Still Robust
The sharp decline in stock and bond prices after the release of a strong jobs report for November was quite appropriate, so it was a surprise that both markets rebounded over the course of the day. While most economists expect the Fed to continue to hike interest rates over the near term, even as it downshifts from 0.75% to 0.50% increments, investors remain convinced that the Fed will soon end its rate hike cycle. So, we think there is some room for disappointment and market volatility will continue.
Fed Chair Powell has spoken clearly at every available opportunity that reducing inflation to the Fed’s 2% target is the entire focus of policy. So, it must have been quite a disappointment that the employment report showed ongoing strong job gains and large wage increases. The October report suggested that wage inflation might be slowing. But those more moderate wage gains were revised higher, even as job growth remains well ahead of sustainable levels. Hiring is sure to slow, since the pool of unemployed is shrinking, as the labor market gets tighter. That labor scarcity will maintain upward pressure on labor costs, which makes the Fed’s 2% inflation target harder to achieve. Nonetheless, it is widely expected that the Fed will slow the pace of rate hikes from 0.75% to 0.50% at the meeting next week, if only because that move has been carefully signaled to the market. That slower pace of rate hikes makes perfectly good sense since the funds rate is already up to 4% and the Fed doesn’t want to kill the expansion. It can squeeze the system more slowly and methodically with 50 basis point moves.
Much of the above has been signaled clearly by multiple Fed officials and should be well understood in the markets, yet the pricing of stocks and especially bonds implies that investors reject the Fed’s outlook. Short term money market instruments are priced for a peak in policy rates in early 2023 around 5% and for a rate decline in Q3 2023, despite Fed statements that rates will not decline anytime soon. Either the Fed or the markets will be proven incorrect.
The Fed’s actual policy behavior will reflect the performance of the economy regardless of its current expectations. The Fed’s forecasts are just that, simply forecasts. The same idea applies to the markets, which must also forecast. Both will respond to incoming data. And that’s why the strong jobs report on Friday was so telling. At least so far, there is simply not enough of a slowing in growth for inflation pressures to be reduced to reach the Fed’s 2% target anytime soon. Nonetheless, the markets quickly overcame their adverse reaction to the strong data and rebounded over the balance of the day. This can continue, but only to a limited degree. Either growth (and inflation) must slow quickly, or rates will need to rise above the market’s expectations.
Stock prices have rebounded over the past several weeks. Valuations are still on the attractive side. Yet if the data continue to run hot, some setbacks could easily occur. The bond market is somewhat vulnerable, especially for longer fixed income maturities. Right now, short maturities offer more yield and a safe port in any storm that might occur.
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