Mixed signals

The impact of the markets on the Fed…and vice-versa

It’s important to understand the current relationship between investors and central banks and what it could mean for equity returns going forward. So let’s look at what the storyline has been for markets through the first six weeks of the year and try to see what’s in store.

The most important dynamic to start the year was the disconnect between investors and the U.S. Federal Reserve (Fed). Equity markets originally rallied in large part because the former believed the latter’s tightening cycle was all but done and that cuts to interest rates were inevitable later this year. This belief was supported by weakening economic data, including contracting Purchasing Manager Indexes, which suggested further rate hikes could lead to recession, as well as the fact that headline inflation has fallen steadily in recent months and now seems under control.

But that disconnect is no longer so extreme. Investors in more recent weeks have started to buy into the idea that rate cuts are still several quarters or more away, which is precisely what the Fed has been trying to communicate all along. Sure, Fed Chairman Jerome Powell’s comments have been more dovish of late than they were throughout 2022, but even then, he has continued to reiterate the idea that more rate hikes are needed to bring inflation down closer to the central bank’s target near 2%.

Where’s the inflation?

So what’s changed from the perspective of investors? In particular, they now seem in agreement with the Fed’s stance that inflation remains stubbornly high on the services side of the economy, which is in stark contrast to the goods side of the equation that has deflated substantially in recent months.

But more than that, investors have reflected on another very strong jobs report for January and better economic data – including the latest U.S. retail sales figures – to finally reach the conclusion that the Fed is being emboldened to keep raising rates well into the spring if not early summer.

In fact, that same idea – although to a much lesser degree – is now making the rounds regarding the Bank of Canada (BOC) as well. Even though the BOC has explicitly stated a pause in future rate moves, many analysts point to the country’s strong employment figures for January as a reason for Canada’s central bank to change its mind and keep raising rates to wrestle inflation still lower without too much fear that doing so will cause severe economic hardship.

Of course, all of this has led to more market volatility in recent weeks. And that should continue for as long as there is any debate about the timing of the Fed’s (and other central banks) shift away from rate hikes to rate cuts sometime in the future.

The market’s impact on the Fed

What effect does the market rally so far this year have on the Fed’s decision-making over the next few weeks?

Most investors understand how the Fed or other central banks can affect the market, but it’s not always recognized how the market can impact what the Fed does. In the current environment, for instance, the rise in equity markets has a wealth effect that may be stimulative to the economy and inflationary by nature. As such, the Fed may view rallying stocks as just one more reason to keep raising rates, not cut them.

In other words, there’s something perverse at play right now where stock prices rise because investors believe the Fed will ease policy, and yet it’s partly because stock prices are rising that the Fed may end up continuing to tighten longer than expected.

The bond market, meanwhile, complicates matters even more. Consider the 10-year U.S. Treasury yield, which has turned up in recent weeks due to the improvement in economic data but is still well short of its highs from last fall. This has acted to ease financial conditions for big-ticket items like buying a house or a new car, which, in turn, helps counteract the economic risk of more rate hikes from the Fed going forward.

Ultimately, it’s hard to believe in a clear path to rate cuts later this year. That doesn’t mean it won’t happen, but investors need to be prepared for a scenario in which the Fed (and other central banks) ease policy at a much slower pace than is currently anticipated.

Non-monetary-policy factors to watch

It’s hard for anyone – let alone investors – to ignore the news about China’s supposed “spy balloon” being shot down by U.S. forces earlier this month. While officials are now downplaying the incident, U.S.-China relations are once again fraught with tension. and that is something the markets will need to monitor as the year progresses – especially given the impact it could have on trade between the two countries going forward.

But of all the potential geopolitical risk(s) to contemplate, the Ukraine War still stands out as the most pressing. As we discussed on the latest episode of AGF’s Inside Perspectives, the biggest concern is how the war progresses now that NATO has step up its involvement – at least in terms of supplying Ukraine with more equipment and weaponry to combat Russia’s assault. While investors may have other things on their mind, an escalation in the conflict could trigger even more volatility ahead.

Finally, investors need to be wary of the U.S. debt ceiling and the potential for default. While this might sound like a broken record, the usual “game of chicken” could be more treacherous as both parties in Washington dig in. Again, this may be an event that markets are not fully pricing in just yet.

Kevin McCreadie is Chief Executive Officer and Chief Investment Officer at AGF Management Ltd. He is a regular contributor to AGF Perspectives. Click to learn more about AGF’s fundamental, quantitative, and alternative investing capabilities.

Notes and Disclaimer

The commentaries contained herein are provided as a general source of information based on information available as of Feburary 17, 2022, and should not be considered as investment advice or an offer or solicitations to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication, however, accuracy cannot be guaranteed. Market conditions may change investment decisions arising from the use or reliance on the information contained herein. Investors are expected to obtain professional investment advice.

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