Summer months have provided relief from the steady selloff of January to June. Corporations have broadly delivered revenue and profit growth above estimates the first half of the year and hope is in the air that the worst of inflation is behind us. Risk seeking behavior was a defining characteristic of the prior bull market and has recently re-emerged, despite some investors taking significant losses in the most risky areas of financial markets earlier in the year. If short-dated call options are Wall Street's version of gambling, then the casino is open and speculators still have money to play (see BBBY call volume chart, below).
A move away from restrictive policy, or a "Fed Pivot" is predicated on "mission accomplished" in the battle against inflation. While the inflation cycle has likely peaked, it may remain at a sticky high plateau. Thus, the potential risk to markets is that the actions needed to move from 9% inflation back to target is beyond what we are currently prepared for. The Fed's mandate remains 2% inflation. Peak inflation thus far is 9.1% (June) and currently stands at 8.5%.
Does peak inflation also mean peak hawkishness from the Fed? That appears to be the market's conclusion. If that conclusion proves false, then inflation hanging around 4-7% is a meaningful risk investors should not ignore. As Duke University professor Campbell Harvey
recently pointed out, there are structural components embedded within the calculation method of CPI that will keep upward pressure on the inflation numbers. Thus, a move back to acceptable levels may take 12-18 months and additional tightening beyond what the market currently anticipates.
Of their stated objectives of price stability and full employment, reining in inflation is currently the Fed's priority. Powell has referenced the noble actions of former Fed Chair Paul Volker (see Volcker quote, below), who broke the inflationary impulse of the '70's by taking short-term interest rates to 20% while unemployment rose to 11% in 1981.
If Powell is committed to following in Volcker's footsteps, we should expect more pain ahead. The read on Powell's intentions has perhaps moved to less "Volckeresque" in recent weeks, as market participants took hold of the "pivot" narrative. If Mr. Powell believes this is premature, he has an opportunity to state his case during a speech at the Jackson Hole Economic Policy Symposium
next week.
