O - Why Markets Were Thoroughly Confused After Fed Chair Powell's Key Speech

2023-10-20 07:00:00 ET

Summary

• Fed Chair Jerome Powell's speech at the Economic Club of New York confused markets, as he provided contradictory views on the Fed's policy tightening.
• The unclear messaging created market uncertainty, leading to a decline in stock market indices for the day (October 19).
• Powell discussed the decision to end rate tightening and the possibility of further restrictive policy due to inflation risks.

Fed watchers who analyzed Fed Chair Jerome Powell’s speech at the Economic Club of New York are likely confused. Powell’s prepared remarks provided a mix of contradictory views on the Fed’s policy tightening. His remarks both implied the potential end to the punitive rate tightening cycle and the justification of further tightening.

The unclear messaging created market confusion, conditions that suit traders the most. The Dow Jones, Nasdaq, and S&P 500 all broke below their trading range by noon on Oct. 19. Importantly, the small-cap index, Russell 2000 ( IWM ), resumed its steep downtrend that began in July. The small-cap firms are the most sensitive forward indicators for the stock market.

How should readers interpret Powell’s mixed commentary? Not much has changed on the Fed policy stance since the Fed Chair’s game-changing Fed rate hold on Sept. 20, 2023 . In that time, the S&P 500 ( SPY ) traded at between around 4,200 to 4,400. However, interest rate-sensitive assets, especially utilities and REITs, resumed their yearlong declines.

Decision to End Rate Tightening

Powell said that the economy might not have experienced the full impact of the central bank’s policy tightening. While recognizing the very resilient economy, interest rates do not negatively affected all sectors. Later, he said that housing , as expected, sees the effects of higher rates.

The Chair recognizes that the magnitude of the impact of tightening does not have precision. The Fed does not know how long the lags between tightening and the impact on the economy would take.

Powell explained that the Fed focuses on short-term rates in its monetary policy. It will need to let long-term Treasury yields play out. On the day, the mid to long- term Treasuries traded above the 52-week high. View the yields from Market Data on the toolbar and then select “bonds.”

Expect heightened bond yield volatility next. Market participants previously waited for the 10-year Treasury break out above 5.0%. This is an expected milestone achieved today . As the demand for Treasury securities weakens, (find the tentative auction schedule here ), yields will continue to climb. 5.5% to 6.0% is the next milestone for the 10-year yield.

In response, the mortgage market already prints a mortgage rate of 8.03% . This is a fixed rate not seen in 23 years.

Decision for Further Restrictive Policy

Powell said that inflation risks could resurge. Evidence that suggests persistently above-trend growth would warrant further tightening of monetary policy. In addition, if tightness in the labor market stops easing, it is another risk that supports a restrictive rate policy.

The Fed is firm on its commitment to achieve inflation of 2.0%. In the Sep. 2023 Consumer Price Index report, the CPI of 3.7% is above the 2.0% target.

Much to the frustration of income investors, the Federal Reserve will carry out its rate policy carefully. Interest rates will remain higher for much longer than markets expect. REIT investors who bet on a pivot (rate cut) in the summer paid a heavy price. Realty Income ( O ), for example, tried to break out in July. By September, the stock fell from $54-$56 to a low of $48.42. Its attractive dividend rose again as shares fell. Its dividend yields 6.18%.

New Neutral Rate

The neutral rate is the rate at which monetary policy neither stimulates nor restricts economic growth. Hutchens Center reported that this declined by around 3.4% since 1972. However, the Fed did not offer to estimate where the neutral rate stands.

Since the Fed thinks the neutral rate is currently not tight. That is, interest rates are not above the neutral rate and therefore do not have a contractionary impact on the economy. Despite the rate hikes, the loose monetary policy still has a stimulatory impact on the economy. By stimulating economic activity, inflationary pressures will persist.

Fiscal Policy Addressed

Powell echoed what readers said for months about the excesses of government spending. Powell said that the fiscal deficit is on an unsustainable path. The Fed inferred that high long-term treasury yields would weaken the government’s fiscal spending.

Spending on defence gets plenty of attention. The Department of Defense has a budget of $773 billion . When the cost of interest on debt exceeds the defence budget, the public will shift its focus on cutting the country’s debt. The Treasury Department paid a record $213 billion in interest payments in the last quarter of 2022.

Markets rewarded patient investors exposed to the defence sector. Stocks like Lockheed Martin ( LMT ) and Northrop Grumman ( NOC ) are up sharply in the last month.

Geopolitical Tensions Rise

NOC and LMT stock rose after the Hamas invasion of Israel. Powell mentioned that geopolitical tensions are highly elevated. They introduce risks to global economic activity. Elliot Investment Management founder Paul Singer echoed Powell’s concerns. The billionaire said that markets are not pricing on the far more dangerous world today. Despite recent geopolitical tensions, stock markets barely reacted.

Markets are complacent because their valuations and volatility do not reflect the real economy. For example, job cuts boost stock prices because companies save money. Yet big job cuts hurt the economy. They will eventually hurt the demand for goods for many firms.

Stocks have yet to allow negative market sentiment to mount. Still, stocks are starting to price in the reality of weak demand. A few weeks ago, fears grew that weaker disposable income would hurt the demand for goods. Proctor and Gamble ( PG ), Coke ( KO ), and Pepsi ( PEP ) are among the firms that traded lower. More recently, KO and PG stock began to rebound.

The electric vehicle market is not so lucky. After cutting prices to sustain its market share, Tesla ( TSLA ) reported weak profit margins. CEO Elon Musk warned shareholders about its new Cybertruck . The truck EV will lose money until it reaches critical volume levels. Until then, the truck is not prosperous for Tesla. Rivian ( RIVN ), Fisker ( FSR ), and Lucid ( LCID ) are among the firms that are nowhere near achieving economies of scale. Those firms new to the EV market will continue to lose money for every vehicle sold.

Your Takeaway

Markets have always been confusing. Powell’s key speech added to that sentiment, creating further uncertainty. Markets hate uncertainty. Combined with rising Treasury yields, Powell’s comments will set up further downside for stocks.

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