Powell’s message: Price stability is paramount
Stocks closed lower yesterday, and the curve inversion steeper with the 2yr – 10yr spread at -106.46bp with a sharp selloff on the short end of the curve (1 and 2 years), the USD much stronger.
The full reality of the inflation fight seems to have finally surfaced at the Fed. Powell’s testimony at the Semiannual Monetary Policy Report to the Congress before the Committee on Banking, Housing, and Urban Affairs, is starkly clear and very much in line with our base case scenario of higher rates for much longer than was being priced in by markets.
Chair Powell stated, “As I mentioned, the latest economic data have come in stronger than expected, which suggests that the ultimate level of interest rates is likely to be higher than previously anticipated. If the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes. Restoring price stability will likely require that we maintain a restrictive stance of monetary policy for some time.”
It has been a long wait, the year-to-date positive move in markets we believed was not justified; thus, we held on to a primarily defensive allocation, except for our overweight allocation to select commodities.
We expected further aggressive monetary policy from the Fed and that once up and the terminal rate level, rates will likely remain elevated for much longer than most expect. The risk the Fed will run is that the combination of high rates and time may create more significant demand destruction than the Fed forecasts. Our concern about the economic and earnings outlook is finally being more widely adopted. Powell was very clear; price stability is paramount.
One speech may not trigger the next trend, but this speech today is in line with our view. For markets, the next hurdles to get over include the US jobs report this Friday, CPI next Monday and the Fed’s March 22 monetary policy decision.
We remain of the opinion that the Fed must engineer a slowdown and get the US unemployment rate up above 4%. See below a chart we have used many times in support of our view that the US economy is operating “too hot” with unemployment far below the noncyclical rate of unemployment, thus inflation is all but certain to not only surface but remain.
The natural rate of unemployment (NAIRU) is the rate of unemployment arising from all sources except fluctuations in aggregate demand. Estimates of potential GDP are based on the long-term natural rate. (CBO did not make explicit adjustments to the short-term natural rate for structural factors before the recent downturn.) The short-term natural rate incorporates structural factors that are temporarily boosting the natural rate beginning in 2008. The short-term natural rate is used to gauge the amount of current and projected slack in labor markets, which is a key input into CBO’s projections of inflation.
Portfolio Implications – Remain defensively positioned, cash at overweight, fixed income and equities at underweight for developed markets, and overweight in select emerging markets (EM). Select EM are supported by a combination of forces, i.e., aggressive and early monetary policy response and pick up domestic consumption, which should support both stocks and bonds.
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