The most powerful economic office on the planet has quietly changed hands, and the market’s nonchalance may prove to be its most consequential mispricing of 2018. On 5 February, Jerome “Jay” Powell was sworn in as the 16th Chair of the Federal Reserve, replacing Janet Yellen after a single term marked by painstaking gradualism and a near-flawless exit from the zero lower bound. Powell inherits an economy firing on almost every cylinder: unemployment at 4.1%, GDP growth accelerating, corporate earnings surging, and equity markets that have spent the better part of two years grinding to record highs with barely a tremor of volatility. The consensus view is that this is a seamless baton pass, a continuation of Yellen’s steady hand.
We think the consensus is wrong. Not because Powell is a radical, but because the environment he walks into demands a tempo that markets have not yet priced.
A Quiet Revolution at the Top
The transition itself was unremarkable by design. Powell, a Republican appointee with a pragmatic, consensus-building reputation, was confirmed by the Senate with broad bipartisan support. He is the first Fed Chair in four decades without a PhD in economics, a detail that may prove to be an asset. Powell’s background in private equity and Treasury gives him an instinctive feel for financial plumbing, for how liquidity actually moves through the system, rather than how it behaves in a DSGE model.
Yellen’s final dot plot projected a median of three rate hikes for 2018. Markets have spent most of the past year pricing roughly two hikes. This gap between the Committee’s stated intentions and the market’s implicit scepticism has become a structural feature of the post-crisis landscape. That dynamic is now shifting, and shifting faster than most participants appreciate.
The Macro Backdrop: Why This Cycle Is Accelerating
Start with the labour market. The unemployment rate at 4.1% is already below the Committee’s longer-run estimate of 4.6%. Wage growth is beginning to stir: average hourly earnings rose 2.9% year-on-year in January, the strongest reading since June 2009. This single data point sent Treasury yields sharply higher and triggered a violent repricing across equity markets in early February.
Layer on top of this the fiscal impulse. The Tax Cuts and Jobs Act represents the most significant corporate tax overhaul in a generation. Meanwhile, the spending deal could add another $300 billion in fiscal stimulus over two years. The US is about to receive a massive, procyclical fiscal injection at precisely the point when the economy is already at or beyond full employment.
For the Fed, monetary policy is still accommodative by any reasonable metric. The real fed funds rate remains negative. Financial conditions are the loosest they have been in years. The Committee’s mandate requires it to respond.
Reading the Dots: Three Hikes or Four?
The central question for rates markets in 2018 is whether the Fed delivers three hikes or four. The December dot plot showed three as the median, but seven participants pencilled in three, four projected four or more, and only two expected fewer. The median is balanced on a knife-edge.
The combination of a tighter labour market, rising commodity prices, a weaker dollar feeding through to import costs, and fiscal stimulus is creating the conditions for an upside surprise in inflation. Core PCE, stuck below 2% for most of the past five years, may begin to move decisively toward or through that target.
What the Market Is Getting Wrong
First, the market is underpricing the fiscal impulse. The closest analogue is the mid-1960s, when procyclical fiscal policy compressed the timeline for monetary tightening.
Second, the balance sheet is a largely ignored second axis of tightening. QT will reach $50 billion per month by October 2018, its cumulative effect equivalent to an additional one or two rate increases.
Third, the volatility regime has changed. The extraordinary calm of 2017 was a reflection of compressed risk premia that have now been violently repriced.
Implications for Investors
- Rate path: The probability of four hikes in 2018 is materially higher than current market pricing suggests.
- Curve dynamics: Expect continued flattening of the 2s10s spread. An outright inversion by late 2018 or early 2019 cannot be ruled out.
- Volatility repricing: The low-volatility regime of 2017 is over. Reassess any portfolio with embedded short-vol exposure.
- Equity sector rotation: Favour financials and cyclicals over bond proxies.
- Dollar uncertainty: The twin deficit narrative is the most difficult call in global macro.
The market wants Powell to be Yellen 2.0. The data may not allow it.
Related Reading
Powell’s early tenure would be tested by the market turbulence covered in The Volpocalypse. For his most dramatic policy action, see Fed Goes Nuclear: Zero Rates and Unlimited QE. For the historic hiking cycle he later led, see The Fed’s Most Aggressive Hiking Cycle in 40 Years. For more on how the Fed’s policy trajectory set up the inversion, see our analysis of The Fed Under New Leadership: Jerome Powell’s First Moves. Powell’s most dramatic reversal came just a year later, as covered in The Powell Pivot: How the Fed Blinked and Markets Roared Back. The EM consequences of the early Powell tightening are covered in EM Pressure: Turkey, Argentina, and the 2018 Emerging Market Crisis.
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