Inflation: Markets believe ‘Powell will not stop tightening policy,’ expert says

The Macro Compass Founder and CEO Alfonso Peccatiello joins Yahoo Finance Live to discuss the path forward for rate hikes following Fed Chair Powell’s pre-testimony remarks to Congress, the state of the market, inflation, and the outlook for the economy.

Video Transcript

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JARED BLIKRE: All right, the Fed remains committed to returning to-- returning inflation to its 2% target as Jerome Powell points to interest rates likely higher than previously anticipated. So where does this leave Powell and his credibility and the path forward for rate hikes? Here to discuss this and more is Alfonso Peccatiello, the Macro Compass Founder and CEO, Alf, as I call you because that is your Twitter handle, "Macro Alf."

Great to see you. We've done webinars together, and you have some amazing macro tools at your fingertips that you have brought to the masses. You've been listening to some of the comments about this latest Powell testimony. Stocks, by the way, are off on the news. Just what's your biggest impression here?

ALFONSO PECCATIELLO: Look, Jared, thanks for having me, first of all. It's a pleasure to be here with you. I think Powell is trying to reassert what I call his Powell credibility indicator. So it basically tells what the market is understanding the Federal Reserve's stance will be, and the market is understanding it's going to be pretty tight for a pretty long period of time.

So the Powell credibility indicator is nothing else than measuring where Fed funds adjusted for inflation will be a year from now because in every instance in the past where the Fed had to bring down inflation, it did so by raising nominal Fed funds rate well above the level of prevailing inflation rates. And that's what the market is pricing in right now with the real interest rates a year from now priced at over 200 basis points. That's a very high positive real interest rate, which means the market is believing that Powell will not stop tightening policy until he gets the job done on inflation.

JARED BLIKRE: Well, maybe markets will believe him. But I want to show another chart here that you've supplied us with. This is global credit. And this has a lot of immediate implications, and also lagged implications for the market and economic growth.

Here, we can see this light blue cyan histogram. This is GDP for the G5. And this is lagged, and it's a year-over-year comparison. And then we have the Market Compass global credit impulse in purple.

And this purple line has crashed recently over the previous quarters. By the way, this goes all the way back to 2006. So what does this crash in global credit mean for the markets and for the economy in the coming months?

ALFONSO PECCATIELLO: Look, Jared, this is one of my flagship macro indicators. It's the Macro Compass global credit impulse. What it does, it basically looks at the five largest economies in the world, and it tries to measure whether we are creating money for the real economy or not. And so this indicator has gone negative, as you have shown there, because fiscal stimulus has basically stopped, and also credit creation for the private sector has come to a halt because borrowing rates are just unaffordable.

So as credit dries up, as that chart shows with a lag of roughly four quarters, GDP growth also comes down. And the credit impulse now is as negative as it has ever been. It's basically the same negative level as heading into the great financial crisis. This suggests that GDP growth will turn negative, in other words, that a recession is the base case for global macro economies starting from late summer this year.

Markets are not prepared, I believe, for a recession. The bond market is pricing the Fed to remain tight, interest rates to be still over 5% in a year from now. That cannot happen if a recession is unfolding. The Federal Reserve will be forced to cut interest rates. And the equity market, at the beginning, especially, will suffer from an earnings recession, which isn't yet fully priced in.

JULIE HYMAN: Alfonso, Julie here. But doesn't that also suggest that what the Fed is doing is working? In other words, that we-- we've had this sort of disconnect, right, where some charts of financial conditions show them loosening. The Fed chair, Jay Powell, has maintained that they're not, they are, in fact, tightening. What you're talking about with credit also suggests that they're tightening, does it not? So it suggests that what the Fed is doing should be working.

ALFONSO PECCATIELLO: Great points. And, yes, it is working. The thing is the lags in this cycle have been a bit longer than usual. Take, for instance, construction employment. So the labor market is one of the reasons why we get a lot of headlines that the economy is still very strong. The reality is that normally at this point in the cycle with housing activity having slowed down so fast-- and this is an outcome of what you just discussed of mortgage rates being very high, of tighter financial conditions.

When the housing market stops this suddenly, as it did this time, normally you get construction layoffs, to a very large extent, and they lead wider layoffs in the labor market. Construction employment is still positive on a year-on-year basis, which means basically the lag in this cycle seems to be a bit longer than people are used to. But it doesn't mean we are not going to get that effect. So I guess the Fed is actually doing what they're supposed to do, which is to slow the economy down. The problem here is that as credit has dried up really aggressively, the issue is the longer we wait for the downturn, the higher the probability the downturn is going to end up being worse.

JARED BLIKRE: And just along those lines, I have one more chart on the YFi Interactive that I want to direct people's attention to here. This is the higher-for-longer sweet spot in-- is coming to be in 2024. So this is the Fed funds term structure today, and this is in purple up here. And then we have it in cyan. That was one month ago, basically February 1. And you can see how it's shifted higher here along the entire curve. What is this saying to you?

ALFONSO PECCATIELLO: Look, Jared, on the Macro Compass, I really like to track the bond market. I've been a bond trader myself for years before opening up the Macro Campus. So the bond market here is trying to absorb the information from the Federal Reserve that the Fed is going to remain tighter for longer. And what this means, basically, is that all the interest rate cuts, which were priced into 2024, especially the first half, are now getting repriced away.

Fed funds future by March 2024, so that's a year from today, guys, are still priced above 5%. 5% Fed funds rate for one year starting today, effectively, for the next 12 months, those are very tight conditions that are to be kept there for longer because this is the new Fed reaction function. Again, the issue is as, Julie highlighted before, is that the tighter you keep borrowing conditions for the private sector, the higher you keep mortgage rates, the higher you keep corporate borrowing rates, the higher the chances you're going to freeze these credit markets and basically sleepwalk into an accident or, in general, accelerate a recession later on.

JULIE HYMAN: Right now, Alphonso, we are seeing stocks fall, take a leg down in the wake of these comments as Powell is talking about the ultimate peak, the end peak to be higher than expected. As you talked about, the market's not pricing in the scenario that you're painting. Stocks are down today. They're not down that much, right? The NASDAQ's down 9/10 of 1%. I mean, what kind of decline, ultimately, would you foresee if the market's pricing in what you're-- if what you're talking about happens, what would happen to stocks?

ALFONSO PECCATIELLO: Look, I believe that a model outcome for the S&P 500 could be a retest of the lows, so around 3,600. And the reason why I don't think it's going to be much lower than that is that the stock market generally bottoms before earnings bottom. So if we are going to get into an earnings recession, which I think has started and will continue, earnings will continue to decline, but the stock market at some point will start going up.

And why that happens is when earnings start to decline there, let's say in the mid part of their long-term decline in a bear market, the Federal Reserve normally capitulates. And the Federal Reserve generally cuts interest rates about 400 basis point in a recession. And that will mean cutting rates from 5 and 1/2% term rate today to 1 and 1/2%, 2%.

But as the Fed does that, it starts getting incorporated into better valuations. So even if earnings keep declining, valuations don't decline anymore, which means the stock market can stop its decline and start slowly but surely moving into a new bull market.

That's why I think we are going to retest the 3,600 lows-- that's at least my base case-- but I don't think the S&P will drop way below that. It's still-- I mean, we're talking about over 10% below where we are today. And I agree with you that the market is very complacent at the moment to this confluence of very tight credit and monetary policy being priced in against a very likely slowdown in economic activity ahead.

JULIE HYMAN: Alfonso, great to get your perspective today, really interesting stuff. Alfonso Peccatiello is Macro Compass founder and CEO. Thank you.