One of the core tenants of US central banking is being shunned by Jay Powell’s Fed. Former central bank leadership had always taken the approach that tight labor markets posed a serious threat for higher inflation. However, Powell is stepping away from that view. Labor markets remain tight, with unemployment very low and strong job creation consistent. Yet, the Fed has completely stepped off the gas pedal on rate hikes, a position that runs counter to previous approaches.
FINSUM: At least in this cycle, the relationship between labor markets and inflation seems to be thoroughly broken. The reality is that no one can give a great answer as to why, but Powell’s policy nonetheless sticks to the idea that the link is severed.
Investors may be worried about a big fall in stock prices, but that is looking less likely than the opposite, at least according to BlackRock. The asset manager’s CEO, Larry Fink, said yesterday that records amount of cash may suddenly flow into the market, driving prices sharply higher. He points out that despite the good year in stocks so far, not a lot of money has been flowing into equities. Fink said dovishness by the Fed has created a shortage of” good assets”, which puts the market further at risk of a melt up.
FINSUM: A melt up could certainly happen, but we wonder what the catalyst would be. Maybe a solid trade deal with China?
The bond market took on a very strong position about the Fed in its recent rally—that rate cuts were likely this year in order to stimulate the economy. However, upon the release of the most recent Fed minutes, that view appears to be quite clearly wrong. The Fed minutes show no indication at all of cuts to come this year. Instead, those at the Fed merely indicate that hikes are likely to be put on hold for the rest of the year.
FINSUM: We don’t think there is much of a chance the Fed will cut this year. Recent economic data has been a little better, which means they seem much more likely to stand pat than to cut.
Do you remember those glory years between the taper tantrum and the end of 2017? The time when inflation was low, but not totally weak, growth was solid but not great, and the Fed decided to do nothing and say little? That was the time when the market surged. Well, those days may be here again as the economic signals right now, and the Fed’s language, are starting to look like they are returning to the post-Crisis “new normal” of moderate growth and inflation, but not enough to bring on a policy response.
FINSUM: Our own view is that we are not headed for recession, but rather a return to the pre-tax cut rate of growth and inflation. This is a solid setup for markets as it produces a dependable environment and a good atmosphere for corporate earnings growth.
The bond market seems to have blind faith in the Fed right now. Longer-term bond yields have fallen dramatically, a sign that fixed income investors are sure the Fed is not planning any moves. Not only are bonds up considerably lately, but implied volatility is very low. That means investors are discounting both the chance for an inflation increase and an economic downturn. In other words, they think the economy and Fed is going to stay right where it is.
FINSUM: Can you blame them? The economy lingered in what we think of as an investor’s “goldilocks” phase for several years after the Crisis—inflation not too low, not too high, Fed on hold, asset prices rising. It does not seem unlikely we go back into that mode.