If you thought the Fed was supposed to be the adult in the room, think again. While the task of party chaperone is never easy, it gets infinitely harder when dealing with toddler-like equity markets, who demand extra coddling while threatening bad behavior. Against this backdrop, Fed Chair Jerome Powell has strongly indicated interest rate cuts are imminent, all to placate markets at record highs.
The classic truism of the Fed’s responsibilities is to take away the punch bowl just as the party gets going, as attributed to the late Fed Chair William Martin. Powell however seems to be taking the opposite approach, doling out the punch and ensuring all partygoers get their share, well after dancing has already been under way!
After all, unemployment at 3.7% represents a 50-year low, and the 10-year is only 50 bps above its all-time low. How are we to make sense of this apparent discrepancy, and more significantly, how should be position ourselves strategically? How can I go defensive without also “fighting the Fed?”
High on His Own (Monetary) Supply…
Patently obvious is that we have come a long way from the “autopilot” remarks of last December. While Greenspan was notorious for his ambiguous Fedspeak, not even he could interpret transitioning from continued hikes, to pausing, to promising cuts as consistent with a Fed on autopilot.
Hindsight has revealed the past seven months to be a crucial turning point in macroeconomic history, revealing the high-water mark beyond which interest rates may be raised no further. While the market has for the past few months suspected rate cuts were probable—as early as January 3rd 2019 a cut was priced as more likely than a hike—Powell’s testimony all but sanctified the impend cuts.
In particular, traders interpreted his economic commentary couched in terms of “muted” inflation concerns and global “crosscurrents” as code for softer policy. That he singled out the strong June jobs report as not altering his view of the economy exemplified not only his commitment to lower rates, but it also removed the market’s largest concern going into his testimony.
The New Big Picture
More significant than the immediate implications for a July cut, however, was how Powell’s testimony presented a real rupture with how the Fed has traditionally viewed the U.S. economy. Specifically, Powell described a new idealization of the economy in its steady state, where several key parameters have diverged from historical norms. Importantly, the Fed Chair articulated the natural rate of unemployment, and the level of neutral interest rates, are now both lower than previously believed.
This statement signifies a marked departure from Powell’s December remarks, where he maintained that after the latest hike the federal funds rate was starting to enter the lower bounds neutral territory. In others, back in December we were not yet at neutral rates, but fast forward to this July and we now have to ease to get back to neutral. If it seems we have come full circle, never mind the 224,000 non-farm payroll number, the Fed appears to be fully committed to this Back to the Future mentality.
This development is striking, as it signifies the Fed has fundamentally reevaluated core dynamics to the U.S. economy, quite suddenly as well. Buttressing his view for lower structural unemployment rates, Powell cited a 20-year breakdown in the classic linkage between unemployment and inflation, that higher employment is not accelerating inflation. Given this perspective, it is not surprising Powell dismisses the strength of the June jobs report, as the Fed has adopted a new macroeconomic framework to guide U.S. monetary policy.
More significant than the immediate implications for a July cut, however, was how Powell’s testimony presented a real rupture with how the Fed has traditionally viewed the U.S. economy.
Moving the Goalposts
To his credit, Powell was quite honest in this admission, even carrying this line of thought to its logical, indeed climatic, conclusion. The grand realization is that if the neutral interest rate is lower than previously supposed, then rates can be reduced without being considered “accommodative,” and importantly, maintained at those levels. Much of the Fed discussion has been framed within the context of insurance cuts à la ’95 and ’98, but Powell’s comments suggest a fundamental paradigm shift.
Rather than providing temporary relief, these new Fed revelations raise the potential for lower rates over the long term, if indeed that is where the neutral rate lies. In other words, the Fed may have expanded the scope and timeline over which cuts may be sustained. The prospect of more dovish monetary policy over the long run may historically favor a risk-on dynamic, but with equities at all time highs such posturing in late cycle may be ill considered. This about-face on part of the Fed presents a true dilemma for investors.
It may have come to the point where investors’ biggest forward-facing risk is not market risk, credit risk or even cycle risk, but instead Powell risk.
In Fed We (Don’t) Trust?
As a potential solution to this conundrum, gold may be well positioned as an asset class. As the diagram above depicts, gold’s status as a hybrid commodity-currency has historically benefited from softer monetary policy. Since gold decoupled from the dollar in 1971, gold has appreciated by an average of 14.5% in the two year period following a rate cut by the Fed. For those who believe recent data carry more weight, the last three rate cut cycles saw gold rally an average of 20.3% over the subsequent two years.
Intuitively, this outcome stems from the reduced carrying costs and weaker dollar that dovish policy implies. Additionally, gold’s non-correlative properties may enable investors to potentially take some market risk off the while still positioning themselves for an accommodative Fed.
The Powell Fed has behaved and communicated in decidedly unorthodox, if not outright bizarre fashion, moving equity and bond markets in its wake. It may have come to the point where investors biggest forward-facing risk is not market risk, credit risk or even cycle risk, but instead Powell risk. Unfortunately, this may be the hardest risk of all to understand, much less hedge.