Investors see no Fed pivoting, but not relying on Powell’s hawkish Jackson Hole message

By Gertrude Chavez-Dreyfuss

NEW YORK (Reuters) – Investors are bracing for the Federal Reserve to double down on its pledge to crush inflation and expect Chairman Jerome Powell at the central bank’s annual meeting in Wyoming this week to send an aggressive tightening message and deny the hopes for a rate cut next year.

The retreat in Jackson Hole, Wyoming comes after investors last week viewed transcripts from the Fed’s July meeting as dangerous and a green light to bring some risk back to the table. The stock market initially held and bond yields held steady, before markets reconsidered that interpretation.

Since the release of the Fed minutes on August 17, the S&P 500 has fallen about 3.8%, the 10-year Treasury yield has risen about 10 basis points (bps) and is down more than 3%, and the dollar has gained about 1 .7% against the yen, the currency pair most sensitive to interest rate expectations.

Powell’s Friday morning speech could bolster the market’s tone leading up to the next Federal Open Market Committee meeting next month.

“Caution and fear is what markets are talking about,” said Steven Englander, head of global G10 FX research and North American macro strategy at Standard Chartered in New York.

“If Powell says something bullish and if you buy stocks or emerging market currencies, you’re going to lose 3% in the blink of an eye. So nobody is buying risk right now ahead of Jackson Hole.”

The Fed, in the minutes of its July meeting, said it saw “little evidence” that inflationary pressures have eased, but acknowledged the risk of tightening too much and curbing economic activity.

Fed Funds futures are priced at a 51% chance of a 50 basis point (bp) rate hike next month, with the Fed Funds rate reaching 3.6% by the end of the year. A week before Wednesday’s minutes were released, the interest rate futures market had priced in a 75 bps rate hike.

Eurodollar futures have priced in at least one rate cut between March and December 2023, with the spread between the two contracts around -44bps on Monday. The Fed Funds rate peaked at 3.9% in March, according to euro futures.

Harley Bassman, managing partner of Simplify Asset Management in Laguna Beach, California, believes futures pricing is a long way off.

“I think the Fed is doing more than the market thinks in terms of rate hikes. I don’t think inflation is going to be 2%-3% next year. It’s baked in the cake,” Bassman said.

Falling fuel costs left US consumer prices unchanged in July, bolstering a subdued inflation scenario, although underlying price pressures remained high. Producer prices also fell last month due to cheaper energy.

Chart: US Inflation Measures https://fingfx.thomsonreuters.com/gfx/mkt/klpykwrazpg/US%20annual%20inflation.PNG

“Basically we’ve seen home prices go up 10-20 percent,” Bassman said. “And you’re going to see OER (owners’ equivalent rent) continue to rise for the next six to nine months. So the actual CPI print that goes to the papers will continue to rise over the next 12 months.”

Perhaps complicating Powell’s messaging, second-quarter US core personal consumption expenditure price data, an important gauge of inflation for the Fed, is expected to be released an hour and a half before the Fed chief’s speech starting at 10:00 a.m. . EDT/1400 GMT.

However, the bond market is pricing in a less dire inflation picture. A gauge, breakeven inflation, which measures the difference between the yield on U.S. Treasury Inflation-Protected Securities (TIPS) and nominal bonds, has fallen since mid-June from a one-year maturity to a 30-year maturity, according to data from Refinitiv.

LESS UPFRONT OF PRICE INCREASE?

Standard Chartered’s Englander believes the Fed will do what it takes to bring inflation down to its 2% target, but won’t make all the hikes at the next few meetings.

“They could say something like: we’re going to hike as long as we need to, as high as we need to, but we don’t have to do it in the next two to three meetings,” Englander said.

Ahead of Jackson Hole, speculators’ net long position in the safe-haven dollar rose for the first time in four weeks, according to calculations by Reuters and the U.S. Commodity Futures Trading Commission released last Friday. [IMM/FX]

Graphic: Net US Dollar Markets https://fingfx.thomsonreuters.com/gfx/mkt/zjpqkblrypx/US%20dollar%20net%20longs.PNG

“The market is panicking as we approach Jackson Hole,” Englander said.

Certainly, there are market participants who believe there is room for the Fed to reduce the pace of tightening because the US economy is slowing.

However, the Fed may not tell Jackson Hole.

Jeffrey Roach, chief economist at LPL Financial in Charlotte, North Carolina, cited a tightening cycle in the mid-1990s in which the US labor market weakened. The Fed responded by keeping interest rates steady while monitoring the economy.

“There’s still an opportunity for the Fed to stick to a soft landing here,” Roach said.

However, a soft landing for the US economy is not the bottom line scenario for Simplify’s Bassman, and recession is definitely on the horizon.

“So you want to buy fire insurance. I’m wildly bearish on interest rates. I see reasonable scenarios for interest rates — whether it’s the 10-year note or the Fed Funds rate — going to 4% or higher.”

(Reporting by Gertrude Chavez-Dreyfuss; Editing by Alden Bentley and Chizu Nomiyama)

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