Fed Chair Jay Powell turns “full dove”… an emphasis on employment, not inflation… the market believes rate hikes will come sooner than the Fed suggests

Fed Chairman Jay Powell just greenlit a rally in stocks.

In yesterday’s Digest, we featured analysis from Louis Navellier and Luke Lango, pointing toward a summer rally in the market. One of the biggest reasons behind this forecast was the Fed.

Luke, in particular, made the point that this Fed does not want to ruin the Wall Street party.

From Luke, in yesterday’s Digest:

This is a Fed that’s always dovish, never wants to upset the apple cart, and always errs on the side of better safe than sorry.

Well, yesterday, Powell did exactly what Luke predicted…

He went “full dove.”

***Hawkish no more

Last week’s Fed meeting took many market participants by surprise. The overly-dovish tone that was expected was replaced by a slightly hawkish Fed, with an accelerated timeline of rate hikes, and an increased inflation forecast.

The shift in messaging cratered U.S. stocks at the end of last week as fears of a tighter monetary policy set in.

Well, the Fed’s hawkishness disappeared yesterday.

In testifying before the House Select Subcommittee on the Coronavirus Crisis, Powell took a dovish tone from the start, noting that the Fed would “do everything we can to support the economy for as long as it takes to complete the recovery”.

As part of this, Powell gave us the Fed’s intended playbook, and jobs, perhaps even more than contained inflation, is at its center.

From Powell:

We will not raise interest rates pre-emptively because we think employment is too high [or] because we fear the possible onset of inflation. Instead, we will wait for actual evidence of actual inflation or other imbalances.

There is a growing realisation across the political spectrum that we need to achieve more inclusive prosperity. Real incomes at the lower end of the spectrum have stagnated relative to those at the top.

Mobility across income spectrums has declined in the United States and now lags that of most other advanced economies. These things hold us back as an economy and as a country.

In determining policy, Powell said the Fed would monitor a broad set of labor market statistics, including how different racial groups are faring.

From Reuters:

We will not just look at the headline numbers for unemployment,” Powell told the members of the House Select Subcommittee on the Coronavirus Crisis. “We will look at all kinds of measures … That is the most important thing we can do” to ensure the benefits of the recovery are more fully shared.

But there’s some uncertainty in what real success here looks like.

Some of Powell’s colleagues have suggested that the pandemic caused many people to retire, so returning to pre-pandemic unemployment numbers might be unrealistic. On this note, estimates from the Dallas Federal Reserve find that some 2.6 million people retired between February 2020 and April 2021.

For now, what we know is that Powell has given himself plenty of room to avoid taking any immediate, drastic policy actions.

***But what about the risk of rising inflation?

So, if (relatively vague) employment targets are the new mandate, what about the risk of rising inflation? After all, consumer prices jumped 5% in May compared with a year earlier. That was the largest increase in 13 years.

Powell has repeatedly downplayed this. Instead, he says that the inflation-spike we’re seeing is directly tied to the economic reopening.

He repeated this message yesterday:

A pretty substantial part, or perhaps all of the overshoot in inflation comes from categories that are directly affected by the re-opening of the economy such as used cars and trucks.

Those are things that we would look to to stop going up and ultimately to start to decline…

The incoming data are very much consistent with the view that these are factors that will wane over time and then inflation will then move down toward our goals.

***All eyes on the fall

In terms of when we might see a change in messaging, Powell and other FOMC members are indicating they’ll be watching the unemployment numbers this fall.

From Bloomberg:

“There seems to be some kind of a speed limit” to hiring, Powell said.

“The very quick job gains of the early recovery, essentially involve going back to your old job,” have largely happened. Now workers are trying to find new jobs and that process takes more time, he said.

“It may just be that it’s hard to match up with a new job,” Powell added. “I think we’ll see strong job creation in the fall.”

Cleveland Fed President Loretta Mester echoed this focus on the fall, saying “I think we are going to get more clarity as we get through the summer and get to September.”

So, put it all together, and we have a very dovish Fed preaching “inflation won’t be bad” and “we’ll do everything we can to support growth.”

This is a recipe for a stock rally, just as Louis and Luke suggested.

***Looking out on the horizon

Directly in front of us, we have an accommodative Fed. And it appears that the market is buying into the Fed’s messaging…for now.

We can see this by looking at the 10-Year Treasury yield. As we’ve pointed out here in the Digest, the yield on the 10-Year Treasury is a major barometer for how traders are feeling about the market and inflation-risk.

As I write around lunch on Wednesday, the yield is coming in at 1.49%. As you can see below, it’s been gradually dropping over the last three months. This suggests market participants are increasingly onboard with Powell’s message of “transitory” inflation.

But it’s on the topic rate hikes that not all traders are buying what the Fed is selling.

As we noted above, last week, the Fed surprised the market when it brought forward the time frame on potential rate hikes. Some officials indicated that hikes could come as early as 2023, after saying in March that it wouldn’t happen until at least 2024.

Well, what about 2022?

If we look at the CME FedWatch Tool, we find that more than 11% of participants believe the Fed will raise rates by a quarter point in the March 2022 Fed meeting.

If we extend our timeline to July of next year, we find that a full 32% of participants believe the target rate will be up a quarter point, while 6% believe it will be up a half of a point. And even 0.4% of participants think we’ll see a three-quarter point increase.

This points toward a market reality…

The Fed can tell us that inflation will be transitory all it wants – and we hope they’re right – but if the economy begins to overheat, the Fed will be forced to act. Perhaps earlier than it wants.

But, for now, that’s off on the horizon. Standing between now and then we have a summer that looks poised for market gains.

Until something materially changes, long stocks.

Have a good evening,

Jeff Remsburg