Amid all the hype and hyperbole in the wake of this week’s speech from Fed chair Jay Powell, there is one more obstacle for the bulls to hurdle before they can bellow, “boom, boom, boom” and charge off into 2023.
Instead of bashing markets lower as he has done on several occasions this year with some hard-edged reality about the brutal reality of the Fed’s rapid tightening of monetary policy, Powell rode to their rescue this week and effectively set up a rally that could continue into the early months of 2023.
Wednesday’s rally slowed on Thursday and Friday but the latest US inflation reading – the one the Fed prefers – helped back Powell’s hint about a slowing in rate rises. The so-called PCE deflator – a measure of cost pressures impacting consumers, slowed month on month in October and in the 12-month reading.
The personal consumption expenditures (PCE) price index rose 0.3 after rising by the same margin in September. In the 12 months through October, the PCE price index increased 6.0% down from the 6.3%rate in September.
Excluding the volatile food and energy components, the PCE price index rose 0.2% after a 0.5% jump in September. That saw core PCE price index climbed 5.0% on a year-on-year basis in October after increasing 5.2% in September.
The PCE readings backed the weakening in October’s Consumer Price Index. The headline CPI has fallen from 9.1% mid-year to 7.7% in October which now looks like being a factor in Powell’s apparent change of heart in Wednesday’s speech.
Helping this week was a surprise upgrade to the second estimate of US third quarter economic growth to Gross Domestic Product increased at a 2.9% annualised rate, the government said in its second estimate of third-quarter GDP.
That was revised up from the 2.6% pace reported last month. The economy had contracted at a 0.6% annual rate in the second quarter after a weak first quarter.
But as encouraging as this all is, in the end it’s all about inflation and interest rates, as it has been all year, and where Fed members sees the key federal funds rate peaking (the ’terminal rate’) next year.
To understand that, let’s re-introduce the Fed’s ‘Dot Plot’, a star forward guidance turn after other Fed meetings but controversial as well with many economists claiming its predictive qualities have more to do with reinforcing existing bias in market observers than actually what is going on in the economy.
The plot has been around a decade this year, having been introduced under chair Ben Bernanke to help guide the market as the Fed started its gradual exit from the big monetary policy easing started in 2008-09 when the GFC erupted.
In June 2021 Powell told a press conference “Dots are to be taken with a big, big grain of salt …They’re not a committee forecast, they’re not a plan. The dots are not a great forecaster of future rate moves. And that’s because it’s so highly uncertain.”
That might be the case, but in absence of anything more predictive than the words of the Fed chair and fellow Open Market Committee members, the markets will always choose the plot (it also looks good in their market notes).
The ‘dot plot’ shows where all 19 members of the Open Market Committee (when it is fully staffed) sees rates going in the next three months to two years. From that it is possible to work out a view on the likely ’terminal’ or peak rate (where the greatest number of dots are on the plot). That is the key at the moment.
The ‘plot’ will be released with the post Fed meeting statement, the separate economic forecasts for 2024 and 2025 and the Fed chair will hold his now usual post-meeting media conference, with the ‘dot plot’ signals on future rate rises to dominate.
In his speech this week Powell did not indicate his estimated “terminal rate,” but he said it is likely to be “somewhat higher” than the 4.6% indicated by policymakers in the September ‘dot plot’. That’s why the new plot will dominate the post December meeting discussions.
He said curing inflation “will require holding policy at a restrictive level for some time,” a comment that appeared to go against market belief the US central bank could begin cutting rates in 2023 as the economy slows.
“We will stay the course until the job is done,” Powell said on Wednesday, noting that even though some data points to inflation slowing next year, “we have a long way to go in restoring price stability … Despite the tighter policy and slower growth over the past year, we have not seen clear progress on slowing inflation.”
So rate rises not as frequent in 2023, but if markets read any more into his remarks ahead of the Fed meeting, they may have taken themselves up another blind alley.
And while the Fed’s Beige Book this week described an economy still doing OK but fraying a little under the pressures of high inflation, high rates and patches of weakening demand, there was the good news in a higher than expected second estimate of September quarter economic growth.
The US economy rebounded more strongly than initially thought in the third quarter, the government confirmed on Wednesday, but higher interest rates as the Federal Reserve battles inflation have raised the risks of a recession next year.
The upward revision reflected upgrades to growth in consumer and business spending (very positive news) as well as fewer imports, which offset the drag from a slower pace of inventory accumulation (as businesses get their overstocks under control and reduce them ahead of the Thanksgiving-Christmas selling season, another positive).
The housing market is crumbling, even with the recent fall in mortgage rates which are retreating from more than 7% in early November to around 6.6%.
Residential investment has now contracted for six straight quarters, the longest such stretch since the housing market collapse started in 2006.
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Despite the rise in share prices, the most interesting reaction to Powell’s speech was the sharp fall in the 10-year bond yield to seven-month low of 3.51% on Thursday (Friday morning, Sydney time).
That was a fall of just over 23 points in a day which is a massive drop from the most recent peak of 3.78% on Wednesday and nearly 70 points from the 4.216% peak on November 7.
The US dollar eased under 105 on the Dollar Index – it was over 114, an all-time high in late September. The Aussie dollar remained above 68 US cents for another day but the falls in the greenback were mostly against the euro and yen.
For all markets, especially commodities, the longer impact on the value of the US dollar will prove to be the lasting outcome if the Fed does convince everyone that it is changing gears down.
If markets become convinced the Fed is turning and the post-meeting statement and dot plot confirms that, then the greenback could sell off through the close of 2022 and early 2023.
But the one thing to watch will be the health of the US labour market (and our labour market here). The EU labour market showed a sharp improvement in November as well.
Friday saw the November jobs report with 200,000 new jobs forecast and no change in the jobless rate around 3.7%. If that is shattered suddenly by the surge of job losses now emerging in tech and the media then the Fed may be forced to switch to a stronger pivot.
Wednesday saw the monthly job vacancies data for October released and it was again very strong – 10.3 million vacancies for the 6.1 million officially unemployed. Remember, it is a similar story here as well.
