RIP Fed credibility: investors wave off Powell’s warning of inflation risk

(Originally published Sept. 24 in “What in the World“) Has the Fed been defanged?

Federal Reserve Chair Jerome Powell sought yesterday to restore some of the mystery around whether or not the U.S. central bank might cut interest rates further, emphasizing the “challenging situation” the Fed faces in trying to ensure that it keep inflation in check. If the Fed tries to stimulate job growth by cutting further, he warned, it “could leave the inflation job unfinished and need to reverse course.”

In doing so, Powell tried to conjure up some of that old voodoo his predecessors wielded to re-instill fear and respect into investors banking on the Fed to backstop their wildest risk-taking.

But investors aren’t spooked by Powell. The Fed last week cut its target for its benchmark interest rate by 25bps—to between 4% and 4.25%—and investors remain 77% certain it’ll cut two more times before year’s end. Maybe they’re a little spooked: last week they were more than 80% sure. Why? It isn’t just that the job market is weakening; it’s that Powell’s boss has succeeded in planting his own economic advisor on the Fed’s rate-setting board and has taken his fight to replace another to a Trump-friendly Supreme Court that just let him overturn precedent by firing a commissioner of the Federal Trade Commission.

But overconfidence usually spells trouble. Famed investor Mark Spitznagel thinks so. Spitznagel is the founder, owner and chief investment officer at Universa Investments, and is famous for cashing in on the 2015 “Flash Crash,” the 2008 collapse of Lehman Brothers and the market crash sparked by the 2020 Covid pandemic. He believes today’s booming stock market is in the middle of a last hoorah before it suffers a 1929-scale crash. Spitznagel is, aside from having been famously right, is also usually wrong: his strategy is to buy protection against unlikely crashes and so most often loses money (like when he predicted the worst in mid-2024) just so he has the rare opportunity to make billions when he’s right.

Why does he forecast doom now? Because valuations on stocks have been allowed to climb too high by repeated “rescues” of the market by the government, i.e. whenever the market shudders, the Federal Reserve delivers an interest rate cut, like last week’s.

And Powell’s latest prevarications have a ring of former chair Alan Greenspan’s “irrational exuberance” to them. Stock valuations are at near-record by most measures. At 23 times their companies’ projected earnings over the next year, stocks are at their highest price since the market’s post-Covid rally or the 1990s tech bubble. The cyclically adjusted price-to-earnings ratio, created by economist Robert Shiller, is at its highest since 2000. And the S&P500’s returns relative to its volatility is suggesting a correction is coming.

It could be a big one: the market’s drumbeat of record highs has pulled more and more investor money in: institutional investor allocations to stocks have climbed back to where they last were in November 2007 before a bear market. U.S. households also have more invested in stocks than ever.

But there are signs investor confidence may be starting to fray. Investors pulled $43.19 billion from U.S. equity funds in the week ended Sept. 17, according to LSEG Lipper, the biggest weekly net outflows since last December. Tech funds led the selloff, registering a $2.84 billion in net outflows. With stocks at a record, though, larger selloffs could merely reflect profits being taken off the table.