September Could Prove Critical for Fed’s Taper Timeline

At this juncture, markets are trying to solve a classic math riddle. If train A is traveling west at one speed, and train B is traveling east at another speed, when will their paths inevitably cross?

Train A is the Federal Reserve and its timeline to taper asset purchases and ultimately raise rates. In train B you have inflation and the labor market. As inflation rises and the labor market improves, the trains speed up. But if the labor market pulls back and inflation slows, the trains may slow. Ultimately, they’re going to meet and trigger a policy shift from the Fed. Markets, however, are trying to figure out when that might be — and recalculating daily.

That’s why you heard about Jackson Hole last week and so much attention was paid to minutes from an FOMC meeting. It’s why inflation is in focus, along with weekly job market updates. All these data affect the speed both trains are traveling, which ultimately impacts the way stocks and, frankly, every financial asset is priced relative to one another.

But you don’t need to attempt to solve this riddle every day. We know every Fed meeting going forward will arouse another “will they or won’t they” hubbub that the market trades off. But we think differently and advise others to do the same. If you have an investing timeline longer than a few days, focus more on the Fed’s vision over the intermediate term like we do.

This is a Fed with a strong bias to always do more. Unlike in the past, it’s willing to overlook inflation (rather than stamp it out) and let the economy run hot in favor of employment growth. The old Fed used monetary policy as a blunt instrument and was willing to dish out tough punishment to markets from time to time. This Fed is different. Keep this in mind in the months ahead, and try to pull back from the daily Fed calculus in markets.

WALL STREET WRAP

The Fed Was Who We Thought They Were: Markets are keenly focused on the Fed, so the spotlight was on Chairman Jerome Powell’s comments from the Fed’s annual economic symposium in Jackson Hole, Wyoming, to close last week. While he stuck to the script largely crafted over the past month, he did move the goal posts ever so slightly.  

We’ve been critical of the Fed’s communication style in the past (see December 2018), but we think Powell nailed it last week. In terms of tapering, Powell moved the goal posts forward an inch, but it was enough to be effective. Powell didn’t give a firm date to begin tapering asset purchases, but he didn’t rule out beginning the process in 2021 — goal post moved. Powell still views inflation as transitory and affirmed an economy that’s recovering but with work to do.

We think the Fed will wait to see the August jobs report this week to get a better feel for how the Delta variant is impacting the economy and, most importantly, the jobs market. Regardless, as we’ve said for well over a year, this is a new Fed that will err on accommodation rather than give markets a bitter pill. Stay tuned.

Inflation Rises Again in July: The widely monitored PCE inflation rate was a touch hotter in July than expected, coming in at 4.2 percent year over year, with core inflation rising 3.6 percent over the same time.  Again, it’s worth pointing out that this number is being pushed around by outliers; and when you look at a more central tendency measure, such as the Dallas Fed’s trimmed mean index, inflation is closer to 2 percent — right in the Fed’s target range.

Markit Manufacturing and Services: Growth in the services and manufacturing sectors decelerated in July as a host of headwinds continued to confront businesses, according to IHS Markit data. The services index pulled back to 55.2 in August from 59.9 in July, an eight-month low. The manufacturing index also decelerated to 61.2 following a 63.4 read in July, which is a four-month low.

Although growth slowed month over month, the economy remains firmly in expansionary territory (anything above 50 indicates expansion). This is still a generally strong report. As the data show, manufacturing has been less impacted by rising coronavirus cases, and we expect that to remain the case going forward.

Eurozone Growth: Growth in the Eurozone continued near its strongest pace in two decades in August, data from IHS Markit show. Though the manufacturing index fell back to 61.5, just shy of July’s 62.8, it remains in lofty territory by historical comparison. The services side of the economy also stayed strong at 59.7, just off July’s 59.8 — the highest reading since June 2006.

Earlier this year we highlighted the potential for robust growth in the Eurozone, given the region was loosely following the trajectory of the U.S. recovery, just several weeks behind. That thesis is clearly playing out today, as the economy is expanding at a rate not seen in over a decade.

THE WEEK AHEAD

Jobs Data Could Solidify Tapering Plans: This week closes with the most important data release of the week. The jobs report for August is critical, as it will convey how deeply the Delta variant is affecting the labor market. If the labor market shows signs of further strength, it could be enough evidence to convince the Fed to begin tapering its asset purchases in 2021, earlier than projected a few months ago. Again, we remind that tapering is not a rate hike, it’s simply removing some supports. While we could see a volatile reaction in markets Friday, it’s a positive sign for the economy that it can function without some additional supports.

And the Rest: Keep an eye on ISM manufacturing numbers this week. Again, the themes will be labor, material costs and supply chains. Markets will expect further expansion and also welcome any early indications that key bottlenecks are beginning to ease. We’ll also get a read on pending home sales, consumer confidence, productivity and factory orders. We’ll keep tabs on these through the week, but again, Friday’s unemployment report should prove illuminative in many ways.

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