The Markets’ Reaction To Powell
This Powell testimony reminds me of the Fed Minutes in that the markets’ reaction doesn’t make sense. There wasn’t much in the testimony which was hawkish, but the markets’ knee jerk interpretation was that it was hawkish. The market has been increasing the odds of 4 rate hikes this year. Therefore, the market just went with its initial fears regardless of what Powell said. Stocks fell modestly after the testimony which is reasonable because there has been such a big rally in the past few days. The S&P 500 has increased 1% six times in the past 2 weeks. It only increased 1% four times in 2017. Not only was 2017 quiet in terms of declines, it also didn’t have many big up days. It was a steady grind higher as if stocks suddenly became bonds. They offered a steady dose of capital gains each month. February looks like it will end the streak of winning months.
The knee jerk reaction to a hawkish Fed was normal. The dollar index rallied about a half of a percent and the treasuries sold off. The 10 year bond yield immediately increased about 6 basis points after the testimony. The CME Group website has the odds of a rate hike in March at 87.4% which is up from 78.9%. The chance of at least 4 rate hikes went from 24.4% to 33.9%. If I was Fed chair Powell, I would be slightly frustrated because he didn’t say anything that was different from the Minutes, yet the market construed it as hawkish. The main reason for this interpretation is likely the recent data as the regional Fed reports show prices paid have been very high. If these inflation reports stay consistent or move up, there will be 4 rate hikes. Personally, I think that’s a big “if” because inflation has been inconsistent.
Was Powell Even Hawkish?
Let’s look at a few of Powell’s quotes which support my point that he wasn’t hawkish. He mentions the recent dot plot which expects 3 hikes and then says, "Since then, what we've seen is incoming data that suggests a strengthening in the economy and continuing strength in the labor market. We've seen some data that in my case will add some confidence to my view that inflation is moving up to target. We've also seen continued strength around the globe. And we've seen fiscal policy become more stimulative." These are simply neutral facts. The government just passed a $400 billion spending bill and the recent data on inflation has heated up. He’s not saying anything about the Fed’s forecast. He’s simply relaying the data we already know.
Further clarifying his statement, Powell said, "So I think each of us is going to be taking the developments since the December meeting into account and writing down our new rate paths as we go into the March meeting, and I wouldn't want to prejudge that." He said he’s not giving any forward guidance on how the Fed will vote in March. He said he doesn’t know how the other FOMC members will react to the recent data. Clearly, he doesn’t agree with every member. Even though Neel Kashkari isn’t voting this year, the fact that he’s now dovish shows there are variant opinions. It’s important to realize that Powell won’t always agree with the FOMC members. Yellen was neutral (not a dove or hawk), so her statements were important to understanding where the Fed would set rates. If Powell leans hawkishly, his statements need to be taken with grain of salt. We’ll get more information on his leanings in the next few meetings.
The most obvious statement which supports my point that this was a neutral testimony was when he said. "This is a time when we need to be alert to buildup of either financial imbalances or to inflation building up. We don't really see those right now." Saying there isn’t a buildup in household debt, financial leverage, inflation, or financial imbalances, is the most dovish statement possible. It’s also factually correct because the mortgage debt decline has pushed consumer debt lower. Inflation is still below the Fed’s 2% target, so it’s far from building up.
The final statement I’ll review is Powell’s point about the yield curve. He says, "It's very typical for the yield curve to flatten as short-term rates come up as the economy strengthens. There's always the risk of a recession at any given point in time. I don't see it as at all high at the moment." This point is consistent with Yellen’s statement last year. The Fed believes a flattening yield curve is a sign of a maturing economy rater than a policy mistake which should be corrected. I agree with Powell that the yield curve flattening isn’t a problem yet, but it will matter if the Fed continues on a hawkish path. The latest difference between the 10 year yield and the 2 year yield as of mid-day Tuesday is about 64 basis points. It will be interesting to see if the Fed maintains this stance when the curve inverts. I expect rate cuts a few months after it inverts.
Conclusion
There were some weird questions Congress members asked Powell which is usual since many members aren’t monetary policy experts. The market’s initial takeaway was that Powell was hawkish even though he didn’t make any hawkish forecasts. The good news is that a hawkish Fed is being priced in now so when the Fed holds its March meeting in 21 days, there likely won’t be a shock. At that meeting, the Fed will obviously raise rates. The key will be if it’s a hawkish or dovish hike. Most of the previous hikes have been dovish, so a hawkish hike would be a change. The Fed remains on its path to normalize the balance sheet in the next 3-4 years. I question if the Fed will be able to get it done before the next recession.