It’s no longer just a talking point from permabears hooked on conspiracy content: the Federal Reserve has made a mistake. Jerome Powell’s decision last week to signal slower interest rate hikes than the bond market expected is a sharp contradiction from the logic he used at another pivotal point in his tenure: the decision to cut interest rates in 2019. One of these choices was almost certainly an error.
Rewind the tape to the fourth quarter of 2018. Stocks were on the brink of a bear market as Powell was hiking rates. Treasury yields fell as investors ran for safety, and President Trump went on a near-daily crusade against the Fed Chair for pinching the economy in the middle of his trade war. Tariffs were complicating the economic outlook, and the Fed signaled in late 2018 that they’d hold off on further tightening. Stocks bottomed, but bond traders wanted more. Investors piled into bonds until the yield curve inverted in March 2019. The message was clear: cut rates.
Global manufacturing data softened, but Powell was not yet convinced. By July 2019, bonds were pricing in multiple cuts, and stocks were back at all-time highs. Amazon
He cut because the bond market told him to. Or at least, that’s the best explanation that doesn’t imply political pressure from the White House.
History’s verdict on the 2019 cuts is unconvincing at best. There was no obvious recession in sight until COVID hit – a completely unpredictable black swan (unless you really want to get conspiratorial). The most obvious outcome of the cuts was a juicy stock rally in 2019 that saw the S&P 500 forward P/E go from 14 to 19, accounting for 92% of index gains vs 8% from earnings, according to Goldman analysts.
Now back to 2022. Last week, the bond market told Powell it expected him to signal a 75 basis-point hike in June. He shocked Wall Street by instead going very dovish and saying 50 should be OK, a sharp betrayal of the loyalty he showed the bond market in 2019. This is a problem.
If the bond market is always right, as his deference in 2019 suggests, then Powell today is making a mistake to not fight inflation more aggressively. On the other hand, if the bond market is not the be-all-end-all truth, then the 2019 cuts were a mistake.
Regardless which it is, the consequence for risk assets is very serious. If Powell’s current dovishness is the mistake, then bonds and stocks will likely keep falling as the market takes financial tightening into its own hands, or Powell reverses yet again. If the mistake was the decision in 2019, then it implies our stock bubble stretches back even further than COVID.
I believe it was 2019 that was the more obvious mistake, and I warned of this as it happened. I think that’s when the bubble in risk assets really began in earnest. Heads up: the Nasdaq traded below 7,000 before Powell’s pivot rescued the market. Also, look at where the 10-year yield is today: sitting precisely on the level from 2018 when the Fed bent to bonds. There’s no easy way out this time. Either stocks and bonds decline together as they have been, or stocks do it alone. This isn’t close to being over.