This week was a masterclass in how investors can listen to one thing, but hear something completely different. As I mentioned on Wednesday, the Federal Reserve was expected to push back against an effervescent stock market by signaling that its tightening agenda would not be over until inflation was brought back to its target. Instead, the language at the press conference was interpreted as support for the growing view that the age of rate hikes is behind us and that the economy (and market) would soon be bolstered by rate cuts. On Thursday, the European Central Bank (ECB) hiked interest rates by half a percent and stated that it would also raise rates by the same amount at its March meeting. What should have been a cold shower on stocks, and bonds for that matter, turned out to be a gentle warm hot tub of optimism.

 

To say that there is tension between central banks and the markets would be an understatement. If the goal is to truly wrestle inflation to the ground, this involves more than just wishful thinking. True, the pullback in various inflation metrics does reflect some progress on the supply front. Some commodity prices have remained low, despite a weak US dollar, including certain foodstuffs. Folks will be happy to know that avocado prices are down sharply, making the Super Bowl dips a little less expensive. China’s re-opening is also expected to help improve supply shortages of industrial inputs and consumer end products; even though this re-opening could also generate increased demand for energy and raw materials.

 

Central banks have been very vocal in their position that economic demand must also cool, in addition to reduced supply constraints, in order for the inflation reduction objective to be met. Demand for goods and services is going to be driven by income factors, such as employment and wages, as well as cost factors. This would include things like the price of energy and rent, but also the cost of debt servicing. Given that official interest rate have now risen by 4-1/2 percent since this time last year, the view is that the cost of borrowing has been extremely restrictive and ultimately will lead to weaker demand.

 

Yet, there is more to the state of financial conditions than just the level of official rates. You may have heard media analysts talk about things like the “financial conditions index” when discussing what the Fed did this week. In fact, there are many different indexes out there, from the Bloomberg Financial Conditions Index to the Kansas City Fed Financial Stress Index to the St. Louis Fed Financial Stress Index. These are all made up differently, but some common elements will be the level of short and long-term interest rates, corporate bonds spreads, the value of the US dollar and equity prices.

 

As the above chart shows, even though the Fed funds rate continues to climb, conditions have eased and there are four main reasons for this. First, US long-term bond yields have fallen by more than 0.8% from their October highs near 4.25%. At around 3.40%, they are still considerably higher than levels below 2% this time last year; however, this decline in yields represents more than a 50% reversal of the sharp uptrend from early August to October.

 

The US federal government has enough on its plate with respect to its debt ceiling to really celebrate the fact that its next auction of 10yr bonds will come with a coupon that is basically where it was 11 years ago. Corporations, on the other hand, are going to be happy with the fact that for all the talk of impending recession and economic gloom, the spreads between their borrowing costs and government bond yields have actually come in. This week, the 10yr triple-B spread in the US fell to below 1.65% after peaking around 2.25% in October. If we exclude the temporary spike in this spread at the start of the pandemic, the 10yr spread has basically traded in a range of 1 to 2.7%, which means that we are now a little below the midway point of that range. Now, it is unrealistic to expect this spread to remain this narrow if a true recession is here or coming, but the move in the last five months again represents an easing in conditions.

 

Every country has a different dependence on exports and the US is definitely not at the top of the list, but that doesn’t mean that export competitiveness is irrelevant. Which means that a declining exchange rate between the US dollar and the currencies of its main trading partners can produce a positive reaction in net exports. The dollar was already gaining strength in 2021 as the US economy experienced a massive recovery from the pandemic, but really took off last year when the Fed began to hike interest rates. In September of last year, the US dollar index (DXY) came close to testing 115 from a 2021 low of just under 90. In the past few months, however, the index has dropped like a stone back to a point above 100. Again, this is still well above the average seen since the financial crisis, but the weakening does represent an easing in financial conditions. More importantly, a decline in the dollar doesn’t help with inflation as it can induce an increase in the price of imported goods.

 

And lastly, we have the good old stock market. This week saw not only an extension of gains in US stocks but the achievement of a key technical objective. The S&P500 had struggled with breaking above 4100, which marked the highs back in December, and without a break above this level, a technical pattern of lower highs since the beginning of 2022 would remain in place. As of Thursday, the index had not only breached 4100, but it came close to taking out 4200. The move this week, as much as it was influenced by not-so-hawkish comments by Powell at the press conference, reflected a major short-covering in the market and a vacuuming of some of the excess cash that had built up on the sidelines.

 

A stronger stock market also adds to general financial conditions and has the effect of making them easier. A simple way to think of this is that if the stocks in your portfolio go up, you may feel like you have a greater ability to spend (wealth effect), even if your own borrowing costs are higher. On that note, mortgage rates in the US have also declined since October, with the 30yr bullet rate dropping a full percent since October.

 

So, let’s bring this back to the apparent disconnect between a seemingly elated equity crowd and what central banks like the Fed are trying to achieve. Calculations of where inflation is heading, based on price movements in recent months, essentially are keying off the quick tightening in financial conditions into the summer and early autumn. Extrapolating those movements may take you to the conclusion that inflation is going to reach the Fed’s 2% target in the near-future, resulting in a reversal of some of the tightening the Fed has brought to bear. However, with financial conditions easing, it’s also possible that demand doesn’t crumble and that inflation hits a plateau that is higher than the Fed’s target – maybe much higher. That will result in only one thing and that is a continuation of rate hikes, or a resumption of hikes if the Fed actually does pause.

 

On Thursday, we saw the stock price of Meta (formerly Facebook) jump by close to 20% - the biggest move in ten years. Ironically, the move wasn’t predicated on the metaverse but on the company’s promise to become leaner, through cutting middle management positions and employing artificial intelligence to gain productivity. The stock came close to touching $200 for the first time since last June. It is far from its highs above $350 back in 2021 and if we strip out the post-pandemic nirvana created for tech stocks, Meta is really only getting back to levels that would cap its upside in 2018 and again right before the pandemic meltdown. If you believe that the Fed is done and that the easing in financial conditions is going to be ignored by Fed officials, such that we get a pause and eventual rate cuts, then the rally in the stock (and the NASDAQ) might make sense. However, if there is more inflation fighting to come, then stock bulls might have been forced to take the metaverse goggles off and face reality.

 

On behalf of the Pyle Group, have a wonderful weekend.   

Andrew Pyle

 

 

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