Wall Street mispriced inflation and misread the Fed.
That’s the conclusion after yesterday’s market upheaval.
Perhaps the perfect illustration of this is seen in the CNBC article below that published on Monday – obviously, the day before yesterday’s unexpectedly-hot CPI print:
Credit Suisse expects the Federal Reserve to pause interest rate hikes sooner than widely expected due to tumbling inflation.
According to the firm’s chief U.S. equity strategist, it will launch a powerful market breakout.
“This is actually what’s being priced into the market broadly,” Jonathan Golub told CNBC’s “Fast Money” on Monday.
“Every one of us sees when we go to the gas station that the price of gasoline is down, and oil is down. We see it even with food. So, it really is showing up in the data already. And, that’s a really big potential positive.”
Yes, we all see lower prices at the pump – but did anyone at Credit Suisse bother to check the nosebleed condition of rents? Or healthcare? Or any of the other CPI categories that aren’t in our faces every time we drive past a gas station?
To be fair, Golub’s expectation for an inflation “collapse” came with a 12–18-month timeline. Of course, I’m not sure I know of anyone who doesn’t believe we’ll have lower inflation in 18 months. He’s not really going out on a limb there.
In the meantime, I suspect much of Wall Street had a different timeline for this anticipated inflation collapse, which basically amounted to “now.”
Softer CPI data had been priced into the market over the last week. Traders were whispering about month-over-month CPI coming in not just flat, but negative, which we reported on here in the Digest.
The surprise increase in inflation kneecapped this belief, and yesterday’s market crash revealed the dissonance between Wall Street expectation and Main Street reality.
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Credit Suisse’s expectation that the Fed is going to pause rate hikes “sooner than widely expected” is based on what exactly?
Well, it’s not based on commentary from Federal Reserve Chairman Jerome Powell who recently said:
We are moving our policy stance purposefully to a level that will be sufficiently restrictive to return inflation to 2%.
[Bringing down inflation will] require maintaining a restrictive policy stance for some time. The historical record cautions strongly against prematurely loosening policy.
It’s not based on commentary from Federal Reserve governor Christopher Waller:
The consequences of being fooled by a temporary softening in inflation could be even greater now if another misjudgment damages the Fed’s credibility.
So, until I see a meaningful and persistent moderation of the rise in core prices, I will support taking significant further steps to tighten monetary policy.
It’s not based on commentary from Federal Reserve Bank of Cleveland President Loretta Mester:
Given current rates of inflation, I believe that the Fed has more work to do in order to get inflation under control.
This will entail further rate increases to tighten financial conditions, resulting in an economic transition to below-trend growth in nominal output, slower employment growth, and a higher unemployment rate.
It’s not based on commentary from Federal Reserve Bank of Atlanta President Raphael Bostic:
It’s going to be really important that we resist the temptation to be too reactionary, and really make sure that we get inflation well on its way to 2% before we take any steps to increase accommodation in our policy stance.
I could keep going, but you get the point.
Practically every Fed member has explicitly said we should not expect a dovish pivot in the near-future – even if we see a softening in inflation…even if we see pain in the economy and labor market.
So, why is Wall Street not believing them?
To show this, let’s review what’s happened since the 1990s.
If you want to avoid the ensuing data-brain-melt, here’s your conclusion: Wall Street has a 100% perfect track record of miscalculating how high the Fed will raise rates.
Here are the numbers…
In January 1994, Fed Fund futures priced a gradual rise in U.S. interest rates. Investors were looking for rates to rise from 3% to about 4.25% by March 1995.
The Fed raised rates much more quickly, eventually hiking them to 6% by early 1995 before cutting them back to 5.25%. At the end of the day, the Fed went 175 basis points beyond what Fed Fund futures had expected.
Next, in June 1999, the Fed decided it was time to begin raising rates after having cut them in the wake of the Asian Crisis and the Russian debt default.
Fed Funds futures expected the Fed would hike rates to 5% by the end of 1999, possibly 5.25% by mid-2000. The Fed blew past those estimates, raising rates to 6.5%, which was followed by the dot-com recession in 2001.
In June 2004, Fed Funds futures prices suggested the Fed would raise rates to 4% by mid-2006.
The Fed surprised investors and instead raised the Fed Funds to 5.25%, which was 125 basis points beyond expectations.
Most recently, the cycle from 2015 – 2018 threw some curveballs.
Most investors expected the December 2015 rate hike. And going into 2016, investors actually overestimated the Fed’s tightening this time around, expecting two more hikes by November of that year.
Instead, the Fed waited an entire year to hike. But then in 2017 and 2018, it jacked rates to 2.375%, which is roughly 75 basis points further than investors had planned on.
Bottom-line: As a whole, Wall Street under-guessed the Fed 100% of the time. And the amount of that under-guess ranged from 75 to 175 basis points.
And yet, here we are again with Wall Street expecting dovishness.
This morning, we received good news from the Producer Price Index (PPI). It fell 0.1% month-over-month, which was in line with expectations.
On a year-over-year basis, headline PPI increased 8.7%. That’s a significant pullback from the 9.8% increase in July.
It’s good news, but the market isn’t really celebrating much as I write. Traders still seem shellshocked by yesterday.
So, what happens next?
The answer is unclear.
And why is that?
Well, are the following Fed phrases clear to you?
Sufficiently restrictive … meaningful and persistent moderation … significant further steps … more work to do … below-trend growth … resist the temptation to be too reactionary … well on its way to 2% …
Now, I sympathize with the Fed – its job is very difficult and I’m not claiming I could do better – but the Fed hasn’t said anything truly concrete in a long time.
Given all this mushy language, we have no clue what “meaningful and persistent moderation” in inflation looks like. Why are we to believe the Fed knows what it looks like? How are we to trust the Fed won’t go blowing past this level?
You can almost see Powell in a Ferrari, his foot slamming the pedal to the floor, speeding away from inflation which he’s watching in the rearview mirror with laser-focus, oblivious to the brick wall of a recession that’s directly in the road ahead.
This leaves us in a dangerous situation in which the Fed miscalculates, eventually breaking something in the economy.
The bottom line is that inflation is dropping. It might not be a smooth drop…it might take longer than any of us want…yet it’s dropping.
But the risk now is that it doesn’t drop fast enough to prevent the Fed from doing major damage to the economy. What we know for sure is that Powell and Co. are terrified of easing policy too soon.
Next Wednesday, the Fed reveals its latest policy decision. It’s a reasonably safe bet that we’ll see a 75-basis-point hike (though 100 basis-points isn’t out of the conversation).
The real issue is what comes after.
Has Wall Street gotten it right, and the Fed’s big talk has been nothing but bluster? We’ll actually see a rate-hike pause in November, or perhaps just a quarter-point raise?
Or will Wall Street continue its perfect track record of underestimating the Fed as we watch rates continue to move substantially higher?
We’ll be listening for clues when Powell speaks next Wednesday, which we’ll report back to you here in the Digest.
Here’s Louis, describing what’s going on:
In just the last few days, I’ve uncovered a group of stocks that not only have everything I look for—growing revenues, expanding margins, and exploding earnings…
These stocks are selling for less than $10 a share.
The last time my favorite stocks were this cheap, I recommended 16 stocks that later went up at least 1,000%, including a gain as high as 7,749% on Netflix.
I honestly believe that most of the stocks I’ve got my eye on will never sell for these prices again.
Tomorrow, Louis will dive into the details. He’ll even be giving away the name of one of his favorite under-$10 stocks right now.
After Tuesday’s bloodbath in the market, I expect Louis will have even more great stocks at bargain prices to put on your radar.
Learn more at the “Under $10 Stock Event” tomorrow at 4 PM ET.
Have a good evening,
Jeff Remsburg
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