The Fed WILL succeed The Fed WILL succeed\images\insights\article\federal-reserves-evening-small.jpg April 8 2022 April 8 2022

The Fed WILL succeed

The only question for investors: at what cost?

Published April 8 2022

The Fed will succeed in bringing down the highest and most stubborn inflation since the ’70s. But at what cost? Can it engineer the trickiest of soft landings, or is a recession inevitable? Place your bets. In this week’s travels, I had a 20-something limo driver complain, “Gas is now making everything out-of-this world expensive!” He shares that his friend paid $23.50 for a beer at the Super Bowl. “I’d have to save for a year if I wanted to go!” My seatmate in first class made his politics clear, complaining about the leadership in Congress. Dining at the local “burger joint” with his mother in Colorado, the menu offered chicken wings at market price.  “The chicken wings!!!” Many of my sources and colleagues think equity investors are underestimating the Fed’s desire to restore credibility. Now why would former New York Fed President and FOMC Vice Chairman Bill Dudley be inclined to declare, “To be effective, the Fed must inflict more losses on the stock market.”? (My contacts at Fundstrat think he might be trying to sell his bond book.) Ideally, Piper Sandler thinks policymakers would prefer to pare the $9 trillion balance sheet to 19% of projected GDP—the same percentage it was pre-Covid. At its current intended pace, that wouldn’t be reached until year-end 2025. It’s highly unlikely quantitative tightening will run that long. The risk of an earlier recession is too high and the financial system’s liquidity needs are too great. At 2.70%, the 10-year Treasury yield already is well above the roughly 2.25-2.40% rate markets consider neutral (neither stimulative nor restrictive). That’s extremely rare. But a Fed increasingly worried about inflation seems determined to bring it down at all costs. The more hawkish it becomes, the harder the landing and the higher the recession risks.

Credit markets aren’t pricing in higher stock prices. Neither is the Dow Jones Transportation Average, down 13% in eight days. Given its correlation to economic activity, the index may be sending a warning. Eighty percent of past market peaks occurred when unemployment fell below full employment, as is the case now. Reading market flows for guidance isn’t much help. The 6-week rally saw underperformance from cyclicals and persistent defensive leadership even as bond yields rose. Rising yields had been pro-cyclical for much of the last two years. Despite a 10-year Treasury near cycle highs, Banks continue to underperform Utilities, nearly 40% of the Consumer Discretionary sector has undercut its February low and weakness in semiconductors is pervasive. Wolfe Research views all this as a market transitioning into a late-deceleration phase, favoring defensives such as Health Care and Consumer Staples. Meanwhile, few are talking about the risks posed by China, where 193 million people are subject to full or partial lockdowns in cities that account for 22% of its GDP. The number of ships waiting outside the Shanghai Port has risen almost fivefold in recent weeks, according to maritime data aggregator VesselsValue. A bottom-up Gavekal Research analysis of China’s 100 largest cities by GDP suggests even under an optimistic scenario, China’s economy will suffer about two months of widespread and intense restrictions. About 12% of worldwide shipping is now stuck, a figure only higher two months in 2021. Many have been counting on China to offset slowing in Europe due to the Russia-Ukraine war.

After a first quarter that saw the S&P 500 decline 4.9% and Energy and Utilities as the only sectors to deliver positive returns, the earnings season that kicks off next week could offer clues on what’s next. While year-over-year (y/y) earnings growth is expected to decelerate sharply, Deutsche Bank expects solid sequential earnings growth with slightly above-average beats (6-7%). But earnings revisions are about to turn negative and, Credit Suisse says, only 29% of the time have markets risen in the subsequent quarter when this has happened. Guidance will be key. It’s hard to maintain profit margins and P/E multiples when inflation is rampant and the Fed is aggressive. While Empirical Research isn’t ready to toss in the flag (more below), Bank of America worries that margins not only have hit a cyclical peak but possibly a secular peak. It thinks globalization that contributed to more than half of margin expansion over the last 20 years is pausing if not in reversal. And on an inflation-adjusted basis, this means P/Es could compress another 70% to match inflation trends. As the saying goes, the easy money already has been made. Place your bets.


  • Consumers still got gas Bank of America says aggregate credit and debit card spending rose 11% y/y in March, with card spending per household up 6.7% y/y. TrendMacro shares all the high frequency data is looking weirdly good. Bank of America also said that, despite the shock of higher gas prices, lower-income consumers continue to lead higher-income groups in spending ex-gas and groceries, with spending from pre-Covid levels up 20% on clothing and 35% on furniture. Bigger tax refunds this year versus last year help.
  • Americans tired of being holed up The ISM services composite strengthened, a sign of a broader rotation into the service sector as omicron cases flatline. The underling components were strong, as business activity, new orders and employment jumped.
  • Help is on the way? While there seemingly is no slack in the labor market (more below), Credit Suisse counts about 1-1.5m extra workers on the verge of re-entering the workforce. And given population growth, TrendMacro thinks there are almost 1.5 million people still outside the labor force who could enter it and work to solve supply-side bottlenecks.


  • The labor market is very tight New jobless claims fell to 166K, nearly their lowest level on record (with data back to 1967, only November 1968 had a lower reading). With the number of unemployed to job openings at a 70-year low, companies are holding on to the workers they have for fear of struggling to find replacements. This has wage growth running at least 75 basis points above the Fed’s comfort zone, feeding wage-price spiral fears.
  • Getting tougher to buy a house Mortgage purchase applications fell to a 5-week low as 30-year mortgage rates closed in on 5%, up two percentage points since last fall, the Mortgage Bankers Association said. Every 1 percentage point increase in the loan rate lowers what potential buyers can afford by about 10%, further squeezing affordability in a market where home prices are at record highs.
  • Bigger than Brexit? A Macron defeat in French elections that get underway Sunday would likely trigger a bigger shock to European markets than the Brexit vote did to British markets, Gavekal Research says, as the French president’s strongest challengers are “populists” who would surely try to upend France’s relationship with the European Union. Macron, who had not seriously campaigned, sees his lead in the polls narrowing within the margin of error. It’s expected voter abstention rates will be high, leading to potential outcomes that defy pollsters’ predictions.

What else

Like a phoenix Talk that the massive Build Back Better bill is dead overlooks the fact that Congress still has the very powerful budget reconciliation tool, which allows the Senate to pass major fiscal legislation with 51 votes. This means Dems may well take one more shot at passing a slimmed-down version of Biden’s landmark agenda.

Et tu, Bretton Woods II? Empirical notes a tech sector that sources more than a quarter of S&P earnings and has been the driver of margin expansion has yet to see changes in orders for machinery and robots, emerging market imports, as well as manufacturers’ construction outlays that would suggest this trend is reversing amid growing pressures on globalization that the Bretton Woods II era ushered in.

Millennials are a hoot Bank of America shares that 71% of millennials would rather go to the dentist than listen to their bank, and 53% would rather lose their sense of smell than their smartphone.

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Tags Equity . Markets/Economy . Monetary Policy . Inflation .

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.

Dow Jones Transportation Average: A price-weighted average of 20 transportation stocks traded in the United States. Indexes are unmanaged and investments cannot be made in an index.

Gross Domestic Product (GDP) is a broad measure of the economy that measures the retail value of goods and services produced in a country.

Price-earnings multiples (P/E) reflect the ratio of stock prices to per-share common earnings. The lower the number, the lower the price of stocks relative to earnings.

S&P 500 Index: An unmanaged capitalization-weighted index of 500 stocks designated to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Indexes are unmanaged and investments cannot be made in an index.

Stocks are subject to risks and fluctuate in value.

The Institute of Supply Management (ISM) nonmanufacturing index is a composite, forward-looking index derived from a monthly survey of U.S. businesses.

Federated Equity Management Company of Pennsylvania