Volatility and Confusion in Markets: Fed Chairman's Remarks Cause Unease
Abraham George Market Musings
The recent remarks by the Fed Chairman to the Senate Banking Committee and the House Financial Services Committee on March 7 and 8, respectively, have caused considerable volatility and confusion in the markets. The Chairman's flip-flopping approach has left seasoned Fed watchers uncertain about the Fed's true stance on inflation and interest rates. Even though it is well-known that a lawyer discussing economics with a group of politicians would not be easy to comprehend, the Chairman's latest comments have left many analysts puzzled.
To make sense of Powell's latest remarks, it is essential to revisit his previous comments after the Fed meeting, which was about six weeks ago. During the meeting, he made pointed remarks about the disinflation (falling inflation) in the economy. He went further to state that they had "covered a lot of ground and that real rates are positive." This gave us good clues to assume that the Fed might be cooling off from its policy of threats and more decisive actions. The market had already built expectations that the Fed would continue to raise rates higher, but in smaller doses, to exceed 5%. Meanwhile, the 10-year yield had moved significantly from 3.5% to 4% in such a short period.
So what did Powell say that was different now? He stated that the full effects of the actions that they have already taken are "yet to be felt." He added that the January data was hotter and could be attributed to "unseasonably warm weather." Powell warned that the stopping point of rates in this tightening cycle could be higher, given the recent data, and that they would move faster if necessary. The algo traders were quick to pick up on the words "higher" and "faster." Stocks finished sharply lower, but yields hardly changed.
The Fed had already built expectations of a terminal rate in the low 5% area, but with the latest comments, they have hedged themselves for slightly higher rates if data continues to show price pressures on the top side. The markets have quickly adjusted to the new announcements from the Fed and are now discounting a 0.5% hike in rates as opposed to the 0.25% rate rise after the conclusion of the FOMC meeting on March 22nd.
What does all this tell us about the overall economy? In under a year, the Fed has taken the Fed funds rate from zero to just over 4.5%, and they are telegraphing a few more hikes too. Despite all this, unemployment is near record lows, and the economy is running at 2.6% real growth based on the much-watched Atlanta Fed's model.
Recently, the news about the collapse of a tech-focused Silicon Valley Bank amid a run on deposits has created a developing story. The bank worked mainly with startups and the investors who fund them. It became the second-biggest bank failure in US history. At the end of 2022, Silicon Valley Bank was the 16th largest bank in the US, and it had assets worth $209 billion, according to the Fed and Wall Street Journal, but now it is no more. This is the biggest bank failure since 2008. This news should put the Fed back into hiking a maximum of 25 basis points on March 22 after the FOMC meeting. This news is developing, and we don't know what all contagion impact this could have on other banks and corporations by the time of the FOMC.
As Warren Buffett has said, "only when the tide goes out, do you discover who's been swimming naked." In the present situation, the "tide" is the easy money and low inflation era. If that is taken out, all the leveraged and mal-investments should get exposed. The high-valuation companies, no-earnings tech companies, many cryptocurrency projects, SPACs, and the biggest bankers in those companies are all at risk of being exposed. The biggest of all is Sovereign debt.
While many experts and seasoned market analysts compare the inflation period of the 70s and 80s to what is happening now, I disagree. I may have been wrong on many things before, but I can confidently say that central banks are not going to go for double-digit interest rates. The Fed and other central banks have adopted other means to address the issue. In the Fed's case, they sought to attack verbally on jobs, wages, and even the stock market.
One thing we all should be mindful of after the GFC is that the Fed and other central banks will cooperate extensively, and there is no uncertainty about what they will and can do. There is no rule book anymore. They make up the rules according to the situation. Their policy will be "whatever it takes" to maintain financial stability and attain their desired outcome.
The 10-year government bond market rate is the benchmark rate from which many consumer rates are set. This is a highly manipulated rate by the Fed and other central banks. As long as this rate hovers around the 4% level, government debt remains manageable. However, the yield inversion that we are seeing between the two-year and 10-year interest rates at over 100 basis points is the worst I have seen in the markets. In normal circumstances, the 10-year rates average 90 to 100 basis points above the two-year rates. Based on this alone, the market is screaming for a recession, and the Fed is clearly over-tightening.
Eventually, lower yields will lead to higher equity prices, but the biggest problem is coping with the current volatility. In conclusion, while the recent comments by the Fed Chairman have caused confusion and volatility in the markets, it is important to keep in mind the broader economic picture and the actions of central banks in maintaining financial stability.
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Abraham George is a seasoned investment manager with more than 40 years of experience in trading & investment and multi-billion dollar portfolio management spanning diverse environments like banks (HSBC, ADCB), sovereign wealth fund (ADIA), a royal family office, and a hedge fund.