Gentle Jay does it again

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Good morning. You are awash in Fed takes, I know, but this is a markets newsletter and darn it, markets newsletters have Fed takes. And mine is the best, I swear. So please read on. Email me: robert.armstrong

No one fears the Fed

When the Federal Reserve makes an announcement, we interpret what it means though the lens of the market response. But what if there is no market response — or almost none? Does that mean that there was no new information in the announcement? And does that mean that the Fed chair is a master communicator, who has signalled his intentions so clearly that when he states them explicitly, all one can do is shrug? 

Or does it mean the market is out of touch?

Start with yesterday’s announcement. It had two significant aspects. One was a clear statement that tapering of asset purchases can start presently. “If progress continues broadly as expected, the [Federal Open Market] Committee judges that a moderation in the pace of asset purchases may soon be warranted,” said the statement. Fed chair Jay Powell was asked in the press conference after the statement release if that means that, say, the next employment report has to be great for the taper to start. Nope: “My own view is that the ‘substantial further progress’ test [on inflation] is all but met.” Barring some real bad news, taper is good to go, starting in the next couple of months.

The second significant bit of the announcement was the famous dots. Here are the rate projections of the FOMC members, back in June on the left, and yesterday on the right:

In June, a majority of members saw no rise next year; now, half of them see at least one. For ’23, the committee in aggregate sees at least three increases, one more than in June. This is not a huge change, but it’s unmistakably a change.

And in response to this change, the market shrugged. Here are stocks, shifting around in their seats a bit before coming back to where they were when the Fed started talking:

Even a bit more hawkishness tends to spook the market; that’s what happened in June. No one was spooked this time around. Perhaps this means that investors now trust the Fed to tighten just enough to keep inflation in check, but not so much that the US economy slows or real rates jump and stock valuations get ravaged; that tightening will be so well calibrated that it won’t matter much, to the economy or to asset values. The volatility of the last week or two aside, the market seems very comfortable with Fed policy, if not with life in general.

Don Rissmiller of Strategas offered me another interpretation:

“This risk-on move in stocks looks specific to the market developments in recent weeks. We know the central bank watches international developments. If the Fed chair believes there’s limited exposure to troublesome events abroad and still enough momentum to taper QE (and eventually tighten), that’s encouraging. The same logic would apply to the political gridlock that’s developing in DC — it can’t be that bad at the end of the day.”

As for bonds, the yield curve could barely conceal its excitement. Here it is before the Fed began and at the end of the day:

Squint hard, and you see some flattening. Well, that’s a little unfair. If you chart the change in the curve and use a magnifying glass, you can make out a reaction:

A few basis points up in the middle of the curve, a few basis points down at the long end. What might that say? How about this: “The Fed will tighten the screws a liiiiittle bit over the next few years, and that will be enough to tamp down inflation in the long term.” Rissmiller suggests a darker interpretation:

“There also may be a bet that this Fed keeps inflation under control by acting like the ‘old Fed’ and over-tightening in the next three to five years. Or, put another way, the market isn’t completely buying the ‘new paradigm’ that Chair Powell has set out.” 

This may be, but remember how small the yield curve moves were. I see serenity, if not complacency. I think the attitude of Blackrock’s Rick Rieder represents this attitude well:

“There’s been a great deal of hand-wringing by some market participants over the potential market implications of the Fed’s eventual tapering of asset purchases, but we think they’re likely to have minimal impact. The fact is that while real yields are at record lows, the supply of financial assets is at record highs, suggesting robust demand for income. In September alone, $625bn of new supply is expected across the US Treasury, credit and equity markets, which is considerably greater than average in recent years.

“With the demand for income and financial assets that we’re seeing (in combination with the enormous stock of liquidity in the system today), the modest tapering likely to be seen from the Fed is not consequential for markets.

“Critically, monetary policy in recent decades has been a tool used to spur demand higher, but the main problem today is a supply shortage, not one of weak demand, and supply can’t be ‘stimulated’ by monetary policy.”

That sounds sensible to me as far as it goes, but it assumes all the risk is on the side of too much tightening. But I can’t dismiss the possibility that the problem might turn out to be too little tightening — that is to say, that inflation could yet get out of hand. I think there is quite a low probability of this happening (though I have no idea how I would quantify the chances!) but I also think the consequences will be very, very bad for markets if it does happen.

The FOMC is not worried about this at all. Here are its members’ official inflation expectations, from June on the left and yesterday on the right. They have adjusted their view of inflation this year (how could they not?) but while the range of expectations for ’22 has widened some, the average expectation (the red line) is all but unchanged:

I think that for most of this year the Fed has struck the right balance between acknowledging inflation pressures and keeping policy supportive. But that chart just seems odd to me when, for example, trimmed mean consumer price index inflation has passed 5 per cent, and held there, in the interim:

Things have changed in the past few months, and it worries me just a bit that the Fed hardly seems to have noticed. I’m not nearly as anxious about inflation as Larry Summers, but I think he is absolutely right to point out that there are inflationary signals we are seeing now that are yet to show up in the indices the FOMC looks at.

For example, we know house prices are screaming right now, and as this chart from the Dallas Fed shows, that will show up in CPI sooner or later (OER stands for “owner’s equivalent rent”):

The market is complacent about the Fed; the Fed is complacent about inflation. Let’s hope both are right.

One good read

Well, two. Evergrande is just the beginning, say Jim Chanos and George Magnus

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