Markets Panic Over Rate Hikes. Will Powell Calm Them Down?

With Fed Chairman Jerome Powell taking center stage this afternoon, the financial markets are still freaking out about potential rate hikes. For example, the S&P 500 and the Nasdaq Composite sold off into the close on Jan. 25, and U.S. Treasury yields continued their bullish ascent.

Please see below:

Source: Investing.com

Moreover, with the inflationary outlook still materially unsettled, the FOMC has little room for a dovish pivot. To explain, the Richmond Fed released its Fifth District Survey of Manufacturing Activity on Jan. 25. While the headline index decreased from 16 in December to 8 in January, both the prices paid and received indexes rallied to new all-time highs. 

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Source: Richmond Fed

Likewise, the report also revealed that “the wage index increased to 40, which is the second-highest value on record. Firms expect wages to continue increasing, with the expected wage index remaining firmly in expansionary territory.”

Speaking of wages, the Fed’s inflationary conundrum has broken the connection between the labor market differential and Americans’ net income expectations. For context, The Confidence Board’s metric calculates the net result of survey respondents’ beliefs that jobs are easy to obtain versus difficult to obtain.

Please see below:

To explain, the red line above tracks the labor differential, while the blue line above tracks Americans’ net income expectations. When the red line is rising, it means that more respondents believe that jobs are easy to obtain. However, if you analyze the right side of the chart, you can see that the blue line hasn’t followed suit. As a result, with inflation eating away at Americans’ net incomes, the Fed needs to act to restore the historical relationship.

To that point, the Fed’s dual mandate is to control inflation and ensure maximum employment. With The Confidence Board’s labor differential near an all-time high, the Fed’s hawkish disposition is valid in this environment. Thus, with a strong U.S. labor market coupled with extremely elevated inflation, it’s the perfect combination for the FOMC to raise interest rates in the coming months.

As further evidence, 3M released its fourth-quarter earnings on Jan. 25. After beating on both the top and the bottom lines, management said: “our revenue in the quarter finished better than we expected across all businesses (…). Overall, demand remains strong across our market-leading businesses, and we are continuing to prioritize growth investments in large attractive markets.”

Moreover, with inflation still increasing, CFO Monish Patolawala said the following during the Q4 earnings call:

Source: 3M/Seeking Alpha

In addition, American Express also released its fourth-quarter earnings on Jan. 25. After beating on both the top and the bottom lines, the credit card giant painted a rosy portrait of the U.S. consumer. CEO Stephen Squeri told analysts during the Q4 earnings call:

“Spending growth reached a record quarterly high, driven by continued increases in goods and services spending, which was 24% above pre-pandemic levels. Global consumer goods and services spending in the quarter grew 26% versus 2019. And we saw continued robust growth in small business B2B spending, which increased 25% over Q4 2019 levels. Overall T&E spending also continued to improve reaching 82% of pre-pandemic levels, driven by stronger consumer travel spend.”

He added:

“Our billed business momentum continues to be led by the U.S., where spending improved sequentially throughout 2021 and grew 16% above 2019 levels in the fourth quarter.”

Please see below:

Source: American Express

What’s more, while the Omicron variant has disrupted travel and expense (T&E) spending, the U.S. is still outperforming the rest of the world. Squeri said:

“We did see some modest impacts from the Omicron variant in T&E spending as the pace of recovery slowed a bit in December. But even with that modest slowdown, U.S. consumer T&E was not only fully recovered in the fourth quarter, but actually grew 8% above 2019 levels.”

As a result:

Source: American Express/Seeking Alpha

Tread Carefully, Powell

Thus, while I’ve stated this on numerous occasions: the U.S. economy remains resilient and the U.S. consumer is quite strong as well. However, with a bullish U.S. economy bearish for the PMs and the Nasdaq Composite, liquidity-fueled assets should struggle in the coming months. 

For example, American Express’ quarterly outperformance supports the Fed’s hawkish stance. With inflation extremely elevated and growth and consumer spending only stifled due to coronavirus disruptions, the warmer weather should result in renewed economic optimism. As a result, hiking interest rates is a logical reaction from the Fed. 

Finally, while the USD Index has been relatively range-bound in recent weeks, brighter days are likely ahead. For context, we don’t expect any bombshell announcements from Powell today. However, with rate hikes poised to commence in the coming months, Bank of America told its clients that the USD Index remains a “buy-on-dip” story.

Please see below:

To explain, the dark blue line above tracks the USD Index’s average performance 40 days before the Fed raises interest rates, while the light blue line above tracks the current price action. As you can see, the USD Index is still trading within its expected range. However, with the dark blue line signaling that higher highs are often the norm as we approach the Fed’s official announcement, fundamental reinforcements should uplift the USD Index over the next few months. As such, more pain should confront the PMs.

The bottom line? While many market participants now fear a U.S. recession, the data suggests otherwise. With U.S. consumers still eager to spend their money, imagine their optimism when the cold weather and coronavirus panic fades in the coming months. Likewise, if U.S. economic growth is holding up this well when sentiment is severely depressed, the FOMC should have the foresight to see the results when consumers can resume their daily routines.

However, please note that resilient economic growth doesn’t mean that things are bullish for the general stock market. Sure, banks, industrials, energy, and other economic-sensitivity sectors should benefit from higher interest rates. Conversely, technology and communication services account for nearly 40% of the S&P 500 and 100% of the Nasdaq Composite. As a result, sometimes too much of a good thing is actually bad.

In conclusion, the PMs rallied on Jan. 25, despite the general stock market’s struggles. However, while Powell may try and calm investors’ nerves today, he has little room to avoid rate hikes in the coming months. Moreover, with U.S. President Joe Biden imploring Powell to curb inflation, the writing is largely on the wall. As a result, the USD Index and U.S. Treasury yields have the fundamental wind at their backs, and it’s likely only a matter of time before the PMs realize this harsh reality.