MWW - War or Warsh- That is the Question

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North American markets gave up some gains this week on the back of weakness in mega cap technology names. We didn’t get around to it in our market comment last week, but we had the first Federal Open Market Committee's (FOMC) under new Federal Reserve Chair Kevin Warsh. The meeting can be summarized as a hawkish pause.

The decision to hold rates steady for a fourth consecutive meeting was widely expected, markets focused instead on the updated economic projections, the revised policy statement, and Warsh's tone in his first press conference as chair. The most important changes came from the Fed's projections. Policymakers raised their inflation forecasts, which likely drove the removal of the previously projected 2026 rate cut from the dot plot.

However, officials remain divided on the path forward: half of participants project at least one rate hike, while the remaining respondents expect no change or a cut. This suggests the Fed is not unified around additional tightening, but the debate appears to be moving toward whether current policy can bring inflation back to target in a reasonable timeframe. Markets responded by pricing in a higher fed funds rate than reflected in the Fed's own projections.

Notably, Chair Warsh did not submit a forecast, consistent with his stated preference for streamlining the central bank's communications. The projections also showed that participants lowered their near-term economic growth outlook, though it remains above trend, while upgrading their assessment of the labour market.

The policy statement was shortened significantly and shifted toward a more inflation-focused message, removing the prior easing bias and forward guidance. Taken together, the projections and statement suggest the key policy question is no longer how soon the Fed can cut rates, but how long rates may need to remain elevated to bring inflation to target.

Kevin Warsh used his first press conference as chair to reaffirm policymakers' commitment to its price-stability mandate. He also laid out a broad review of the Fed's operations, with new task forces set to evaluate the central bank's communications, balance sheet, maximum-employment and price-stability frameworks, and use of data. Meaningful changes would likely require broad consensus across Fed officials, but these announcements suggest Warsh intends to revisit and potentially fundamentally rethink how the Fed operates and communicates.

Right now, financial markets are looking at two nearly equal and offsetting forces: the U.S. and Iran Memorandum of Understanding to halt the conflict, and this apparent hawkish pause by the US Federal Reserve. The market reaction to the FOMC countered the relief from the latest dive in oil prices, as Oil dropped another 6-7% on the week, breaking the $70 threshold for this first time since March. While still well up from the pre-war levels (low $60s), that leaves crude roughly in line with its long-run norms (in real terms).

On its own, the steep pullback in oil prices would normally have carved deeply into rate hike expectations. After all, the primary reason why we are all even talking about the possibility of hikes by some central banks—and the reality of hikes by others, such as the European Central Bank (ECB) and Royal Bank of Australia (RBA) —is that headline inflation has bounced on the oil price spike, with some threat of a spillover to core. But if oil is now in full-scale retreat and close to long-run norms, the casus belli for hikes disintegrates. Suffice it to say that markets don’t quite see it that way in the wake of Warsh’s tough talk.

The shifting perception on the Fed revived the U.S. dollar, which rose almost 1% in trade-weighted terms this week and is again flirting with its highest level of the past year. It was especially strong against currencies whose central banks are on hold, such as the Bank of Canada and the Bank of England, but it still rose nearly 1% against the euro even after last week’s ECB rate hike. Of course, it doesn’t hurt the greenback’s cause that the AI/tech boom rolls on, seemingly unabated.

We dig much deeper into the finer points of the FOMC in Focus, but it is fair to ask: What exactly did Warsh signal that made such a profound shift in views on the Fed outlook? Arguably, very little. He simply reaffirmed, in an incredibly terse statement, that the Fed was on hold and committed to controlling inflation, and that the vote was unanimous. But perhaps more importantly it was what he didn’t say—there simply was no suggestion that he was looking to lower rates, and no defence of such.

Even with that myriad of caveats, we would readily allow that there is next to no appetite among Fed officials for rate cuts in the foreseeable future. Thus, even as economists have shaved their oil price assumption based on the details of the MOU—to an average WTI of $80 this year and $75 next (from $85 and $77.5)—BMO’s economics team has further pushed back their call on Fed rate cuts. (Yes, cuts, not hikes.) They now see the Fed waiting until the latter stages of 2027 before resuming trims. To briefly recap why they still lean lower, not higher, on short-term rates: Current fed funds of 3.50%-to-3.75% are still above neutral, and economists see GDP growth easing to below potential next year on a tighter turn in fiscal policy after the mid-terms, as well as some cooling in AI spending growth. And, yes, they are also assuming that headline inflation recedes notably in 2027 to closer to 2%, as the spike in oil prices fades from memory.

While higher-for-longer rates could be a headwind for U.S. equities, we believe continued consumption and earnings strength can help offset higher discount rates, especially if inflation gradually moves back toward target. Valuations have pulled back recently, but earnings growth has offset much of the impact, helping support performance. Overall, we recommend staying invested while staying mindful that geopolitical and monetary-policy uncertainty could remain sources of potential volatility. We see opportunities in large- and mid-cap stocks, which we think stand to benefit from their quality and broadening leadership amid continued economic resilience.

 

Sources: BMO Capital Markets Economic Research- BMO Economics Talking Points: A-Hiking We Will Go?

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