We entered the Fed decision today with the 2-year yield above 5% and the S&P 500 having just delivered a down 4.7% month.  And with GDP in the first quarter having just been revised down dramatically, to under 2%.

These are circumstances that were brought to us by the Fed.

By the Fed’s historically high level of real interest rates (Fed Funds rate minus the inflation rate).  And by the Fed’s “sentiment manipulation” (“communications strategy”).

On the latter, the numerous public speaking engagements by Fed officials over the past three months successfully moved market expectations from one extreme (expecting as many as seven rate cuts by year-end) to the other extreme.

How extreme had expectations shifted?

As of yesterday’s close, the interest rate market was pricing in less than one full rate cut by year-end.  And based on recent comments from a voting Fed member, some in the investment community had even begun to speculate that rate hikes could once again be back in play.

Moreover, if we look at the year-end expectations on where the Fed Funds rate will be, it’s projecting higher today than it was back in October.  And at that time, the Fed was projecting an additional rate hike in December, and still engaged in the tightening cycle.

Now, not only does this dramatic swing in market interest rates and expectations tighten financial conditions (adding to an already historically tight real interest rate, set by the Fed), but it increases the risk of a liquidity shock.

With that, as we discussed in my Monday note, it was crucial in today’s Fed decision/press conference that they move the rate expectations pendulum back toward the middle.

So, what did the Fed Chair, Jerome Powell, have to say today?

He shot down the notion that Tuesday’s hotter wage report was an inflation concern.

He shot down the notion that the economy is settling into a stagflation stage (i.e. slow growth, high inflation).  He said growth is neither slow, nor is inflation high (relative to historic stagflation periods).

And he shot down the notion that the policy path could include a rate hike as the next move.  He said the discussion at the Fed is not about direction, but “how long to hold rates in restrictive territory.”

This was clearly a dovish message from the Fed today. And it countered a market that was positioned for something ranging from hawkish to very hawkish.

That should take pressure off of the interest rate market.  And should provide support for stocks, coming out of an April retracement.

There was broad-based selling across markets today:  Stocks, bonds, commodities, everything.

It started with hotter than expected wage data (Q1 employment cost index).  With the Fed decision tomorrow, on the back of hotter than expected inflation data in recent months, the influence of rising wages on the inflation picture spooked markets.

But it’s an overreaction.  Why?

Remember, we’re in a productivity boom!

We averaged just 1% productivity growth for the decade prior to the pandemic, and negative 0.7% from the fourth quarter of 2020 through early last year.   Since then, productivity growth has averaged 3.7%.

And as Jerome Powell has said in the past, wage gains should equal productivity gains plus inflation (a formula of non-inflationary wage growth).

The latest inflation of 2.7% plus 3.7% productivity, gives us year-over-year wage gains of 6.4%.   The wage number this morning was 4.2% (year-over-year rise).  That means wages should be rising faster.

With the above said, among the important events of the week (Fed, earnings, Friday’s job report), the Q1 productivity report on Thursday is a big one.

Let’s take a look at a couple of charts as we head into tomorrow’s Fed decision …

Relating to the above chart, it’s important to remember that the Fed made an official policy change in the way they evaluate their 2% inflation target back in September of 2020. 

 

We heard from Meta after the close yesterday, which we discussed in my last note.

They grew revenues by 27%, compared to the same quarter last year.  They grew net income by 114%.  And they expanded operating margins from 25% to 38%.

Meta was scrutinized for its ongoing massive investment in AI infrastructure.  They are in the third year of what will be a $100 billion three-year spend on servers, data centers and network infrastructure.

The stock was punished.

Today we heard from Google (Alphabet) and Microsoft.

Google grew revenues by 15% compared to the same quarter last year.  They grew net income by 57%.  And they expanded operating margins from 25% to 32%.

Microsoft grew revenues by 17% compared to the same quarter last year.  They grew net income by 20%.  And they expanded operating margins from 42% to 45%.

Like Meta, both Google and Microsoft are making massive investments in building AI infrastructure capacity.  Both stocks went up after earnings (Google, about 10%).

From 2022 through this year, all of the AI barons are spending in the neighborhood of $100 billion in capex on AI infrastructure.  And they will do more, to build the capacity needed to meet the insatiable customer demand for computing resources to run AI products and services.

As Microsoft put it, in the their call this afternoon, this is just the first wave, and they are building for the “second wave” of AI.

So, these are trillion-dollar plus companies, growing at an accelerating double-digit pace, rapidly adding new products and services, with smaller headcount, and at a higher and higher rate of profitability.  And they’re not expensive (Meta – 23x forward PE, Google 22x, MSFT 31x).

It’s still the early days of the most productivity enhancing technology advancement of our lifetime: generative AI.