Has the Fed really turned hawkish? Or is it just an act?
Investors have got used to the constant support of the Federal Reserve. New boss Jerome Powell may change that – but how much of a tough guy is he really?
Like it or not, you can't ignore the Federal Reserve's influence in the markets.
The US central bank sets the interest rate on the world's most important currency, and therefore has an impact on the entire global financial system.
The question for markets now is: has the "easy money" Fed of the past several decades been replaced by a "no more Mr Nice Guy" Fed in the form of Jerome Powell?
Has the Fed really changed its spots?
For as long as I can remember, you've been able to rely on the Federal Reserve to err on the side of dovishness. In other words, given the choice, the Fed would always prefer to keep interest rates low, or cut them, than to raise them. And even if it was raising them, it would do so cautiously and at a slower pace than anyone expected.
This was the case under Alan Greenspan. It was true under Ben Bernanke. It was very much the case under Janet Yellen.
Jerome Powell, however, is trying to give the impression that he's different. I don't think it's a huge coincidence that Wall Street had its first big shudder in February, the very day that Yellen left office. The whispered hints at regime change rattled markets even then.
Since then, markets have been on edge. Inflation data hasn't been punchy enough to really rattle them. But nor has Powell shown much sign of being easily rattled by falling markets. The odd several-hundred-point slide in the Dow Jones is not met with an emergency statement by the Fed, ready to dab the markets' sweaty brow.
Some have even gone so far as to say that the "Powell put" is set at a far lower level than the "Greenspan/Bernanke/Yellen put" ever was (this refers to the perceived tendency of central bankers to intervene to prop up the market if it falls by much you buy put' options to protect your portfolio against a fall in the market, hence the name).
And if you look at how various assets are trading, it looks as though Powell is doing a good job of convincing investors that there's a new sheriff in town.
Firstly, the US dollar is strengthening. That suggests that investors really do believe that we'll see higher interest rates (which would make investing in dollars more attractive).
Secondly, the gap between short-term US Treasury yields and long-term US Treasury yields is very narrow. That suggests that investors are more worried that Powell will tighten too much, too soon, and thus choke off economic growth. (If they were worried about inflation taking off instead, then the long-term Treasury yield should be higher.)
This is what's known as a "flattening yield curve". It's not a great sign. And if the yield curve inverts (the short-term interest rate goes above the long-term one), it's a sign that markets expect recession, and it's a pretty reliable indicator that one is around the corner. We'll keep an eye out for that.
Thirdly, gold is struggling after its recent solid run. Gold doesn't like rising "real" interest rates if interest rates start to rise faster than inflation, gold won't do well.
Fourth, despite decent earnings results, stocks have struggled this year. If the market was more worried about inflation than about tighter monetary policy, I'd expect stocks to have gained more they like loose money and they can cope with inflation in the early stages at least.
So to sum up, the mood has changed distinctly since Yellen stepped down and Powell stepped up.
But how much of a tough guy is he really?
The testing of the Fed
The Fed met again last night. Nothing much came out of the meeting. But the message was very much "steady as she goes". On the one hand, the Fed noted that inflation in the US is very close to its target of 2%.
On the other hand, they pointed out that this is a "symmetric" target. In other words, it's fine for inflation to rise above 2%, just as it's been fine for it to be below 2% for quite a long time.
Yellen always used to talk about the idea that the Fed should be ready to let inflation "run hot" for a while, given that it had been below target for so long. The idea is that you "make up" for the undershoot by allowing a prolonged overshoot.
I'm not sure that makes a lot of sense logically, but it does give the Fed a bit of an "out". If it wants to keep monetary policy loose, even as inflation rises, then talking about the symmetry of the 2% target is one way to have its cake and eat it.
For now, the market doesn't seem to be any happier. Stocks fell yesterday, partly because there was no relief from the strengthening US dollar, and partly because nothing that the Fed said convinced anyone that they won't hike rates in June, as was previously expected.
Watch out for wage inflation data
The reality is that we just won't know until inflation rises sharply enough to force the Fed to tip its hand. That's when we'll find out if Powell is just a tough talker, or if he really is the second coming of Paul Volcker (who had to raise interest rates to double-digit levels in the early 1980s to crush rampant inflation).
That might take a while. Or we might get a hint as early as tomorrow, which is when the next batch of US jobs data comes out. Depending on what the wage inflation data looks like, Powell might face decision time sooner rather than later.
For what it's worth, I struggle to see the Fed really taking inflation seriously until it's a lot hotter than it is now. Powell might talk a good game, but he has to be aware of the rampant fear of deflation characterised by Yellen's reign.
And he also understands that he has breathing space interest rates are still very low and only expected to rise by 0.5 percentage points this year. You don't have to use your imagination very hard to picture a scenario in which inflation rises by more than that.
In short, there's still plenty of space for Powell to give the impression of being a hawk while in fact, presiding over a monetary policy regime that becomes gently looser in "real" terms.
That's what I see as the highest-odds scenario this year, which is why I'm favouring inflation plays (such as commodity stocks) and I'm sticking with gold as a hedge.