CPI comes in as expected … what will the Fed do next week? … the market is suddenly betting big on a much lower terminal rate … are we seeing too much bullishness yet again?
This morning, the Fed dodged a bullet.The latest Consumer Price Index report showed that February inflation matched expectations. It rose 0.4% in February and 6% from one year ago. The “win” for the Fed is that these numbers didn’t come in above expectations, which would have held the Fed’s feet to the fire to raise rates 50 basis points next week, as was the market’s expectation just one week ago. As I write, the prevailing sentiment is the Fed will raise rates 25 basis points next week. However, not everyone believes that…
Could the Fed pause interest rate hikes next week?
That’s what Goldman Sachs believes.From Fortune:
Less than a week after Federal Reserve Chair Jerome Powell opened the door to a re-acceleration in the pace of interest-rate hikes, traders slammed it shut again amid the sudden eruption of financial strains at US regional banks.Goldman Sachs Group Inc. economists said they no longer expect the Fed to deliver a rate increase next week, even after US authorities moved to contain a crisis spurred by the exodus of depositors from Silicon Valley Bank and Signature Bank.
Now, think of the optics of this, were it to happen.Remember, it was one week ago today that Federal Reserve Chairman Jerome Powell testified in front of Congress and said:
The latest economic data have come in stronger than expected, which suggests that the ultimate level of interest rates is likely to be higher than previously anticipated.If the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes… We have covered a lot of ground, and the full effects of our tightening so far are yet to be felt. Even so, we have more work to do.
If there was “more work to do” a week ago, pausing rate hikes would be admitting a huge miscalculation.If Powell backs away from his tough words by completely pausing rate hikes, what happens to his credibility? I’d see it as a new layer of egg on his face…building upon the heaping portion of “transitory inflation” egg that’s still there.
But the real story here isn’t what happens next week – it’s the market’s new expectation for the Fed’s terminal rate
The debate over whether next week’s FOMC meeting will result in a pause versus a 25- or 50-basis-point raise isn’t the most important issue.The needle-changer has always been the Fed’s “terminal rate,” or the highest target rate the Fed will set in its effort to kill inflation. Following Powell’s commentary last week, the market was bracing for a terminal rate of nearly 5.75%. This is in line with commentary we’ve heard from some of the Fed presidents in recent weeks. So, what’s happened now, in the wake of the SVB collapse? Wall Street is now pricing in a terminal rate of about 4.95%, and stocks are exploding higher as I write Tuesday morning. In other words, terminal-rate expectations have crashed nearly 100 basis points practically overnight and jubilant sentiment is suddenly back, all because the idea is “the banking system can’t handle it so the Fed will pause.” I see the logic, but is this analysis balanced? Are the stock market gains warranted? Inflation isn’t just going to disappear because a bank goes under. So, if the Fed pauses rate hikes and ends its inflation fight at a level that’s nearly 100 basis points lower than was expected just a week ago, what happens to inflation? Well, even if we assume that inflation will go away naturally (which is debatable), it means it will take longer for inflation to go away than it would have with a higher terminal rate. And that longer lasting inflation will erode corporate earnings and Main Street buying power. But hold onto that one. We’ll circle back. Not everyone is convinced we can be so optimistic about inflation just slowly declining without more Fed help. Here’s economist and chief economic advisor at Allianz, Mohamed El-Erian:
We have an inflation problem and the longer we allow it to get embedded into the system, the greater the cost to society. We may end up in stagflation.
And remember this quote from Stan Druckenmiller, arguably the most successful investor in modern history:
Once inflation goes above 5%, it has never come back down without the Fed Funds Rate exceeding the CPI.
The CPI just clocked in at 6%. And now Wall Street is throwing a party because it’s decided that the Fed will only hike rates to about 4.95%.There are some obvious problems here.
So, the question becomes “what does all of this mean for the market?”
As noted a moment ago, the market is having a grand ol’ time this morning based on hopes of a Fed pivot and a lower terminal rate.Here’s the general narrative… The SVB collapse shows the consequences of a reckless Fed… we clearly can’t continue with rate hikes like this without risking systemic danger to the banking sector, so expect a pause or just one more rate hike (max two) then the Fed is done completely … this is the catalyst the market needs… get ready for a return to January’s bullishness. Again, let’s think through the full implications. Stopping rate hikes early means inflation lingers, and that materially hurts corporate earnings. And that’s before we even ask whether earnings forecasts are already too high. Morgan Stanley’s chief investment officer Mike Wilson think they are. From CNBC:
Wilson sees a murky path ahead for the market, believing that earnings growth expectations remain “materially too high” and markets are more likely to “price that risk more quickly.”An end to this volatile bear market won’t come until investors see earnings disappointments priced in before those revisions appear, Wilson said.
But we can follow the breadcrumbs even further – beyond corporate earnings – to the U.S. consumer.How will lingering inflation impact consumer buying power? Obviously, it’s not good. Robust consumer spending is a major reason why the economy has remained strong in recent months. But as countless reports have concluded, this spending has come from pandemic savings that could run out as soon as this summer. Lingering elevated inflation will only accelerate this melting ice cube. Meanwhile, credit card debt has gone from near-record-lows to record highs in two years and is now rising at one of the fastest rates in history. Clearly, this situation will only further deteriorate with higher-for-longer inflation. But there’s another issue for stocks that we haven’t even touched on yet…
What if investor sentiment finally rolls over?
You might be shocked to learn that investors are very bullish today.A proxy for investor sentiment is the S&P’s price-to-earnings multiple. This reflects how much an investor is willing to spend for a unit of earnings. Clearly, when investors are confident (or irrationally bullish), they’re willing to spend more for the same amount of earnings. As I write, the S&P’s PE multiple comes in at 21, meaning this is an expensive market. For context, the long-term average price-to-earnings multiple of the S&P is 16, and the long-term median number is less than 15. In other words, today, investors are willing to buy stocks at prices that are roughly 30% more expensive than average. That sounds bullish to me. Bearish is when investors don’t want anything to do with stocks, which means the PE multiple drops down into the 12-15ish range. In fact, the average PE ratio of the last six bear markets was 14. Here’s CNBC with Wilson’s take:
This could also mark the beginning of a sharp move in the earnings revision process that brings price-to-earnings multiples as low as 13 to 15 times and creates the “final low” for this bear market, [Wilson] added.
So, how likely is it that investor sentiment could deteriorate?
Well, we just witnessed the second-largest bank failure in U.S. history. Folks might feel less secure about their savings.And just this morning, Moody’s cut its outlook on the U.S. banking system to negative, citing a “rapidly deteriorating operating environment.” Meanwhile, last week, we learned that January and February layoffs by U.S. companies touched the highest level since 2009. How do you feel about your job security? If the bulls prevail and the Fed does an about-face with rate-hikes next week, leaving the door open to a resurgence of inflation, how would you feel about the purchasing power of your nest egg? With consumer spending making up about 70% of the U.S. economy, and with pandemic savings nearly running out, how do you feel about the durability of the U.S. shopper and by extension, recession risk? As we noted a moment ago, credit card debt has gone from near-record-lows to record highs in two years and is now rising at one of the fastest rates in history. How do you feel about consumer health? The Fed actively wants to crash the value of your home, and it wants to put some people out of work to beat inflation. Does this make you feel more or less secure overall? Put it together and ask yourself… In light of all this, do you want to buy stocks that are already 30%+ more expensive than average? Sure, the Fed might pause rates. It might even be done. But even if so, be careful before you assume a bull market has just begun. Have a good evening, Jeff Remsburg