The market is still dreaming

After the onset of a crisis, a certain degree of volatility usually persists, reflecting investors’ nervousness. American regional banks have not seen significant rebounds, as their stocks have reached new lows, both in absolute terms and relative to the rest of the market. Nevertheless, stock markets have continued to rise without considering their situation. 

The main reason why a banking crisis is almost interpreted as good news on the stock market relates to the broader direction of monetary policy. Conventional wisdom suggests that the Fed will continue to raise rates until inflation is contained. Banking risk could temper the Fed’s enthusiasm or even bring about a rate cut sooner. The argument is twofold: the Fed could lower rates either for macroprudential reasons, to maintain financial stability, or for economic reasons, to avoid a slowdown in growth. 

However, the latest survey of economic forecasts from the Fed governors last month showed that almost all members expect the federal funds rate to be above 5% by the end of this year. This week, Cleveland Fed’s Loretta Mester said the federal funds rate would increase and remain high for some time. James Bullard of the St. Louis Fed also sent the same message, indicating that inflationary pressures were here to stay. The Fed is committed to the idea that it can address macroprudential issues using its balance sheet while acting against inflation using interest rates.

The 3-month-10-year yield curve is the most profound inverted ever recorded, a classic sign that the bond market expects both a recession and imminent rate cuts. Whether on a nominal or real basis, 10-year rates are now at their lowest of the year, barely higher than in the middle of last summer. Despite this, federal funds futures contracts predict a rate of 4.13% after the last FOMC meeting in the following December, a percentage point lower than the Fed’s forecasts. 

Investors are convinced that the economy, and especially the labor market, is about to slow down decisively. This is not necessarily good news for the stock markets that continue to rise. Of course, US corporate profits showed remarkable resilience, which, combined with a hypothetical rate cut, created favorable market conditions for stocks. One of the main reasons for the excellent performance of companies is that they have maintained their margins and passed on all their additional costs to consumers.

Rates that remain relatively low compared to inflation, reducing borrowing costs. The rise in unemployment makes it easier to control wage costs. Concentration in many sectors facilitates the maintenance of high prices. Some forces help companies maintain high margins. Public outrage at what is perceived as a profound injustice is only increasing and will likely lead to new regulations making life much more difficult for companies.  

However, in this optimistic logic, one mistake persists the belief that the Fed will change its tune. The decision of OPEC + to reduce production takes us back to the 70s and the errors of monetary policy that Jerome Powell does not want to be associated with. The world has changed. Globalization which had been the great catalyst for lowering world prices, is over. The time of expensive energy is over. Relocations of so-called strategic industries are an inflationary factor. The energy transition necessary for our future is also inflationary, at least for the next five or six years. Short-term inflation may decrease, but medium and long-term inflation is here to stay. High inflation goes hand in hand with higher interest rates. This is a reality that the markets have yet to integrate.

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