The Fed Is Circling The Wagons
Quite a bit of unusual hawkish talk from the Fed this week had the markets up and down in trading action. The market, and the Fed, are making a lot out of the "disappointing" inflation numbers this week. Is the Fed "circling the wagons" or "falling off the wagon?"
This week's musings are inspired by the idioms we often speak that are founded in actual happenings in history. Pioneers who were travelling west by wagon train would often encounter thieves, hostile indians, or packs of wild animals. They would "circle the wagons" together to make it easier to defend one another. Side note - if you haven't seen it already, I highly recommend Taylor Sheridan's "1883" prequel to his hit show "Yellowstone." This week, the Fed has absolutely "circled the wagons" to reinforce the idea that they are committed to fighting inflation.
We would argue that they have "fallen off the wagon" in terms of their monetary mandate and are playing with investors' psyche. At the turn of the century, and especially following Prohibition, men who wanted to stop drinking would climb aboard the 'water cart' in a vow to drink the dirty street water in the tank rather than drink alcohol. When they would struggle with their vows, they would "fall off" the wagon and head back into the local saloon. That's where I think the Fed is now and we'll explain why.
Here's what we're seeing so far this week...
Inflation - The Gift That Keeps On Giving. Both CPI and PPI did not drop as much as the market expected and that gave the Fed room to bludgeon the market with hawkish speeches.
Economists had expected (hoped, rather) that January's CPI would come in at 6.2% (year-over-year) versus 6.5% last month. January's reading was 6.4%, but that's still the 7th consecutive month of declines since the peak in June of 2022. PPI for January was expected to drop to 5.4% from December's 6.5%, but it only dropped to 6.0% in January.
The fretting of the market is nonsense. Throughout history, inflation has rarely moved in a straight line toward an ultimate bottom. Over a 14-month period, year-over-year inflation has hit speed bumps and/or been flat versus the previous month in at least 10 of the last 15 inflation down cycles. In fact, hardly any economic statistic moves in a straight line up or down.
The Fed knows this, but they are using this week's disappointing inflationary news to achieve their agenda - controlling the "wealth effect." In a surprise move, both Fed governors Bullard and Mester (non-voting) indicated this week that they advocated for a 50 basis point rate hike during the last FOMC meeting at the beginning of the month. We rarely, if ever, hear a Fed governor give an outright number of what they may have proposed in an official FOMC vote. We should take this as the Fed "gaming the system" to help keep equities under control after sentiment has shifted (more on that in a moment). Even though futures on Fed Funds is showing an 80% probability of a 25 basis point rate hike in March, the Fed speeches this week accomplished their goal. Futures of a 50 basis point rate hike moved from 4% a month ago to 18% today.
What's Changed? One reason for the slight pause in inflation was energy costs. During the month of January, gas prices rose by more than 10%, causing the PPI to come in hotter-than-expected.
The good news? Since the end of January, fuel prices have come back down. It's possible inflation's disappointing numbers from January could be temporary. One thing is for sure, consumers are still quite resilient. The Retail Sales from January came in this week at +3.0%, nearly double the market's expectation of +1.8% and a nice rebound from December's -1.1%.
The Job Market is also no hinderance as Initial Claims were less than expected at 194,000 and lower than even last week's revised decline. The Fed knows this all too well. Sentiment in the market has also shifted as two measurements of market sentiment we heavily watch - the VIX (volatility) and the TED Spread (fear) have declined.
The VIX is trading well below its 200-day moving average and remains below the 50-day moving average. Since the beginning of October, 2022, volatility has been steadily declining. The TED Spread finally broke below its 4-month range-bound status and is now the lowest it has been since mid-September of last year. On top of that, the fundamentals are pointing toward a "soft landing" if that's what you want to call it. For now, there's no good reason for the Fed to keep pumping the breaks, except to keep equity securities from moving considerably higher with better investor sentiment. Unless we see an unprecedented spike in either volatility or fear, we should expect equities to perform better moving forward.
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