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Higher for longer: The bearish path for stocks?

13:42, 30 August 2022

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Macrodesiac on the Fed's path for interest rates
Tim Vollans of Macrodesiac explains how stocks could be affected by higher inflation and rates - Image: Macrodesiac

The Jackson Hole event at the end of last week has been billed as the death of the Fed pivot narrative. It was never really anything more than a story. This idea that the US Federal Reserve, the largest provider of global liquidity was going to turn tail at the first sign of trouble and rush back to the comfortable, well-trodden path of extremely low interest rates has always been fanciful while inflation continues to run well in excess of 8% in the US.

From September, that same liquidity pot that so recently fuelled multi-month rallies in share markets, meme stocks, crypto, and even cartoon monkey pictures is going to be drained at a much faster pace. At the same time, Federal Reserve officials are talking up the price of capital (interest rates) and keeping that cost high for the foreseeable future.

It’s not just about the liquidity though. Although this is one essential part of the bigger picture, there’s a lot more going on, including government responses to energy crises, the durability of inflation, housing weakness, company earnings and just how resilient the consumer really is.

First up, let’s address the elephant in the room: why did the S&P 500 (US500) fall by more than 3% on Friday, and end the week almost 4% in the red?

S&P 500 (US500) index price chart

Fed Chair Powell didn’t give markets what they’d hoped for. There was no dovish pivot, no mentions of economic weakness elsewhere in the world, just a single-minded focus on one thing: Inflation.

Now, this was far from the first time the market had heard this message from the Fed Chair or any number of Federal Reserve officials. This time, he was a man on a mission. One of the shortest speeches at any Jackson Hole event, no straying from the point, nothing to misinterpret. No Q&A. He delivered his message and left the stage. The resolve was unquestionable.

As speeches go, it was a communication masterpiece. In case the audience were in any doubt, Powell led with the key message:

“The Federal Open Market Committee's (FOMC) overarching focus right now is to bring inflation back down to our 2 percent goal. Price stability is the responsibility of the Federal Reserve and serves as the bedrock of our economy.”

Once again, nothing new in these words, but the position of the message at the start of the speech is significant. The Fed Chair then proceeded to tear down the structure supporting the pivot narrative: “The Fed will pivot as soon as the economy slows”. Nope. He told the people to prepare for pain (but it’ll be the lesser of two evils): 

“Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance. Reducing inflation is likely to require a sustained period of below-trend growth. Moreover, there will very likely be some softening of labor market conditions. While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.”

Bang. Another support pillar taken out. Powell continued to reiterate the message throughout the speech, made clear that the central bank is highly aware of the mistakes made when (not) addressing the Great Inflation of the ‘70’s and finished by reinforcing once again that they’re not stopping until the objective is complete. 

“These lessons are guiding us as we use our tools to bring inflation down. We are taking forceful and rapid steps to moderate demand so that it comes into better alignment with supply, and to keep inflation expectations anchored. We will keep at it until we are confident the job is done.”

Have a read of the full speech here. In this central bank game of expectation management, there wasn’t much more Powell and the speech-writers could have done.

However, it’s one thing to talk the talk, and another thing entirely to walk the walk…

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Warren's backlash

US Senator Elizabeth Warren lashed out over the weekend worried that the Fed’s actions would tip the economy into recession. Market veterans will say “that’s the entire point. Without a recession, expectations won’t be reset”. Warren isn't a market veteran, she’s a politician giving an interview to CNN: 

“What he calls 'some pain' means putting people out of work, shutting down small business because the cost of money goes up because the interest rates go up,

US100

11,322.70 Price
-1.540% 1D Chg, %
Long position overnight fee -0.0116%
Short position overnight fee 0.0025%
Overnight fee time 21:00 (UTC)
Spread 1.5

NIFTY50

17,235.80 Price
-1.960% 1D Chg, %
Long position overnight fee -0.0043%
Short position overnight fee -0.0035%
Overnight fee time 21:00 (UTC)
Spread 7.0

US500

3,698.00 Price
-1.670% 1D Chg, %
Long position overnight fee -0.0117%
Short position overnight fee 0.0025%
Overnight fee time 21:00 (UTC)
Spread 1.5

DE40

12,304.00 Price
-2.290% 1D Chg, %
Long position overnight fee -0.0063%
Short position overnight fee -0.0018%
Overnight fee time 21:00 (UTC)
Spread 3.5

“There is nothing in raising the interest rates, nothing in Jerome Powell's tool bag, that deals directly with those and he has admitted as much in congressional hearings,

“Do you know what's worse than high prices and a strong economy? It's high prices and millions of people out of work. I am very worried that the Fed is going to tip this economy into recession,” she said.

This is the battleground now. Once the Fed’s actions start to impact the economy and lives of everyday people, politicians are bound to raise concerns over the plight of their voters. That’s why they were appointed. Meanwhile, the Fed’s job is to bring inflation down and restore price stability.  

Turning point for economic stability?

It’s not just the US either. ECB Board member Isabel Schnabel also spoke at the event and asked if this was the beginning of a new era for the world economy:

“The question I would like to discuss is whether the pandemic, and Russia’s invasion of Ukraine, will herald a turning point for macroeconomic stability – that is, whether the Great Moderation will give way to a period of 'Great Volatility' – or whether these shocks, albeit significant, will ultimately prove temporary, as was the case for the global financial crisis?” Schnabel asked.

The Great Moderation is the name given to the period of relative stability since the liberalisation of the Soviet Union, followed by China’s integration into the global economy. Essentially, globalisation.

Schnabel continued: “As a result, just as globalisation led to excess supply in product and labour markets, limiting price and wage increases, the emergence of the US as a large net exporter of energy buffered the impact of demand shocks on oil and gas prices over the past 15 years.”

If this is indeed the beginning of the end for globalisation, cheap energy, and the transition to a new economic regime of competing blocs, then supply chains will continue to be impacted, and domestic production will need to increase. At that point, the really tough decisions will need to be made, and it may be that governments and central banks return to the post-world war playbook of low interest rates and aggressive economic expansion.

Rates higher for longer

For now though, the inflation fight is the top priority. Schnabel explains: “There are two broad paths central banks can take to deal with current high inflation: one is a path of caution, in line with the view that monetary policy is the wrong medicine to deal with supply shocks.”

“The other path is one of determination. On this path, monetary policy responds more forcefully to the current bout of inflation, even at the risk of lower growth and higher unemployment. This is the 'robust control' approach to monetary policy that minimises the risks of very bad economic outcomes in the future.”

“Three broad observations speak in favour of central banks choosing the latter path: the uncertainty about the persistence of inflation, the threats to central bank credibility and the potential costs of acting too late.”

All of which points towards a higher for longer interest rate regime in the EU & US. If this plan is followed, it could be extremely damaging for companies that depend on a low cost of capital. Especially those that don’t turn a profit and exist firmly in the wants rather than the needs category. 

Further reading

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