The Fed has changed its message, but not the way you think

Ajay Rajadhyaksha is global chair of research at Barclays.

At the end of the first quarter, financial markets seemed to be in a reasonable place. Sure, the Federal Reserve had pivoted hastily towards tightening monetary policy, and the Russia-Ukraine war was a nasty shock, adding to already high inflation. But the Fed was talking tough, and investors seemed to take heart.

The S&P 500 was just 4-5 per cent off all-time highs by late March, and the 10-year US Treasury yield was hovering around 2.4 per cent. The main measure of the US yield curve did turn negative on March 30, but if equity investors were concerned, they hid it well — the Vix volatility index was below 20 in the last week of March.

Just a few weeks later, the financial world looks worse. Much worse.

After dropping 4.6 per cent in the first quarter, the S&P 500 tumbled 9 per cent in April, the worst monthly performance since March 2020. May has brought little respite. At pixel-time, European shares remain under pressure, and futures indicate that the US equity market pain will deepen when the New York Stock Exchange opens.

Corporate earnings are not to blame. By Barclays’ estimates, companies are beating earnings forecasts at a record pace in both the US and Europe. But equities are ignoring earnings and taking their cue from bonds, which are having a horrific year.

The US 10-year Treasury yields jumped 80 basis points from the start of April to above 3 per cent for the first time since 2018. It’s now close to a one-decade high.

There are ripple effects everywhere; Italian bond yields near decade highs, the US dollar on a tear, Vix above 30, and the Nasdaq in a bear market. Also of note is the US yield curve now steepening, even though the Fed hiked by 50 bps for the first time in two decades last week, and hinted that more half-percentage point increases are coming.

So what has worsened in these five weeks? What explains this sudden shift in market sentiment?

Not US inflation data. The last core CPI print was soft, rising 0.3 per cent month-over-month, or less than 4 per cent annual. Core PCE inflation — the Fed’s own preferred measure — ran below 0.3 per cent month-on-month in February and March.

Average hourly earnings in the US are also levelling off, with the three-month average at 0.3 per cent. And used vehicle prices are dropping for the third month in a row. It’s hard to blame recent inflation data for the bond market puke.

So if it’s not data, and it’s not earnings, then why are financial assets — led by the nose by fixed income — doing so miserably? I think bond investors are picking up on a shift in the Fed’s rhetoric, and not liking what they hear.

Sure, Fed officials are still in a hurry to get to neutral “expeditiously”. But increasingly, the Fed is pushing back on the idea that it will go much above neutral.

Chair Jay Powell has emphasised the importance of a “soft landing”. The Philadelphia Fed’s Patrick Harker cautions that the Fed should not “ruin the economy” by being “too aggressive” on inflation. San Francisco president Mary Daly said the Fed should hike such that inflation falls to 2 per cent five years from now, implying that she is OK with it staying above the central bank’s target for a half decade!

To many bond investors, this is the Fed walking back on its commitment to do “whatever it takes” to get inflation to 2 per cent. And that is unnerving.

For example, if core inflation settles at 3 per cent by 2023, but the US economy is growing below its potential, will the Fed keep raising rates? The Fed seems to be saying — no, we won’t. Bond markets have reacted accordingly.

Longer-term inflation expectations have risen lately despite equities falling sharply, and the yield curve has steepened. But this has also led to longer bond yields now coming unanchored, rising to the highest level in a decade in some countries. And as bonds have gone into a tailspin, so have the world’s financial markets.

For now, it is unlikely that the Fed will make soothing noises to calm investors. After all, tightening financial conditions — even if it is disorderly — is the means by which the Fed slows the economy.

But if markets stay queasy in the coming weeks, the Fed may feel compelled to respond. And surprisingly and perhaps counter-intuitively, the correct approach this time — unlike in the past — might be to emphasise its commitment to 2 per cent inflation rather than a soft landing.