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Resurgent ‘animal spirits’ in financial markets may undermine Fed’s inflation battle, Nomura says

A contrarian viewpoint is emerging that challenges investors’ recent optimism over the Federal Reserve’s ability to bring inflation down to 2% without a U.S. recession or a big rise in unemployment.

It’s the idea that Wednesday’s unexpectedly dovish pivot by policymakers, who penciled in three quarter-point rate cuts for 2024, may end up undermining their inflation battle and create a new set of problems. The reason is that it’s reawakening the market psychology forces known as “animal spirits” — giving investors greater confidence and easing financial conditions in a way that might make it harder to control inflation.

The resurgence of these animal spirits in the financial markets is the largest risk created by the Fed’s policy update this week, as officials attempt to pursue an economic soft landing “through greenlighting a deeper preemptive series of cuts,” said Charlie McElligott, a cross-asset strategist from the global equity derivatives desk at Nomura Securities International in New York.

In a note on Thursday, a day after the Fed unveiled its update and projections, McElligott cited how financial conditions are easing at a time when the labor market remains historically tight. In addition, households and corporations are enjoying a positive wealth effect as the result of a rising stock market and the interest that can be earned on cash-like investments. The collective impact of all this is that reawakened “animal spirits” could continue to drive consumption and stimulate inflation, “risking the future need to re-start policy tightening,” the strategist wrote.

The “Powell Preemptive Pivot” is translating into what looks like a “QE/portfolio-rebalancing channel trade” in financial markets, said McElligott, who has warned about the risks created by animal spirits for months.

For now, he said, there’s no reason to try and fade the “everything rally” until inflation and economic growth reaccelerate, which would require “an Arthur Burns retightening-cycle capitulation,” or until a “hard-landing” scenario comes to fruition with a cracking of the labor market that would require “300bps+ of cuts, and fast.” Arthur Burns was the Fed’s chairman from 1970-1978, and the predecessor to Paul Volcker.

McElligott isn’t the only one expressing concerns about the impact of this week’s Fed policy announcement and projections. The investment team at Northwestern Mutual Wealth Management Co. in Milwaukee, which oversaw $255.7 billion in assets as of September, said it thinks inflation is going to be difficult to snuff out completely, and that policymakers are going to be reluctant to cut rates until it moves sustainably back to 2%.

The implications of Northwestern Mutual’s line of thinking are that a perfect economic landing is highly unlikely and that, under that situation, certain investments such as small- and mid-cap stocks will do better than others over the next 12 to 18 months, according to a report distributed on Friday.

Helping to give greater credence to the skepticism about a dovish pivot by the central bank were remarks made earlier on Friday by New York Fed President John Williams, who said officials aren’t really talking about cutting rates right now.

Treasurys initially sold off on the comments by Williams before stabilizing, leaving yields slightly higher to little changed on the day. Meanwhile, all three major stock indexes DJIA SPX COMP were mixed in afternoon trading Friday. Fed fund futures traders continued to see a high likelihood that as many as five to seven quarter-point Fed rate cuts will occur next year.

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