There is a shift happening in the policy foundations on which financial markets stand. The European Central Bank’s (ECB) decision to reduce rates by 0.25% this month marks the first cut in the effective policy rate since 2016 and the Bank of England (BoE) may follow later in the summer.
While the recent inflation intransigence in the US seems to prevent the Federal Open Market Committee (FOMC) from pursuing the same course so soon, that does not necessarily mean the US Federal Reserve’s view on its policy settings is unchanged. In truth, despite an understandably cautious tone struck by the FOMC last week, it seems there has been a significant shift in the Fed’s stance.
This may help explain why risk assets have been so resilient this year, despite the market radically paring back expectations for rate cuts in the US from seven to closer to two, boding well for investors in the second half of the year.
Fed chair Jay Powell effectively curtailed the distribution of policy outcomes by declaring last month: “I think it’s unlikely that the next policy rate move will be a hike”.
An options market that, prior to those comments, had priced in a 20% probability of further tightening this year now assigns the risk to be below 5%. That clarity can create a helpful asymmetry for equity markets and credit spreads.
Weak data might still be embraced by the FOMC as providing the leeway to take rates down but, by contrast, strong data are unlikely to provoke tighter policy that might crush risk appetite, undermine equity market valuations, and precipitate spread decompression. The investment implication seems clear: dial-up portfolio risk, albeit judiciously.
Investors could be encouraged both by the construct and application of the Fed’s dual mandate. The Fed – unlike the ECB or the BoE – is not a ‘pure’ inflation targetter. Its dual mandate requires the FOMC to take account of labour market conditions in its quest for ‘maximum employment’.
There are various conflicting signals from the labour market data, but a number of indicators suggest the US economy may be about to dip below ‘maximum employment’. The unemployment rate has just climbed back up to 4% for the first time in more than two years, initial jobless claims are creeping higher, and data from job openings and labour turnover surveys have moved lower.
Since the Fed began to tighten monetary policy in March 2022, the debate among policymakers (and, consequently, investors) has centred on how to return inflation to target. Hitherto, resilience of the US labour market left the employment part of the dual mandate as the dog that did not bark. This left the FOMC free to pursue a unidimensional application of a dual mandate.
No longer. Signs of weakening in the labour market, in conjunction with moderation in inflation over the past year to a level closer to target, mean the committee would now be thinking more explicitly in terms of trade-offs. How large a deviation from ‘maximum employment’ is tolerable, in the quest to bring inflation to heel?
Once again, Jay Powell has provided commendable clarity in that regard, noting that with two mandate objectives: “If one of them is further away from goal than the other, then you focus on that one… so our focus was very much on inflation… The employment goal now comes back into focus. And so we are focusing on it.”
Put simply, the labour market now seems to matter more in the policy debate – and thus for investors – than it has done for some time. Inflation reduction is no longer the only game in town.
Powell’s two interventions, first to curtail the distribution of rate outcomes, and second to emphasise the contingent shift in the FOMC’s focus, can signal to markets a welcome realignment.
Those who had begun to voice concerns that resurgent inflation could cause renewed tightening of Fed policy have been sent a placatory message, that the rules of engagement have changed from those of the past couple of years. It is a message highly supportive for valuations of risk assets.
In chess, any player seeking to realign their pieces on the board without being ready to make a move must first declare ‘J’adoube’ (which is French for ‘I adjust’). The Fed may not be ready to move quite yet, but Jay Powell has certainly undertaken a careful but deliberate realignment. Think of it as the ‘Jay’doube’.
James Ashley is head of international market strategy, strategic advisory solutions at Goldman Sachs Asset Management. The views expressed above should not be taken as investment advice.