In the last 6 weeks or so the market has rallied strongly. While this is always welcome and gives everyone time to regroup, it is my opinion that these gains still fall under the category of a relief rally in the middle of a bear market. But before I get into that, let’s take a look back before we look forward.
Back in June, the US Federal Reserve and its chairman, Jerome Powell, provided some commentary following their latest interest rate increase of 0.75%. The market interpreted their language as an indication that they will not increase interest rates as much as the market was thinking. The market is wrong on this point. To make matters worse, the markets started to factor in interest rate cuts in 2023.
This is the same pattern of miscommunication errors the Fed and financial markets have been making ever since inflation became a problem. It’s a complex and flawed relationship but neither side seems to be able to be honest with each other. At best, the Fed continues to sugarcoat the situation and at worst, is incompetent. Share market investors, always happy to misinterpret the absence of bad news as good news, continue to be enthusiastically led down the garden path by the ambiguous and sloppy communication of the Fed.
So, from that point in mid-June, in the absence of bad news resulted in a bigger rally to the point of becoming a mini bull run in early August. To be clear, there was no fundamental reason for this to happen. But once it got a little momentum it was always going to continue…until told otherwise. By told otherwise I mean by the Fed being clear and deliberate in their communication about raising interest rates or economic data doing their job for them.
Unfortunately, reality catches up at some point. I think we are at that point now.
Everyone knows the rally has pushed the share market up too high, too quickly. Chairman Powell has been forced into a corner and will need to set the record (and markets) straight. As luck would have it, this week is the Jackson Hole Symposium, the annual meeting of central bankers from across the world. This is the perfect (and much needed) opportunity for Chairman Powell to unequivocally state that when push comes to shove, they will choose to raise interest rates to kill off high inflation.
What he needs to say is this:
“The US economy is well positioned. The US consumers have solid balance sheets. Both have proven resilient in the face of difficult times. We expect there to be more uncertainty in the months ahead and it is possible that the economy and economic growth will slow. However, the biggest threat to our economy and our standard of living is inflation. So as long as inflation is above the range of 2-3% we will continue to raise interest rates. That is our top priority.”
If he says that share markets will fall significantly. Bond values will fall too as yields increase.
But it is necessary to say it.
If left unsaid, then he only creates a more severe disconnect between markets and reality. Powell and the Fed will lose even more credibility if they continue with their wishy-washy and ambiguous language. I believe the Fed and Powell should have realised from this latest share market rally that their language is betraying them. They have acted to push rates up and they have been prepared to go up in hikes of 0.75% when only a few months ago it was unthinkable. But their subsequent comments in press conferences have allowed the share market to change the narrative to suit their short-term agenda.
So, I expect Powell and other central bankers, such as the UK’s Andrew Bailey, to emphasise the threat that inflation poses to the global economy. At Jackson Hole, there will be other central bankers speaking too and the inflation situation in other western nations is even more dire. The UK for example now sits at 10.1% inflation (as of July 2022) and with the energy crisis taking hold the most recent forecast from major institutions such as the Bank of England and Citi have inflation in the range of 13%-18% by early 2023. If the Fed address their language correctly it will turn the mood of the share market back into bear territory, and in my opinion, we will retest the share market lows of June, but it will ensure that the appropriate line in the sand is drawn for the battle ahead.
If they leave any room for doubt or ambiguity in their message, then it tells us that Powell and the US Fed have their head in the sand and are quietly hoping that inflation magically disappears. Now it is possible that supply chain woes unwind and all inflationary pressures on the supply side do ease. But this cannot be the base case. If they get that wrong, they are setting up the global economy for the worst of all scenarios and risk many years of stagflation across the world. That situation would be far worse for both share markets and the global economy in the long term than putting up rates too high in the short term. Markets will sort themselves out in the end regardless, but the path can be made significantly simpler by taking the medicine required sooner rather than later.
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