The Fed’s Reverse Jinx

The Fed wants inflation to drop to 2%.  Fed Chairman Jerome Powell says that getting to that level will require below-trend GDP growth and softer labor market conditions.  Did he just say recession without saying recession?  On one hand, things would be so much easier for the Fed if the economy started falling apart.  There’s a playbook for that.  However, the Fed can’t save the economy if the economy saves itself first.    Inflation has been sticky, but so has low unemployment.  GDP refuses to lay down and even growth stocks have gotten over the initial shock of higher interest rates.

The Yield Curve and St. Augustine

“Lord, give me chastity and continence… but not yet.”  The yield curve reminds me of this quote from a young St. Augustine.  An inverted yield is a signal that the bond market expects that today’s higher rates and inflation will not last, historically preceding a recession.  After more than a year of yield curve inversion, recession and lower rates continue to be a struggle for tomorrow’s market participants, not today’s.  A more secular version may be Joe’s Crab Shack’s “Free Crab Tomorrow” sign that never changes.

This is a weird situation to be in.  The Federal Reserve is practically begging for recession to bring inflation down, but it has pulled off a reverse jinx instead.  The economists at First Trust are excellent and may have some good (bad) news for the Fed.  First Trust sees the S&P 500 as grossly overpriced.  The S&P is at roughly 4500 today (8/31/2023).  First Trust’s models point to a fair value of 3170 at today’s interest rates.  They see the market as fairly valued if the 10-year Treasury yield dropped to 3.05% which is unlikely given the Fed’s inflation battle.  A third road is if profits skyrocketed, but this would send GDP way up, too.  We’ve seen the Fed react to market price in the past, what if there’s a pullback followed by the Fed dropping rates a little?

For now, the Fed’s main concern is high inflation.  As unemployment lingers on the low end, the Fed seems to have plenty of room to hike.  The market thinks they are unlikely to do so at the September meeting and that rates will actually be lower by May.  On top of all this, we are closing in on election season (does it ever really end?) which will put the economy under a microscope and leave the Fed open to fire from every angle.  Even if the market is up, expect no one to be satisfied and everyone to have an opinion.