Market Commentary – The Fed Painting Itself into a Corner
By: Eric Sterner, CFA, CAIA, FRM, CIPM
Chief Investment Officer, Apollon Wealth Management and Apollon Financial
As everyone who has taken on a painting project knows, the most important rule is to never paint yourself into a corner. Such a situation leaves you with no alternative and no escape route. The Fed raised rates yesterday by 25 basis points, which, in my opinion, was due to Fed Chairman Kevin Warsh painting himself and the Fed into a corner by abandoning forward guidance.
Since becoming the Federal Reserve Chairman, Kevin Warsh has consistently expressed his opinion that he prefers to let the market lead the way in interpreting economic data independently and for the Fed to communicate less on forward guidance. This stance contrasts with former Fed Chairman Jerome Powell who offered forward guidance, and because of his highly telegraphed messaging, there was often little doubt what the Fed would do with interest rates before each meeting.
Under Kevin Warsh, the financial markets are effectively allowed to dictate interest rate decisions. Several weeks ago, there was a 50/50 probability that the Fed would hike rates at the September meeting, but those probabilities shot higher due to several factors including Warsh’s hawkish speech at Jackson Hole, a hotter-than-expected August labor market report, an August retail sales report beating expectations, and another CPI report with elevated inflation. Due to those compounding events, the probability of a rate hike spiked to 92%. If the Fed did not increase rates yesterday, it could have caused government yields to climb higher as the Fed’s credibility would have taken a major hit.
While we clearly still have elevated inflation, most of the pressures are on the supply side with oil spiking due to the US-Iran conflict. Higher energy prices are also feeding through to transportation and warehousing costs as that component of the most recent Producer Price Index (“PPI”) report rose 2.3% on a month-over-month basis, which was its largest monthly rise since April. Higher fuel prices are also driving airfare costs up. The other major inflationary pressure is coming from electronics due to the massive demand from the AI data centers.
As one journalist pointed out during Warsh’s press conference, a 25-bps rate hike does not open the Strait of Hormuz. That summed up my thoughts as the Fed hiking rates will not address the underlying major inflationary pressures. A 25-bps rate hike will also not stop this incredibly powerful AI revolution. There are plenty of disinflationary trends in place now as shelter inflation is taming, tariff effects are fading, and wage growth has been subdued for months. Inflation will most likely remain elevated until the fighting in the Middle East ends. Unfortunately, there is no end in sight for now. It appears that Iran wants to draw out this war longer to apply political pressure on President Trump with the midterm elections around the corner. This war is generally not popular, and affordability will be a major theme to these elections, so elevated inflation and energy costs will cause more financial pain to the US consumer, and, in turn, may hurt President Trump politically. We may not see Iran come back to the negotiating table until after the midterm elections.
While I do not believe the Fed rate hike was warranted, I’m not concerned as of this moment. The rate hike was priced into the markets without any major consequences and corporate earnings remain very strong. If this war ends in the next few months, I do expect oil prices to drop quickly, which, in turn, will greatly ease these inflationary pressures.
If this conflict continues into 2027, my concern will certainly grow as these higher energy prices will continue to bleed into other components of inflation. While food inflation has recently been tame, diesel is very important to food prices as most farming equipment and trucks moving goods to grocery stores rely on diesel. I expect food inflationary pressures to build in the coming months if fighting continues. Diesel prices can affect food prices with up to a 9-month lag based on the timing of the planting versus harvest season.
For now, I remain bullish on the markets with a slight bias towards the Quality factor due to these elevated risks. I, like many people, continue to pray for an end to this conflict.
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