Since the December meeting, commentary from the Fed’s members hinted at smaller rate hikes ahead, as did the economic data. The remaining questions were how high would the Fed take rates before pausing and how long will it need to leave them there before inflation makes a sustained move towards the 2% target?
As a result of that information, the bond market was pricing in a 25 bp hike at today’s meeting, another in March, and then a pause at the May meeting. And today, Jerome Powell and the Federal Open Market Committee (FOMC) unanimously delivered exactly what was expected.
So what, if anything changed? And why did the market react the way it did?
To help answer question one, we turn to Nick Timiraos of The Wall Street Journal. As usual, he did a great job outlining what’s changed via Twitter and a follow-up article. But we’ll cover the main points below.
FOMC decision:
25 bps increase (approved unanimously)
FOMC statement:
Minimal changes to the forward guidance
“Ongoing increases” language is retained pic.twitter.com/RUFCV2HEc8— Nick Timiraos (@NickTimiraos) February 1, 2023
The redline version of the statement reiterated that not much has changed since the last meeting.
The key takeaway is that the Fed maintained its “ongoing increases” language, which means all eyes turned to Powell’s press conference. As usual, reporters probed and prodded Powell on the release’s language and recent economic events.
In return, Powell did his best to tow the hawkish line, with phrases such as: “We are talking about a couple more rate increases…”, “The job is not fully done…” and “It would be worse to get close to getting on top of inflation and then find out in six or 12 months that we didn’t do enough…”
Yet despite his efforts, stocks, bonds, and other risk assets continued to rally. And while there are many drivers of today’s rally, two stick out the most.
The first is that as the pace of hikes slows, it removes uncertainty and volatility from the market. Secondly, and arguably more important, financial conditions continue to ease because expectations are that inflation will fall faster than the Fed anticipates.
And that’s the critical point. Just as the bond market anticipated inflation better than the Fed on the way up, it’s betting it will also do so on the downside. A faster decline in inflation means the Fed could pause or reverse its tightening policy sooner rather than later. And lower rates are a positive for stocks.
Essentially, the market is playing a game of chicken with the Fed. And whoever is right about inflation’s path will be right about the appropriate level of interest rates.
All we can do now is see who flinches first. But while we wait for that to happen, let’s quickly recap today’s economic data dump.
January’s employment data is released this week, giving the Fed another reading on the labor market. While wage growth has slowed, the labor market remains tight by historical standards.
First up today was the ADP payroll number. January’s report indicated that private companies added 106,000 new workers, well below the 190,000 expected. Strength in the services sector continued, with the hospitality industry responsible for roughly 95,000 new jobs. Additionally, larger companies fared better than smaller firms in attracting workers, likely due to their ability to pay higher wages. 🔻
Expectations for the Job Openings and Labor Turnover Survey (JOLTS) were for a continued decline in job openings. Instead, December’s report showed a sharp rise to 11.01 million, outpacing the 10.25 million expected by analysts. The accommodation and food services industries led the charge in hiring efforts, followed by retail trade and construction. Layoffs climbed about 4.1% MoM, and the number of workers quitting their job was about flat. 🔺
The number of job openings to available workers ratio ticked back up to 1.9 after falling in October and November.
Moving onto manufacturing activity, the Institute for Supply Management (ISM) indicated that the manufacturing Purchasing Manager’s Index (PMI) fell from 48.4 to 47.4 in December. This represents the third straight monthly contraction, with the index settling at its lowest since May 2020. The U.S. manufacturing sector represents 11.3% of the U.S. economy, and any readings below 50 indicate a contraction in activity. 🏭
Meanwhile, some analysts speculate that a trough in the eurozone’s manufacturing activity has already occurred. S&P Global’s final manufacturing PMI for January rose to 48.8, up from 47.8 in December. While that value is still in contraction territory, it marks a five-month high in activity. Elsewhere, the world’s second-largest economy’s (China) reading edged up to 49.2, its sixth month in contraction territory.
Whether or not the recent uptick in manufacturing activity is a genuine turning point or a blip within its downward trend remains to be seen. But what is clear is that the labor market remains strong, and that’s keeping the Fed aggressive in their policy decisions as they fight inflation.
And in the face of that aggressive stance, the market is front-running the Fed once again and loosening financial conditions. All we can say is that bulls better hope they’re right on inflation’s path (and the Fed’s subsequent moves), or things could turn ugly very quickly. 😬