Stock bulls won’t find much to celebrate in Fed’s pause

Investors have traditionally made a lot of money buying stocks when the US Federal Reserve delivers the last increase of a rate-hiking campaign. But not every interest-rate apex is the same, and this “hawkish pause” looks particularly precarious for equities. First, consider the wording that the Fed used to communicate the change in its posture on May 3. In announcing its latest 25-basis-point increase in the Fed funds rates to a range of 5% to 5.25%, the US central bank also removed this key wording from its post-meeting statement (in the third paragraph): “The Committee anticipates that some additional policy firming may be appropriate... ”

But it retained a version of this word-soup formulation: “In determining the extent to which additional policy firming may be appropriate to return inflation to 2% over time, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.”

In the strange world of Fedspeak, that amounted to a half-hearted admission that the elusive “pause” has finally (probably) arrived. But the Fed still retained its hawkish bias, which should disappoint market doves who think the Fed should already be weighing rate cuts in the second half of the year. The central bank could have opted for two-sided language about future policy rate “adjustments”, but instead it opted to keep the single-sided phrase “additional policy firming”. In other words, the Fed is most likely to stand pat, but any deviation from that plan would almost certainly entail more firming, not easing.

Fed Chair Jerome Powell further drove home this point in his press conference when he refused to say whether policy was now “sufficiently restrictive”: “That’s going to be an ongoing assessment. We’re going to need data to accumulate on that. Not an assessment that we’ve made — that would mean we’ve reached that point. And I just think it’s not possible to say that with confidence now.”

Inflation bugbear

Inflation has been policymakers’ top priority for more than a year now, and it has not gone away. The core personal consumption expenditures index — which the Fed tends to focus on — shows inflation essentially moving sideways on a threemonth annualised basis. With the Fed funds rate now above the rate of underlying inflation, the Fed’s leaders can take some solace in the belief that policy is now restrictive enough to bring inflation down over the coming year. But they will not have the hard evidence that they are succeeding until the blue line in the chart below is moving meaningfully back towards the Fed’s 2% goal.

Meanwhile, the maximum employment part of the Fed’s dual prices-jobs mandates is still holding up, giving it latitude to raise interest rates further if it deems necessary. Unemployment is still near the lowest since the 1960s, and data from ADP Research Institute on May 3 showed private payrolls just posted their largest increase since July 2022. Compensation for civilian workers rose 1.2% in the first quarter, a pace that Powell suggested was inconsistent with his goals of reducing inflation.

It is hard to fight history, of course, and equity investors in particular will recall that stocks almost always gain in the three months, six months and 12 months after a Fed pause. In the past four decades, the only noteworthy exception was May 2000, when the Fed pause failed to ignite any sort of short-term rally and the market started collapsing about four months later in early September. Assuming the pause has arrived, some investors may find it irresistible to turn bullish again.

But as I wrote last month, post-pause rallies tend to rely on two fundamental drivers: a rally in Treasuries (which inflates price-earnings multiples) and the assumption that earnings are still expanding. On both counts, 2023 is unlike other recent Fed pauses.

First, yields on 10-year Treasury notes are already trading 186 basis points below the Fed Funds rate (upper bound), something that has never been true when other pauses occurred. The market has gotten way ahead of the central bank this time around, which may leave little room to rally in the short run.

Second, the US is already in an earnings recession, which has also never been true at the time of other pauses in the sample data. The Fed tends to pause when there is still some upside in companies’ bottom lines, but not this time.

All told, there is plenty of reason to temper enthusiasm about the long-awaited “pause”. Unlike previous pauses, the risks to the downside are substantial in the coming year. With its latest language, the Fed has not given markets much reason to think the potential rewards are worth the risk.