08.24.22: As Fed officials convene in Jackson Hole, Wyoming this week, investors fret that Jay Powell & Company could pull the rug out from under the markets’ incipient optimism. Since bottoming on June 16, US equities, led by the NASDAQ 100, rallied more than 22 per cent before retreating 6 per cent over the last five trading sessions. The summer surge added $7 trillion to US equity market values. The added wealth effect, however, runs counter to the Fed’s desire to quell a price spiral with diminished demand.
Market participants, as gauged through the lens of the TIPs market, don’t expect inflation to fall below 2.5 per cent until 2028. In the meantime, they expect American consumers to cut spending as employers cut staff: the national unemployment rate is expected to climb past 4 per cent and real GDP growth to remain mired between 1 and 1.5 per cent.
Fed Funds futures show traders expect the overnight rate to peak at 3.7 per cent in May 2023 although, as Bloomberg points out, even Fed doves like Minneapolis Fed President Neel Kashkari suggest the benchmark rate probably needs to approach 4.5 per cent by the end of next year. As recently as last month, traders penciled in peak overnight rates of 3.4 per cent in January 2023. Even though it’s recently taken a decidedly hawkish tilt, bond traders’ optimism isn’t necessarily off base. That’s because it was largely fueled by Chairman Powell’s enthusiasm that inflation would roll over in response to modestly tighter financial conditions, and that an economic recession is not a forgone conclusion. July’s inflation reading played into that narrative. Those of us paying attention to this week’s Jackson Hole meetings worry that the Chairman’s message could darken.
The US dollar is one of the best real-time barometers of the Fed’s intentions relative to the central banks of our trading partners. The tighter future Fed policies appear to be relative to those of their developed market counterparts, the stronger the dollar will be relative to their respective currencies. The US dollar has rallied nearly 14 per cent this year, to its highest level of 2022 and to its strongest year-to-date showing in over 20 years, suggesting a tighter Fed.
Meanwhile, the Euro has fallen through parity with the dollar to its lowest level in 20 years, off about 12 per cent for the year. Even though the ECB tightened a half-percent at its July meeting, its benchmark deposit rate current sits at 0.5 per cent, a far cry from the Fed’s 2.5 per cent target rate. The 2 per cent differential between the ECB and Fed rates explains most of today’s Euro weakness. Europe not only faces 8.9 per cent inflation year over year, but the ECB must grapple with weakening growth.
We continue to anticipate dollar strength in the near term as investors digest further Fed action in its ongoing inflation battle. Only when investors sense a peak in the Fed’s overnight rate will the dollar roll over, a phenomenon we expect later this year. When that happens, we expect non-dollar equity markets to lead global stocks higher.