Following the Federal Reserve-induced banking crisis that gripped the capital markets last month, much debate has focused on the next course of action. Clearly, the Fed’s sharp and relentless rise in interest rates, and negligence of its regulatory responsibility contributed to the demise of Silicon Valley Bank and Signature Bank. From that, an argument can be made that they should pause from any additional rate hikes to evaluate their action to date. If for no reason other than to let any banks that extended duration too soon generate some net interest income. However, an equally persuasive argument is that the inflation mentality is starting to become entrenched.

January was a peculiar month in that the New Year kicked off with a general feeling of malaise in terms of market sentiment stemming from what proved to be a disappointing holiday selling season. The stock market commenced the year trading at the December low as economic data continued to disappoint. The Fed, reacting to the string of weak Q4 economic reports and continued stubborn inflation readings, communicated that they would reduce the magnitude of rate hikes again from 50- to 25-basis points. In holding to their word, they did so at their February 1st meeting. Moreover, the committee members loosely suggested that the peak of the rate would reach 5% and not the 5.25% to 5.50% they communicated just 3 months earlier. That change in messaging succeeded in boosting investor concerns as witnessed in both stock prices and bond yields. The 30-year kicked off 2023 yielding 3.96%, only to close the month at 3.63%, as investors fretted that the economy was on the verge of recession and the Fed would be forced to cut rates later this year. Paradoxically, equity indices rallied for the same reason. The S&P 500 gained more than 6% for the month. While still more than 15% below the all-time high touched in December 2021, the index has rallied nearly 20% off of the 2022 low touched last October.

Judging by the November Consumer Price Index, the Fed’s harsh medicine of higher interest rates is starting to work. While year-over-year CPI still rose 7.1% last month, that’s down from 7.7% in October, and the 0.1% month-over-month increase is exactly what the Fed has been expecting. While the November Producer Price index came in higher than expected, that measure of inflation takes a back seat to CPI in that some of those price pressures can be absorbed by margin compression at the corporate level. The CPI, on the other hand, directly impacts consumers and risks the spiral effect in which consumers expect prices to continue to rise into the foreseeable future.

As of late, there has been little for the Fed to celebrate. The all-important employment report has been relegated to second tier status as the Producer and Consumer inflation measures take center stage as the most important measure of the Fed’s success. With the release of the September report, the Fed’s efforts this year represent a distinct failure. Both measures came in above expectations and didn’t really offer any indication that the rate hikes to date have been successful. The markets reacted mostly as expected. The 30-year bond, after a brief short covering rally on the day of the CPI release is trading just above 4.00%. Similarly, the 2-year note is trading just below 4.50%. Fed Fund futures reset materially higher, with the May 2023 contract indicating a peak Fed Funds rate of 4.93%.

The S&P 500 has recovered from its early summer swoon and is currently trading midway between the high and low print for the last year, supported by the two most recent economic wayposts. The July employment report and the consumer price index (CPI), were both better than investors had forecast, indicating that the Fed may not need to be as aggressive in tightening policy as thought just a month ago.

Following a mixed June employment report, the July tally blew past all expectations. Coming in at 528,000 new jobs added, the report more than doubled the consensus expectation of 250,000 and exceeded the highest expectation of 325,000. Moreover, the details were equally eye popping, with average hourly earnings up 5.2%, year-over-year, and the unemployment rate ticking down to 3.5%, equaling the low touched on September 2019. The bond market didn’t like any of it. The yield curve that placidly drifted below 3% recently, convulsed back above that measure on the day. Month to date, the 2-year note is 30 basis points higher, and the 2-year/30-year interest rate spread went negative for the second time this year.