A few weeks ago, the Federal Reserve declared its intentions to hold fast to its inflation-fighting tactics, which include higher interest rates into 2024. In his remarks following the last Fed meeting, Chairman Powell said that the Committee did not discuss cutting rates this year. In direct opposition to this view, the markets believe interest rates are too high and need to come down. This is made clear by the fact that the short-term rates controlled by the government are higher than the longer-term rates determined by the markets.
This is a condition that should not exist in the natural world. It exists when the Fed is putting pressure on the financial system and the financial system is in danger of breaking.
This game of chicken that Chairman Powell is playing with the markets is important because it will determine if the employment markets break, if the economy drifts into recession, and if the stock and bond markets rally from here or must suffer one final swoon.
The Fed believes it must continue to tighten financial conditions to slow the economy and reduce inflationary pressures. This strategy was well underway when the recent banking problems presented themselves. In fact, the higher rates the Fed has engineered over the past year helped create the current banking crisis.
The Fed needed to break something to slow the economy and inflation, and now we know what it was. If the banking troubles persist, we would expect banks to reduce the supply of credit to the economy leading to slower economic growth, thus reducing inflationary pressures and increasing the risk of recession. In effect, the Fed would win with some pain for the economy.
If the banking problems resolve themselves quickly with little to no contagion, the Fed will remain under pressure to increase rates further to combat inflation. The government’s monetary policy and the level of market concern about the banks and state of the economy are “irreconcilable differences.” The outlook for the markets depends on which is right.
Until the next economic cards show themselves, and a trend in inflation and economic policy can be determined, HCM will remain cautious about the equity markets as stocks will most likely struggle with the threat of recession rising.