen by more than ten basis points, while the December contract has increased by almost 20 basis points, now standing at around 4.65%

The dollar has jumped on the day as well by 90 bps, which, if this should carry over in the days ahead, will lead to financial conditions beginning to tighten again, which is exactly what the Fed wants. As long as the data supports the Fed's view, financial conditions will likely continue tightening because the economy remains more robust and will need tighter monetary policy.

That policy will probably need to hold for, as the Fed suggests, all of 2023, and something the equity market appears to be mispricing. The best example may be the Nasdaq 100, which now has an earnings yield of about 3.75% versus a 10-year real yield of 1.27%, making the spread just 2.47%.

The Nasdaq 100 is now more expensive vs. the 10-year TIP than at any point since 2008.

The spread between the 10-Year real yield and the Nasdaq 100 has consistently been around 4.30%, with a reasonable range of 3.8% to 5.35% over the years. The current spread is more than two standard deviations below the average over the past decade.

It would seem that the equity market's valuation is stretched, and perhaps it was stretched because it was under the impression that interest rates would be falling and was trying to get in front of that rate decline. However, the bond market has a different view, as the 10-year TIP rate 1-year forward suggests that the TIP rate will still have a value of around 1.07% one year from now and 1.19% two years from now.

So again, the equity market may have gotten ahead of itself on the soft data, leading to the Fed not being able to raise rates, but as Powell said on Wednesday, he's not going to try and persuade anyone, which means you are on your own.

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