January was a continuation of the market rebound experienced in the fourth quarter of 2022. Equity markets in the US and abroad posted healthy gains to start the year. Developed markets outside the US outpaced domestic markets as the US dollar weakened a bit against a basket of major currencies. Emerging markets were the relative standout, as China continued to focus on its economy.
Bonds posted a strong month, as rates fell and credit spreads narrowed. In our view, the strength is partly due to the slowing of inflationary pressures and a view that the Fed is near the end of its interest rate increases. This seems aligned with the Fed’s point of view, as far as what remains to be done. However, the market seems to be going a step even further by taking the view that rates could fall later this year. This prediction is misaligned with the Fed’s own forecast, which is to take rates higher and leave them there for a while.
Powell addressed the difference in opinions at his most recent press conference on February 1st. Here is an excerpt, edited for brevity and clarity:
“CHAIR POWELL: I'm not particularly concerned about the divergence, no, because it is largely due to the market's expectation that inflation will move down more quickly… So, again, as I just mentioned, we -- you know, our forecasts -- there are different participants of different forecasts, but generally, those forecasts are for continued subdued growth, some softening in the labor market but not a recession... And we have inflation moving down, into this somewhere in the mid-threes or maybe lower than that this year… Markets are past that. They show inflation coming down in some cases much quicker than that. So, we'll just have to see. And we have a different view and it's a different forecast, really. And given our outlook, I don't see us cutting rates this year if our outlook turns true, as I mentioned just now. If we do see inflation coming down much more quickly, that'll play into our policy, of course.”
It’s worth analyzing the forecasters a bit.
The Fed board is a group comprised mostly of academic economists. They are very smart people but have been trained in similar ways, potentially beholden to groupthink, and have made forecasting errors in the past. There are more resources and data available to the Fed than practically anyone else. Behavioral economists, and as far as we know the Fed board does not have a behavioral economist in their ranks, are quick to point out that more data tends to increase confidence in a forecast more than it does accuracy. They could be correct in their forecasts, but they could just as easily be wrong. It begs the question: are they overconfident in a forecast that may prove incorrect?
Markets tend to represent very diverse points of view from participants with financial incentives to get their forecast right and relying on the wisdom of crowds is generally the right default position from a forecasting perspective. However, the wisdom of crowds can morph into the madness of crowds and does so with some regularity. It begs the question: is the market wise or mad?
We don’t have a strong view but observe that the rate of change has been slowing and the real time data seems somewhat supportive of the market’s view for now, but that could change.