The chart showing market expectations of what the Federal Reserve will do and what the central bank wants to do is fascinating at the moment. Take a moment and sit back.
As Powell highlighted in his latest FOMC press conference, the Fed is aiming for a peak interest rate in this tightening cycle of above 5.0 per cent and then to hold that rate at least until the end of the year. The market countered that the Fed will never go above that 5.0 per cent and will cut interest rates at least from November. That is quite a mismatch.
In view of the Fed’s upcoming interest rate decision, this Wednesday, I expect Powell to give no indication that a rate cut is an option this year. The only exception would be if the Fed changed its mind in the last few weeks and expected a recession to be imminent, but that is not going to happen.
So what is the reason markets expect interest rate cuts? I don’t have a straightforward answer to that. Normally, the expected likelihood of a recession would play a role here too. But the opposite is true. The latest equity rally has been accompanied by both an upward revision of just about all growth forecasts, including those in Europe, and earnings growth expectations that remain stubbornly positive. Indeed, for the MSCI World Index, expected earnings growth has risen from +5 per cent to +10 per cent in recent weeks. Incidentally, the market’s expectation should be a lot more aggressive still if they do expect that recession, as the Fed would then rapidly cut interest rates.
Suppose there will be a recession
To understand the market, let’s assume for a moment that there is indeed no recession coming. What ‹incentive› would Powell then have to cut interest rates anyway, despite the spate of earlier reports confirming otherwise? I can only think of one reason and that is Goldilocks. Inflation is miraculously sinking back to the 2 per cent targets and the economy is growing at a mundane pace. With inflation back ‹on target›, the Fed can cut interest rates a lot so that growth is not slowed as much, if at all.
So in that case, Powell & Co. must be very convinced that inflation is under control. But it seems particularly difficult to achieve that conviction. Some recent inflation data points in a row:
The sub-index for prices in the ISM Services Index - as Powell has also pointed out, it is now mainly about wage-intensive service sectors characterised by a large labour shortage - stands undiminished high and has barely fallen since September.
PMI points to fresh price pressures
The recently published US Composite PMI, a key measure of economic activity in both the services and manufacturing sectors (manufacturing), showed that price pressures for businesses have actually increased again.
Real wages are still contracting, but persistently strong wage growth and falling total inflation are reducing that contraction. So purchasing power is increasing in relative terms.
The first signs that the Chinese «reopening» is having a price-driving effect - temporary or otherwise - are trickling in.
Add to this the fact that we’ve seen it in the past that a big wave of inflation can be followed by another big wave when the economy recovers, and I can easily predict that as Powell, you’re not taking any chances. Especially not when you are busy regaining confidence because you have been so horribly wrong on the way up.
You understand, I eagerly await Wednesday’s FOMC meeting to see if I am really completely wrong.
Jeroen Blokland is founder of True Insights, a platform that provides independent research to build diversified multi-asset portfolios. Blokland was most recently head of multi-assets at Robeco. His chart of the week appears every Monday on Investment Officer Luxembourg.