A Healthy Correction; No Change in the Call

Jay Powell, welcome to being Chair! Recent volatility in equity markets, even before he had time to put his pictures on the wall, may seem like a hazing ritual. Sort of like the welcome Greenspan got in 1987. It looks like a healthy, modest correction. The S&P 500 is now about 8% below its late-January peak. It would have been reasonable to see equities as vulnerable to a correction, as many have argued, given the steady gains inequities that had continued until last week despite continuing increases in the fund’s rate. Alternatively, or additionally, it may reflect a change in market assessments of the strength of growth, the potential for overshooting the inflation objective, and the prospect of a larger rise in rates than previously anticipated. That would be consistent with the sharp rise in the 10-year Treasury yield since mid-December. Whatever the story, we see it as healthy because it means financial conditions have become (at least slightly) less accommodative: Monetary policymakers had been frustrated by the failure of financial conditions to become less accommodative as they raised rates. While this makes us more alert to downside risks, at this point it warrants no meaningful change in the forecast and no change in the policy path. Still a March hike, and four moves this year. 

Some Perspective 

Let’s keep this week’s equity market volatility in perspective: The S&P 500 is down about 8% from its peak.  Corrections of this magnitude are not unusual; they happen regularly.  

FOMC participants, as well as former Chair Yellen, have mostly been saying that, while valuations might be rich, there did not appear to be a bubble in equity markets. But the rise in equity prices to those levels did increase the vulnerability to triggering events and increases the potential magnitude of any correction that might occur. 

What Were the Triggers? 

The obvious proximate trigger would appear to be the January employment report, released last Friday. In particular, there was unexpected strength in average hourly earnings, supporting the idea that labor markets are now tight enough to put wage inflation on an upward trend. The ten-year Treasury yield rose again last  Friday, after which it had risen 20 basis points since the S&P 500 peaked in late January and 50 basis points since mid-December. Before mid-December, the ten-year yield had been relatively stable and remained low.  This rise would be consistent with the narrative that there had been a reassessment of the balance of risks,  with a greater risk of a faster return to 2% inflation and greater potential for an overshoot. That in turn would point to a faster-expected pace of rate hikes and a greater chance of an overshoot of the neutral rate. Equities often respond to changes in long-term rates, though, notably, that had not been the case recently, as they continued to reach new highs even as Treasury yields moved higher and more and more questioned how long the bull market in equities could continue. In general, however, rising rates and higher equity prices are quite normal at the start of a tightening cycle driven by stronger growth. In this case, this narrative is complicated by the fact that funds rate expectations haven’t shifted sharply higher since the employment report. And much of the move in longer-dated yields since mid-December has been because of a rise in term premia,  though funds rate expectations have moved up somewhat as well. Perhaps the rise in term premia reflects in part a shift in the balance of risks to inflation or was itself a correction, perhaps prompted by a reconsideration of the risks to the economic outlook.  

Whatever the source of these moves in Treasuries and equities, we see it as healthy, at least from the perspective of monetary policymakers: Up until now, the FOMC has been frustrated in its attempt to withdraw monetary accommodation because of financial conditions have been becoming more and more favorable. 

No Change to Our FOMC Call 

At this point, the movements in the stock market are not large enough to warrant a change in the outlook and a change in the course of monetary policy. A March hike remains a go, and we continue to expect four hikes this year.  

Most likely, the course will be: steady as she goes. Markets may be volatile; monetary policy not so much!

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