I think Fed officials set the stage for one of the greatest bear traps of all time yesterday with the adjustments they made to their Summary of Economic Projections. What is a bear trap? It is a false signal that a reversal is coming from what was an up-trending stock market to one that is down-trending. Stocks plunged, and bond yields rose immediately following the Fed’s decision to leave short-term rates unchanged, which was highly expected. The selling arose from modifications made to the consensus view of where Fed officials see short-term rates over the coming year.
Before delving into the details, note that there was nothing particularly unusual about yesterday’s selloff in stocks. In fact, yesterday’s action was in line with what has happened on average after the prior eight Fed meetings. It has become a knee-jerk reaction to sell on the news, no matter what the news is, but that has consistently been a big mistake. Understandably, the bears are hungry for red meat in a market that has left them starving all year long, and they will try to make a mountain out of what was a molehill to sway sentiment in their favor. They still have seasonality on their side, but that period is nearing its end.
The molehill I am talking about is the Fed’s updated “dot plot,” which represents where each of the 19 officials see short-term interest rates at the end of this year and each year after. The change that has investors spooked is that the median forecast for where short-term rates will be at the end of next year is 50 basis points higher than it was three months ago, feeding the “higher for longer” outlook. This is absurd. Fed officials have no more of a clue where their benchmark rate will be a year from now than they did one year ago. As Chairman Powell has repeatedly stated, the outlook is uncertain, and the committee will remain data dependent at each meeting.
The reason some officials see short-term rates higher one year from now than they did before is that they grossly underestimated the strength of the economy a year ago. The latest update clearly outlines the Fed’s more optimistic forecast for a soft landing. The median estimate for economic growth in both 2023 and 2024 increased, while the unemployment rate decreased. At the same time, the median projection for the core inflation rate (PCE) was lowered for the end of this year from 3.9% to 3.7% and held steady at 2.6% for the end of next year. All three of these updates are positive. The projection for where short-term rates will be at the end of this year did not change from June, implying one more 25 basis point rate increase, which investors still find suspect based on CME futures.
The economy has dramatically outperformed the Fed’s forecast for 2023 from the end of last year, which was sharply downgraded back then, as seen in its Summary of Economic Projections below from last December. At the same time, its expectation for core inflation to fall to 3.5% by the end of this year is very much on track. Therefore, there was no need to increase the outlook for where short-term rates should be to meet the Fed’s inflation target, but some are assuming that the stronger economy will slow the disinflationary process. I disagree. Regardless, this move is what drove 2- and 10-year Treasury yields higher, thereby strengthening the dollar and pressuring stock prices.
The bears want us to think that the Fed’s forecast is a plan of action for policy over the coming year, but Chairman Powell made it clear yesterday that it is not. He emphasized that the committee needs to be cautious as it approaches peak rates, which I think we have seen, and that it will remain data dependent at each meeting. The “higher for longer” outlook is based on the Fed’s upgrade to the economy and labor market, on the assumption that it may take longer to bring inflation down to 2% in that environment, but it has no more clue about that today than it did a year ago. In fact, inflation has come down as anticipated one year ago with an economy that has remained resilient.
I expect more of the same in the months ahead, but that won’t prevent the bears from having their day in the sun as the stock market exhausts this latest corrective phase in advance of what should be another better-than-expected earnings season for the third quarter. Investors should let this correction play out and position for a strong finish to the year in the fourth quarter.