A contrarian view is emerging that questions investors’ recent optimism about the Federal Reserve’s ability to return inflation to 2% without a U.S. recession or a major increase in unemployment.
It’s the idea that Wednesday’s unexpectedly dovish change in policy by policymakers, who had planned a three-quarter-point rate cut by 2024, could ultimately undermine their inflation fight and create a new set of problems. The reason is that it reawakens market psychological forces known as “animal spirits,” boosting investor confidence and easing financial conditions in a way that could make it harder to control inflation.
The resurgence of these ‘animal spirits’ in financial markets is the biggest risk created by the Fed’s policy update this week, as officials try to pursue an economic soft landing ‘by greenlighting a deeper pre-emptive series of cuts ” said Charlie McElligott, an asset strategist in the global equity derivatives desk at Nomura Securities International in New York.
In a note on Thursday, a day after the Fed unveiled its update and forecasts, McElligott cited how financial conditions are easing at a time when the labor market remains historically tight. In addition, households and businesses benefit from a positive wealth effect due to a rising stock market and the interest that can be earned on cash investments. The collective impact of all this is that reawakened “animal spirits” could continue to drive consumption and fuel inflation, “jeopardizing the future need to tighten policy again,” the strategist wrote.
The ‘Powell Preemptive Pivot’ translates into what appears to be a ‘QE/portfolio-rebalancing channel trade’ in the financial markets, says McElligott, who has been warning for months about the risks posed by ‘animal spirits’.
At this point, he said, there is no reason to try to blunt the “everything rally” until inflation and economic growth accelerate again, which would require a “capitulation of the Arthur Burns tightening cycle,” or until a “hard landing” scenario becomes reality. with a labor market burst that would “require more than 300 basis points of cuts, and fast.” Arthur Burns was chairman of the Fed from 1970 to 1978 and was Paul Volcker’s predecessor.
McElligott is not alone in expressing concerns about the impact of this week’s Fed policy announcement and projections. Northwestern Mutual Wealth Management Co.’s investment team in Milwaukee, which oversaw $255.7 billion in assets as of September, said it believes it will be difficult to completely eradicate inflation, and that policymakers will be reluctant to cut rates until they return sustainably to 2%.
The implications of Northwestern Mutual’s thinking are that a perfect economic landing is highly unlikely and that under that situation, certain investments, such as small- and mid-cap stocks, will outperform others over the next 12 to 18 months, data show from Northwestern Mutual. a report circulated on Friday.
Adding credence to skepticism about a smooth central bank move were comments made earlier on Friday by New York Fed President John Williams, who said officials are not really talking about rate cuts at the moment.
Williams’ comments helped push the policy-sensitive 2-year yield BX:TMUBMUSD02Y up 5.8 basis points to nearly 4.46% on Friday. Meanwhile, all three major stock indexes DJIA SPX COMP finished mixed. Fed funds futures traders continued to see the likelihood of as many as five to seven quarter-point Fed rate cuts next year.
