Fighting the Fed

10.19.2022 Equity investors have been remarkably resilient in the face of an unprecedented Fed fight against generational inflation. Over the last 30 days, the S&P has moved more than one percent in nearly half of the trading days, with two trading days exceeding two percent. October 13^th stands out as the day the Dow surged 828 points despite a hotter-than-expected September inflation report.

While most investors celebrate market surges, there’s one constituency, besides short sellers, who’s actively rooting against the market right now. The Fed.  Fed officials, blaming the wealth effect, believe a sustained equity rally would undermine their ability to combat inflation. That’s because 20% of US households own equities and their spending, particularly on discretionary goods and services, is tied to how rich they’re feeling. Market gains have historically led to higher discretionary spending which the Fed argues is inflationary. History shows that the relative performance of high-end retailers relative to their low-end counterparts is highly correlated to the markets’ direction. Market gains mean more demand Prada shoes.

It shouldn’t come as a surprise that every time the market surges Fed governors come out of the woodwork to bang the drum for higher rates and tighter financial conditions.  It’s a strategy we call the “Federal Open Mouth Policy.” Just this morning Minneapolis Fed President Neel Kashkari asserted the Federal Reserve can’t pause its campaign of monetary policy tightening once its benchmark interest rate reaches 4.5% to 4.75% if “underlying” inflation is still accelerating.  His remark was clearly directed at the equity market’s impressive gains earlier this week.  Equities, which rose earlier this morning, sold off in response to his comments.  It’s a pattern.  Market rallies one day and Fed proxies tamp down investor enthusiasm the next.  This starkest example the Fed’ strident gum flapping was Chairman Powell’s Jackson Hole remarks on August 26, stating, “We are taking forceful and rapid steps to moderate demand so that it comes into better alignment with supply, and to keep inflation expectations anchored. We will keep at it until we are confident the job is done.”  Equity markets subsequently lost 15% over the next five weeks.

While we embrace investor enthusiasm, we have enough battle scars to know not to agitate the Fed. We believe US central bankers will conspire to beat down investor optimism until they believe inflation is under control. Until then, we recommend caution.