How Jerome Stole Christmas

By Scott Poore, AIF, AWMA, APMA
Chief Investment Officer, Eudaimonia Group

The Fed decided to dash the hopes of equity bulls this week as it announced a highly expected 50 basis point rate hike, but also signaled more rate hikes and a higher median/terminal rate.  It reminds me of the great children's tale, "How The Grinch Stole Christmas."  The story, by Dr. Seuss (Theodor Geisel) was first published in 1957 by Random House.  It is on the list of the Teachers' Top 100 Books for Children.  It was adapted into an animated movie in 1966, featuring Boris Karloff, and into a 2000 movie starring Jim Carrey.  

"Every Who down in Whoville liked Christmas a lot.
But the Grinch who lived just North of Whoville did not!

The Grinch hated Christmas! The whole Christmas season!
Now, please don't ask why. No one quite knows the reason.

It could be, perhaps, that his shoes were too tight.
It could be his head wasn't screwed on just right.

But I think that the most likely reason of all
May have been that his heart was two sizes too small."

Here's what we're seeing so far this week...

But Jerome, Who Lived Just North of D.C. Did Not!  Powell came out firing in his speech just after the conclusion of Wednesday's last FOMC meeting of 2022.  Initially, markets took the news in stride as the 50 bps rate hike announcement was widely expected.  However, as the Fed's "Dot-Plot" was released and Fed Chairman Powell began to speak, the mood shifted on Wall Street.  Some of Powell's key comments are as follows:

• "need substantially more evidence of lower inflation"
• "This year it was very important to move quickly on inflation."
• "We'll make February decision based on incoming data."

Let's take a deeper look at these statements.  When Powell says the Fed "needs substantially more evidence," has he seen inflation lately?  Five consecutive months of lower PPI and CPI on a year-over-year basis.  Question, has inflation declined for 5 consecutive months after peaking, only to head higher thereafter?  Answer:  it's only happened 4 times since 1951, and in each of those cases (1995, 2005, 2008, and 2018), CPI peaked on average at 3.97%.  When inflation peaked at 5% or higher (as it has earlier this year), it was lower 12 months later by 3.3% on average.  Powell's comment of "very important to move quickly on inflation," what about in 2021 when CPI was at 7% and PPI was at 9%???  Did we see the Fed move quickly then?  Lastly, Powell stated, "February decision based on incoming data."  Is the Fed going to make a different decision based on 1 and a half months-worth of data when they meet on February 1st, 2023?  What we're witnessing is the word-smithing of a seasoned politician.  You don't get to that level without knowing how to parse your words to get the outcome you desire.  How do we know this?  In the FOMC's official statement...ONLY TWO WORDS CHANGED from last meeting to this meeting.  December's statement took out the words "creating additional" and inserted "contributing to."  That's it!  What's really moving markets is the expectation of investors that further rate declines were in the cards and that the Fed might stop its rate hiking cycle at the next meeting in February.

Jerome Hated Christmas! The Whole Christmas Season! Markets have not responded well to the Fed's language and economic projections. And, rightfully so, because they don't match up well.  For example, the Fed moved their Dot-Plot for their median Fed Funds Rate for 2023 higher than expected yesterday from 4.6% in September to 5.1%.  That sent markets in a tizzy, despite the fact that the Fed did come down from 0.75 bps rate hike in the previous four meetings to 0.50 bps yesterday.  As we've already laid out, the language provided by Chairman Powell was very hawkish.  So, one would think that economic data looks so good that it requires the Fed to slow things down to fight inflation, right?  Wrong.  the Fed changed their 2023 projections for GDP lower (from 1.2% to 0.5%) and their projections for Unemployment higher (from 4.4% to 4.6%).  If growth is lower and job losses are higher, does that equal a strong economic situation?  Even more puzzling, the Fed's measurement for inflation was revised higher for 2023 from 2.8% to 3.1%.  Question:  if growth is down and unemployment is higher, how can inflation be higher than previously forecast?  Wouldn't that scenario be "deflationary?"  What this signifies to the market is that the potential for a recession just increased.  And, the Fed is determined, based on Powell's speech, to curb economic growth to perhaps prevent further large rate hikes.  Yet, history shows that this Fed has been much more aggressive in the current rate hiking cycle than previous cycles in fighting inflation – at least since 1983.  The historical data we laid out in the previous section clearly shows inflation is coming down and is likely to stay down.  Most economists agree that it takes 12-18 months for a Fed rate hike to take effect in the economy.  So, if the 4 rate hikes previous to Wednesday were all 75 bps and those will still be working through the economy over the next 8-12 months, why the need to be so hawkish with inflation having declined for 5 consecutive months?

Every Who Down In Whoville, The Tall And The Small, Was Singing Without Any Presents At All!  Even though Scrooge Powell didn't give us two farthings for Christmas and probably cost us a Santa Rally, there is a lot to be thankful for.  Equities are off two-month lows.  The October 13th low marked a 27% decline for the S&P 500 on a year-to-date basis.  Right now, even after today's action, equities are up 11% since that low and are down only 18% on the year.  Not a good number, but it could be worse.  Investors now need to adjust to the idea that the Fed is no longer on their side, for the time being, and adjust expectations.  All things considered, the economy is hanging in there.  Last month's Jobs Report was solid and today's Jobless Claims came in lower-than-expected.  The economic numbers haven't fallen off a cliff, yet.  The Adjusted National Financial Conditions Index is at -0.11, which means financial conditions are still "loose" and not tight enough to consider the economy in contraction yet, and despite comparisons to the contrary, we are no where near the levels on the ANCFI that we saw in 2007 as the recession was beginning.  In fact, the Atlanta Fed is currently projecting GDP for the 4th quarter to come in at +2.8%.  So what can we take from all of the action this week?  Don't overreact.  We're still trying to determine how serious the Fed is about future rate hikes or if they’re just trying to keep the economy/market from over-heating.  By next week, things could change, but making major investment changes right now is not recommended.  For example, the futures on the February rate hike are at a 74% probability for 25 basis points.  That would definitely qualify as a slower pace.  We need to see how markets absorb this new information.

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