Powell And The Fed Are More Hawkish Than You Think: Expect Economic Weakness Ahead (2024)

At today's FOMC meeting, the Fed voted to hold interest rates steady, raised its inflation expectations, and guided for only one interest rate cut for 2024. The Fed's view on inflation itself contrasted with a relatively benign monthly core CPI inflation report in the morning that sent markets soaring (note that the Fed prefers to use core PCE inflation numbers to set policy). Stocks ended the day somewhat in the middle. I was surprised by how hawkish the Fed was at the press conference. While Powell indicated that the Fed has all but ruled out more hikes, policy continues to passively tighten, and the cumulative effect of tightening is showing up in a weakening labor market in the U.S. and other similar countries like Canada and the UK.

Other countries have more variable-rate debt, so their business cycles should turn before the US does. The Fed's own financial stability report indicates that it's concerned with asset valuations being high relative to fundamentals. Between the lines, my feeling is that Powell & Co. are keeping policy rates higher than they otherwise would as insurance against further stoking asset bubbles. While a soft landing would be hard to pull off anyway, this makes me feel that the Fed would prefer a harder landing later to a larger asset bubble now.

Where Should Fed Funds Be? Taylor Rule Models Think Lower Than The Fed Does

Econometric models using the Taylor Rule are increasingly suggesting that the Fed should cut rates. While a few model runs are still suggesting the Fed hike, more and more of the model runs are suggesting that the Fed begin to cut. This contrasts with what the Fed is saying in its Summary of Economic Projections – which is that they're going to hold rates steady for longer than expected.

Curiously, the Fed just raised its expectations for inflation. Fed chair Jerome Powell pointed to tough year-over-year comps in the press conference, but these would have been known in advance. Import costs were also discussed. The data from the economy itself seems like the Fed should begin to cut rates. The rates market itself is currently pricing two rate cuts this year, not substantially different than the Fed's forecast for one.

What Taylor Rule models don't take into account is the idea that while the Fed would like to cut rates from an underlying economic perspective, stock investors have been conditioned to expect the Fed to bail them out at any sign of trouble. Therefore, the Fed may be keeping rates higher to hammer home the point to the market not to misprice risk. This could go on for quite a while – certain areas of the economy have benefited from higher interest rates (big tech, wealthy older homeowners) while others are clearly weakening (housing, autos, and now the labor market). Eventually, the Fed is going to win.

The Fed will rarely admit to allowing unemployment to rise – their projections never show growth going below trend or unemployment rising above very low levels. Of course, these things happen in real life, but to keep Congress from being at their throats, the Fed has to project unemployment to never really go up. Their actions, however, indicate to me that they're more concerned with financial markets being increasingly out of whack with fundamentals than they are with whether the unemployment rate peaks at 6% or 6.5% this cycle.

The Fed May Have A Geography Problem

Another idea I took away from my research is that inflation is still higher in the Northeast and California but lower in Texas and Florida. One recurring theme in economics occurs when interest rates are set on a national or international level, but business conditions are local.

In the early 2000s, low interest rates were thought to stoke real estate bubbles in places like Florida, Arizona and Texas while policymakers were distracted with the labor markets in manufacturing centers in the Northeast US and Northern Europe. Then, when they jacked up rates, it caused huge real estate busts.

During the pandemic, the Fed set rates to counter economic weakness in the Northeast and California, allowing a massive real estate boom in Texas, Florida and Arizona. Now, my anecdotal evidence is that a fair amount of people who moved to Texas and Florida during COVID are moving back home now that the pandemic is over. This means that supply (especially housing supply) is currently in the Sunbelt, while demand is in the Northeast and California. Overbuilding is a market failure that happens in most business cycles, and this cycle probably isn't an exception. As has been the case for the last four years, the continued changes to the economy from the pandemic might present unique challenges that might be hard to forecast.

Are Stock Valuations A Financial Stability Risk?

The defining theme of investing in the 2010s was "TINA." The idea was that with interest rates set at or below 0%, there was no good alternative to the stock market. That's not the case today.

Investors currently have two options, in my mind:

1. Today, you can take a very conservative stock/bond/cash allocation and make annual returns of about 6%-7%. Money market funds are paying 5.5%, you can get roughly the same in core bonds, and valuations aren't crazy in areas like small caps and international stocks. When the cycle turns, you'll have plenty of capital you can deploy to take advantage of a probable market crash.
2. Or, you can ride the momentum now and run up big gains in speculative tech stocks trading for 50x earnings or more. But stocks like these have crashed 80% in past cycles, so if you don't sell at the right time you'll lose money and you won't have capital available to invest in good deals down the road that would arise from a bear market.

Many investors are choosing option 2, going all-in on momentum. Nvidia (NVDA) is up 159% so far this year, and I wouldn't be surprised if it hit $200 soon. I also wouldn't be surprised if it ends up at $20 5-6 years from now (Nvidia recently split its stock so the price may not be comparable to other recent articles). Nature hates monopoly profit margins at this kind of scale, and capitalism exists because of competition. One report found the nascent AI industry spent $50 billion to generate $3 billion in revenue last year. Those are metaverse kinds of numbers. Like Tesla (TSLA), Nvidia is a very polarizing stock, but there are tons of examples of strange valuations elsewhere. For example, why does Costco (COST) trade for 53x earnings with 9% growth? Why does Walmart (WMT) trade for 28x if Costco is supposedly winning their business? Why does Eli Lilly (LLY) trade for 63x earnings when every drug company is developing its own weight loss drug? Are weight loss drugs even good? The people I know on them just push their food around on the plate and don't look all that healthy after being on them. Individually, you can justify any of these valuations. But collectively, people are not doing a good job of pricing risk. Why are small caps (IJR) at 14x earnings, much lower than their long-term average? If you really think the Fed is going to cut a bunch, that's who it's going to help– not the same big tech companies that benefited from rate hikes goosing the interest on their cash hoards.

And I won't say a ton about real estate, but the number of investment deals I see from acquaintances that have negative cash flow that are intended to benefit from unrealistic appreciation assumptions shocks me. Just because the Fed cuts interest rates does not mean that mortgage rates will go down much, if at all. The Fed is seeking to reduce the amount of mortgage-backed securities it holds to zero over time so as not to distort the allocation of credit in the economy. That means while businesses may see cheaper borrowing due to rate cuts, homeowners are less likely to see it due to the long duration of mortgages and due to the government unwinding its mortgage holdings, recognizing its mistake in making mortgages too cheap during COVID. Homeowners who overpaid for houses at the peak thinking they could refinance are more and more likely to have to sell.

Bottom Line

The Fed was more hawkish than I expected today. The disinflationary process should continue to progress, although unevenly. The U.S. and global economies are weakening. Despite what my models are showing, the Fed doesn't seem too concerned with keeping interest rates high. That's good news on the inflation front, but bad news for traders holding high-priced assets that they expect will continue to appreciate. I continue to believe that we're heading towards a moderate recession, but with stock valuations near dot-com levels, there could be a long way down to the bottom for pumped-up areas of the market.

Logan Kane