An interest rate Love Story: Being Jerome Powell means never having to say you're sorry?

In just two months, Federal Reserve policy has pivoted from employment to inflation, from massive monetary stimulus to balance sheet reduction.  Until November 30 the Fed had insisted price increases were transitory. Are they now permanent? What's a trader to think when a central bank gets the most basic economic prediction completely upside down?  Join FXStreet senior analysts, Yohay Elam, Eren Sengezer, and Joseph Trevisani for a critical look at the Fed's astonishing mistake.

 

Joseph Trevisani: I borowed the "Never having to say you're sorry" line from Love Story yesterday in an interview to describe Fed policy.
Two months ago, after nearly half a year of hinting the Fed changes policy, and no one says Woops.

Yohay Elam: I think the surprise came from the fact that Powell seemed to play down the chances of a rate hike in March when he spoke in December, but the minutes took the hawks out of the shadows. 80% chance of a hike in March, huge shift indeed.

Joseph Trevisani: Agreed, but then Powell was always the strongest voice for the need to keep rates low to restore employment.

Yohay Elam: The slow boiling frog. Gradually moving toward hawkishness.

Joseph Trevisani: It's the Fed analysis that is on record.  Many folks, myself included, have been saying for most of the last year, that this inflation is not temporary.

Eren Sengezer: He did change his tone on employment after the December meeting though. He said they can't wait for "maximum employment" with inflation staying high.

Yohay Elam: The comment about employment shows he's become nervous about inflation.

Joseph Trevisani: Policy tilted for the last 10% or 15% is bad policy.  It's the old market cliche..with apologies to the porcine set..who are actually quite intelligent. Pigs get slaughtered and chickens come home to roost.

Yohay Elam: And bears have awakened yesterday.

Joseph Trevisani: It might be more accurate to view Fed inflation policy as wish fulfillment.  How long did the Fed predict rising inflation after the financial crisis?  I think it is interesting that the delay to monetary inflation takes in the QE policies of the last decade.  In comparison to the last bout of inflation in the 1970s and early 80s, it also took about a decade for the deficit spending of the late 1960s and 70s to really fuel price increases.
Yes, but I think the economy and equities can bear higher rates at least for another point or two. The 10-year US Treasury yield is still below any point prior to October 2019, essentially the pandemic rate repression. 

Yohay Elam: For yields and the dollar, I think the question is: when will peak Fed hawkishness come?

Eren Sengezer: That should start with the Fed turning to 'quantitative tightening'.

Joseph Trevisani: If the Fed uses natural roll-off for the balance sheet, reduction begins almost as soon as the Fed halts bond-buying.

Eren Sengezer: Do you think markets are actually pricing a 'quantitative tightening'? It's still too early to say but I would expect a deeper correction in stock markets and a more decisive rally in yields.

Yohay Elam: I think the Fed will only go for a natural roll-off in 2022.

Joseph Trevisani: I agree, I do not think the Fed will begin selling assets.

Yohay Elam: QT is undoubtedly bearish for stocks. QE is the main driver behind the relentless buy-the-dip mentality.

Eren Sengezer: QT would probably be too aggressive of a move.

Joseph Trevisani: The Atlanta Fed has the US economy growing at 7.4% annualized in the fourth quarter. The question is, are equities pricing Fed liquidity or economic growth?

Eren Sengezer: That's a great question.

Joseph Trevisani: The answer is both, but the balance is unknown.

Eren Sengezer: I'd say they have been pricing the liquidity until COVID vaccinations and pricing strong recovery afterward. So yeah, they have been pricing both. Do you think the Biden administration will go for another round of COVID relief? And would that change the Fed's inflation outlook?

Yohay Elam: I also think both.

Joseph Trevisani: No Covid relief is dead. As is the BBB project.

Yohay Elam: The mix of rate hikes, a natural roll-off of bonds, and the lack of fiscal stimulus could cool the economy by mid-year.

Joseph Trevisani: The US is headed into an election, Biden's polling is terrible and worsening, the administration's political leverage is non-existent.

I agree the combination could cool the economy, but I don't think it is a certainty. After the massive monetary intervention of the past 13 years, I'm not sure anyone knows how the economy will respond to rising interest rates. At least Powell has been reappointed, which may diminish any political pressure if the economy does start to slow under the rate flail.

Yohay Elam: A rate hike in March, then one in June, and the Fed is done for the year.

Joseph Trevisani: Fed futures have had three hikes by December. The percentage this morning is 76.7%. I think that is high. If the economy and job creation do slow, the Fed will respond. 

Eren Sengezer: Inflation is the main concern and it is largely caused by supply bottlenecks, which has nothing to do with the Fed's policy.

Yohay Elam: Inflation may also be peaking, at least according to ISM Manufacturing PMI.

Eren Sengezer: Policy tightening might not be the answer to inflation and the Fed could move to the sidelines if prices pressures start to ease by themselves.

Joseph Trevisani: Perhaps, but there is the PPI reading at 9.6% in November.

Eren Sengezer: Again, that brings us to wage inflation and how it would alter long-term inflation expectations.

Joseph Trevisani: Rate policy is a very blunt instrument against inflation. It basically tanks the economy to get inflation down.
Yes. The voluntary job departure figures from the JOLTS report were the most on record in November. Folks are switching jobs because of the opportunities but how much of that is seeking higher pay to compensate for inflation is unknown?  My guess is that it is not yet the dominant motive, the inflation surge is too recent.

Yohay Elam: Some were fed up with their jobs. Some used savings and stimulus to open a business.

Joseph Trevisani: I think that may be a pretty common motive for changing employment.

Yohay Elam: Pent-up demand for job change, changes in the economy. More logistics, less retail.

Eren Sengezer: Speaking of jobs... December NFP report is coming up. Do you think it will have a noticeable impact on March rate hike expectations?

Joseph Trevisani: No, unless it is very much below expectations. At least for the first quarter, I think the Fed has set policy expectations.

Eren Sengezer: November print missed the market expectation by a wide margin and was largely ignored. I agree that the Fed will keep its hawkish tone for the time being.

Yohay Elam: Real expectations are high after ADP, even if we all know that ADP´s figures are not very precise.

Joseph Trevisani: There is room for maneuver, but the balance sheet discussion in December has given the odds to a March hike.

Yohay Elam: Unless CPI tumbles and job figures badly disappoint, a rate hike in March is certain.

Joseph Trevisani: In the 11 months through November, ADP and NFP have moved in the same direction 6 times and opposite the balance. I agree. But who thought in November, when the Fed started the taper, that two months later, the Fed would be actively discussing reducing its balance sheet.

Eren Sengezer: Yeah, it took only six months for the narrative to change from taper to balance sheet runoff. That is a sharp U-turn.

Yohay Elam: Powell said it's the Employment Cost Index that was the tipping point, cynics say it's his reappointment. I say it's the persistence of inflation – core inflation continued rising. Inflation related to supply-chain issues spread into basically every part of the economy.

Joseph Trevisani: I think the supply chain issues are deeper than many realize. I think the pandemic and China's response have reordered manufacturing ideas and that will take time to play out. In the same fashion, the pandemic has recast work, from offices and cities to home, and that also is a disruption that needs time to settle.  My guess is the record job departures indicate people are looking for a new balance.

Yohay Elam: Yeah, rebalancing of people's lives and rebalancing growing demand for goods and falling demand for services are all disruptive forces, also pushing inflation higher.

Joseph Trevisani: Exactly. As for Omicron, I think its influence is over.

Yohay Elam: Omicron caused flight cancellations en masse. But I agree the worst is behind us. The drop in covid cases in London, the first major Western city the variant landed in, is encouraging Israel didn't waste one second and shut its borders when Omicron just got its name. Today, the government announced that there no more "red" countries and tourists are welcome. The horses are out of the stable with record number of cases but few hospitalizations. More cases from abroad won't make the difference.

Joseph Trevisani: Omicron will still generate hysterical reactions in some quarters, but it is less virulent than normal flu.  It cannot be contained, nor should it.  China's reaction in shutting down cities has more to do with Beijing saving face than anything else.

Yohay Elam: Beijing's reactions could cause more supply-chain shocks and inflation.

Joseph Trevisani: It could, but the mandarins in Beijing are practical people, I think they sense the global distrust their policies and denials have generated. Does Israel have a public and school mask mandate?

Yohay Elam: I only follow the international entry regulations in Israel. When I'll visit, I'll let you know... Everything is selling off on Fed fear, even Bitcoin or is that a sign of maturity in Bitcoin?

Joseph Trevisani: Yes, surprising to say, I think it is.  Equity selling in response to Fed rate hikes seems eminently normal.