It looks like we are going to start this week with a down day for stocks, mainly because Fed Chair Jay Powell, in an interview that aired last night on "60 Minutes," made it about as clear as he could that the market was getting ahead of itself in anticipating rate cuts coming early and often this year. He said that the central bank wanted more confidence before starting to cut, but also that tighter policy would cause more pain at some point, even if that wasn’t being felt quite yet.
I am not a mind reader, but that sounds to me like someone who doesn’t believe that the fight against inflation can be won without some economic pain, and we look to be even further from that right now than we have been based on an extraordinary jobs report for January and some of the earnings that have been reported this morning.
The U.S. economy added a remarkable 353,000 jobs in January, according to the Bureau of Labor Statistics report released on Friday. That would be a pretty good number during an economic recovery or at a time when the Fed was trying to encourage growth, but after a sustained period of rate rises it is simply amazing. It just shouldn’t happen. Higher interest rates should discourage growth but clearly that isn’t really happening right now.
That could be because the theory is based on a “normal” economic cycle, whereas the events since the spring of 2020, when the global economy faced a challenge like no other in history and central banks around the world cut interest rates to zero, or even lower in some cases, were anything but normal. Maybe, in that situation, raising interest rates to around five percent is just returning to some degree of normality. Or, more importantly, that is how it is felt to be by businesses and consumers. It seems that maybe five percent base interest rates are not punitive enough to prevent businesses from investing in future growth fueled by the increasing deployment of AI, nor enough to damp the enthusiasm of a post-pandemic consumer who is still living for today and not worrying about tomorrow.
That view of an economy undeterred by five percent interest rates was reinforced this morning when Caterpillar (CAT) released their Q4 earnings. That stock is up substantially in this morning’s premarket trading after the company reported a beat on the top and bottom lines and year on year growth fueled, they said, by strength in the North American market. Caterpillar produces capital intensive heavy equipment with a long lifespan, just the sort of thing that should be hit hard by higher interest rates. Evidently, five percent rates and what many regard as an uncertain future are not discouraging corporations in the U.S. from investing.
The question now is whether or not Jay Powell and his FOMC colleagues believe that inflation can be beaten without actively harming the economy. So far, the evidence suggests that that can be done, but if economic activity remains strong, the last few points of reduction in inflation to get to the Fed’s two percent target may prove difficult to obtain. The best case scenario then suggests that we are at least looking at “higher for longer” as the accepted path again, but if economic pain is taken as a sign of success, then inflation that remains stubbornly at around three percent, could even prompt another hike or two this year.
Don’t get me wrong -- I am not saying that will happen. Nor am I saying that the possibility of it, however remote, means that stocks are about to fall dramatically. However, it isn’t as far fetched a scenario as the market would currently have us believe, so there is some downside risk over the next few weeks, but with very little upside potential. From a trading perspective, that means a cautious approach slightly favoring short positions is warranted.
If we see the more likely “higher for longer” scenario play out, or at least be strongly hinted at by Powell, then it becomes a question of how the market views it. So far, that has been seen as a negative by traders, but both the strong jobs report and CAT’s results suggest that maybe the U.S. economy can handle a five percent Fed Funds rate just fine, and that holding steady, even for an extended period of time, is not a bad thing at all.
The most important thing for investors this week, and indeed over the next few weeks, is to keep a close eye on speeches and interviews given by FOMC members. The market is potentially at a major pivot point. If a consensus seems to be emerging that there has to be an economic downturn for current policy to be deemed successful, then we could be in for a rough couple of months. On the other hand, if there is a growing acceptance among committee members that a slower decline in inflation is acceptable and that that can be achieved while the economy continues to grow, then we will see considerable strength and soar to new highs.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
Martin Tillier
Martin Tillier spent years working in the Foreign Exchange market, which required an in-depth understanding of both the world’s markets and psychology and techniques of traders. In 2002, Martin left the markets, moved to the U.S., and opened a successful wine store, but the lure of the financial world proved too strong, leading Martin to join a major firm as financial advisor.
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