- Investors hope the Fed pivots away from increasing interest rates soon.
- Stubborn inflation and low unemployment suggest a subtle shift in language is more likely than an outright pivot.
- Uncertainty over how investors will react to the Fed's announcement makes betting on a pivot risky.
The potential for a so-called Fed pivot on interest rates has fueled stock market rallies this year, including the latest run-up since mid-October. However, a pivot suggests a rapid turn from hawkish to dovish, and Federal Reserve policy will unlikely turn so quickly. The latest PCE inflation report shows prices remain stubbornly high, and third-quarter GDP growth suggests that the economy while showing cracks, has been resilient.
The Fed’s dual mandate remains price stability and full employment. The 5.1% year-over-year increase in PCE, excluding energy and food, in September was the highest since March, so prices remain unstable. Following two-quarters of negative GDP growth in the first half of this year, the U.S. economy expanded 2.6% in the third quarter, supporting near-record-low unemployment.
That’s not a combination suggesting the central bank is about to surprise everyone by pivoting from rate hikes to rate cuts. Instead, it’s more likely that the Fed will temper some of its hawkish rhetoric, setting the stage for smaller hikes before heading to the sidelines to watch how its interest rate increases play out. So let’s call it a subtle shift rather than a pivot.
Data suggests higher rates, but less hawkish rhetoric
In “The Numbers Don't Add Up for the Fed to Be Less Hawkish,” Real Money’s James DePorre explains why the latest economic data is less than encouraging for those in the “pivot” camp. He writes:
“The ISM Manufacturing Index was higher than expected, which is inflationary, but the main problem is the JOLTS [Job Openings and Labor Turnover Survey] report which measures the number of open jobs. The number of job openings in September rose by 437,000 to 10.7 million, and the August number was revised higher by 200,000…The Fed wants to see the ratio of job openings to unemployed workers decline, which would indicate a weak labor market, but the ratio moved up instead to 1.86 from 1.68 in September, according to the Wall Street Journal.”
The JOLTs data suggests that employers remain hesitant to reduce headcount, given they had to compete fiercely to hire workers last year. So the JOLTS data may help keep hope for a soft landing alive, but it doesn’t force the Fed’s hand to stop reducing bonds on its balance sheet (quantitative tightening) or give up its inflation fight.
That's only likely to happen if the unemployment rate ticks higher. It hasn't yet, but Friday's October jobs report could contain seasonal revisions that offer more insight into trends.
In “Will the Fed Cut Off the Nose to Spite the Face?,” Real Money Pro’s Peter Tchir outlines reasons for a subtle shift, though. On the inflation front, Tchir writes:
“Commodity prices are coming up to relatively easy year-on-year comparisons, and it is getting even easier. Even oil is well off its post-OPEC+ cut highs. Meanwhile, rents are dropping (maybe not the Owners Equivalent Rent used in the consumer price index, but as I search for stories and data on rent, it shows that September declined, and so far, October looks like it is more so. With mortgage rates above 7% and housing already weaker, don't expect any support from that part of the economy…Autos are getting hit with a double whammy. The supply chain issues are getting resolved, and inventory is building up, just as affordability and need are declining. That's not good, and that is something that is applicable to other big-ticket items, where the cost of financing any such purchase has increased dramatically.”
Indeed, this is something we’ve talked about on Smarts. West Texas Crude oil prices peaked in June above $123 and are now trading below $90 per barrel. As a result, U.S. gasoline prices peaked at $5.03 in June. Gas prices averaged $3.86 last week nationwide. The Invesco DB Agriculture and DB Commodity Index ETFs are significantly below their summertime highs. The housing market is also starting to reflect falling demand caused by higher fixed-rate mortgages. In September, the median sales price was $384,800, down from $413,800 in June.
Broadly, if prices stay roughly where they are now, inflation will fall simply because prices anniversary price spikes from the first half of 2022. So, for example, the following table shows what would happen if September’s PCE level stayed at September’s level into 2023. Notice how inflation steadily drops because of the comparison alone?
Tchir also mentions high inventories, falling earnings outlooks, and stable wages as reasons the Fed could embrace a subtle shift in language. He writes:
“Given what the market is pricing in -- including a three-quarter percentage point hike in November and lesser hikes in the following months -- getting more than a 1.75% increase by the March meeting seems high…Look for some concession to the "success" of existing hikes, to allow a little more data dependence creep into FedSpeak [emphasis mine].”
The million-dollar question may not be to pivot or not-to-pivot, but if softer language is enough for bulls to hang their hats on. Stocks have had a big run ahead of tomorrow’s meeting, and major indexes are bumping heads on downtrending resistance.
Will investors be disappointed if there isn’t a more convincing Fed pivot? Or will they latch onto a “fewer and smaller hikes” style of Fedspeak and push stocks higher? The uncertainty makes tomorrow’s Fed meeting a bit too binary to want to pick a side.
Back to DePorre:
“I can't justify taking on more exposure in front of the Fed…If we have a big positive reaction to the Fed, it is going to make entry points more difficult, but that is a risk I am willing to take.”
The Smart Play
Stocks do best when the Federal Reserve is cutting rates, not increasing them. We may see a subtle shift in the Fed tomorrow, but the final destination of rates still appears higher.
It can be tempting to assume investors can pocket quick profits from the significant volatility following the Fed’s decision. Unfortunately, that’s a risky assumption. Often, wild swings following its announcement leave bulls and bears disappointed, suggesting patience is paramount. So instead of gaming tomorrow’s announcement hoping the Fed will or won’t pivot, consider lightening up exposure and sitting on cash like DePorre. After all, we’ll have better insight into how institutional investors view any language changes soon enough, and then, you can make higher probability trades with a better risk to reward.