The Fed Can't Save The Market This Time

Summary

• Jay Powell will go before Congress starting tomorrow.
• His testimony will be crucial.
• The market is betting the FOMC chairman has a less hawkish take.
• The market's viewpoint may be very wrong.
• Looking for a helping hand in the market? Members of Reading The Markets get exclusive ideas and guidance to navigate any climate. Learn More »

Alex Wong/Getty Images News

Wednesday and Thursday will be interesting days, with Jay Powell expected to appear before Congress and likely to take a grilling. Financial services and banking committee members will need to be tough on Powell to show they're fighting inflation and avoid being voted out of office in November's mid-term elections.

Powell's testimony will be even more critical in light of how the market has repriced risk and rates since the Russian invasion of Ukraine. Powell is likely to acknowledge the risk of the conflict but lean toward not seeing a material impact or threat to the US economy. If Powell has that viewpoint, it will come in stark contrast to the viewpoint of the market.

Fed Funds futures have plummeted, suggesting that the market thinks the Fed is likely to be less hawkish. Fed fund futures yields have dropped sharply as the yield curve has steepened. Expectations that the Fed will be less hawkish could prove to be a massive mistake by the market, and it could turn out to be extremely painful for anyone on the wrong side of the trade.

Path Unchanged

Even with the events in Ukraine all week, the Fed's path seems unchanged and is likely to remain unchanged. The Fed's Chris Waller noted late last week he would like a 100 bps hike by the middle of the year and the balance sheet reduction to start. Meanwhile, the Fed's Loretta Mester also indicated that she didn't think the current conflict changes the need to remove accommodation, with these comments made after Russia moved into Ukraine. It's why Powell's testimony tomorrow will take on extra weight, given that the market is pricing in a less aggressive Fed, and Powell's colleagues' views are unchanged.

This is where the considerable risk for the market lies because should Powell echoes a similar view to some of the governors and FOMC board members that have recently spoken. The assumption of fewer rate hikes by the market will prove painfully wrong, leading to a massive reversal pushing yields higher.

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Old Ways

The market may be getting caught up in its old way of thinking. Historically, geopolitical shocks have led to the Fed easing back on its monetary policy stance due to growth concerns. But this time, the key for the Fed is inflation, and with inflation running well above the targeted level, the Fed won't be able to back off its projected path due to geopolitical risk as it has done in the past.

Bloomberg

Generally speaking, in the past, the Fed could cite concerns of slowing growth as reason enough to take an approach to sit back and wait. But this time is very different, with CPI running north of 7% and even the trimmed mean PCE index running above 5%. It will take much more for the Fed to back off its raising rates and reduction of the balance sheet path.

For the Fed to change course, there would need to be a direct impact on the US economy from the Russia/Ukraine war or a threat to the banking system's stability.

Bloomberg

Another reason the Fed isn't like to change course. The latest geopolitical events have triggered inflation expectations to surge, with the five-year breakeven inflation rate rising to more than 3.2% and up nearly 50 basis points since its mid-January lows. Not what the Fed wants to see. The Fed would like to see inflation anchored at lower levels. Inflation expectations rise stems from surging energy prices and commodities like Wheat and Corn.

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Growth Scare

Additionally, the Russia/Ukraine conflict has resulted in the dollar surging and the dollar index climbing to around 97.50. Nothing can kill global growth, like a strengthening dollar, along with higher food and energy prices can. Piece all of this together, and the underlying narrative of the market's collective view is a massive slow down in global growth is coming, causing expectations for fewer rate hikes and yields dropping sharply, all due to higher inflation.

Powell

Therefore, Powell will not show any signs of a pivot in policy at tomorrow's testimony. Powell is likely to acknowledge the risk of the Russia-Ukraine war but will likely lean toward not seeing a material impact or threat to the US economy. Of course, it will result in a massive reversal in bond yields, with rates at the front end of the curve rising dramatically. In contrast, the back of the curve would worry about higher prices and the stronger dollar killing growth, ultimately leading to the spread between 2's and 10's heading toward zero and potential inversion. All of this will likely freak out the equity market as it worries that the Fed is making a mistake.

But the Fed is fighting a different problem this time. Inflation is the root of many economic issues at this point, and the Fed needs to bring inflation rates down; it has no choice.

With that said, it should be interesting, to say the least.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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