“This sets the stage for Powell on Wednesday”, I gingerly noted on Tuesday morning, after documenting the dramatic moves across DM bonds catalyzed by Mario Draghi in Sintra.
Draghi’s suggestion that more stimulus is coming piles more pressure on the Fed, unless, of course, the Fed is in on this (more on that possibility below).
For one thing, Draghi’s remarks elicited a sharp rebuke from Donald Trump, who will doubtlessly insist that the Fed is obliged to offset the ECB’s dovish turn. This just adds to the political pressure on Powell.
But, perhaps more worrisome for the Fed in the short run is that Draghi’s comments reinforce expectations for a dovish policy turn, and with front-end rates already priced as aggressively as they are, any small disappointment from Powell on Wednesday has the potential to spark a dangerous unwind.
“The Fed HAS TO be conscientious of the market pricing such a powerful dovish outcome as any ‘disappointment risk’ would see a de facto TIGHTENING of financial conditions and risk another 4Q18 tantrum scenario”, Nomura’s Charlie McElligott writes on Tuesday, adding that “with so much $ into this trade already, ‘disappointment risk’ could drive profit-taking which could develop into something much uglier when considering the length in Long Duration / Long Rates / Long USTs / Long Receivers & Curve Caps trade, particularly across the Leveraged- and Target-Volatility- universe.”
That is especially true considering the cost of carry and positive P/L just sitting around and waiting to be monetized.
But what if Draghi’s Tuesday comments are telling us something about the market actually underpricing the risk of a Fed cut tomorrow?
Unlikely though it may seem, it’s at least worth mentioning, and Charlie does – mention it, that is.
“Off the back of this morning’s ECB escalation, there is a growing sense or even outright concern in the market that June Fed cut odds are in fact too LOW as these statements to the market are often times coordinated in nature”, he writes.
That said, Charlie doesn’t think a Fed cut is in the cards this week. “I still personally believe that dovish guidance via lower dots and the likely announcement of an earlier end to QT will be enough to assuage the market until July’s Fed meeting, as traders will rationalize looking-through this June meeting, and further firm the belief in a July ‘big-bang’ Fed cut expectation”, he says.
Whatever the case, Powell is walking on egg shells. In addition to risking a disorderly unwind in the trades mentioned above, a disappointment (i.e., not leaning dovish enough to placate markets) from the Fed risks pulling the rug from under equities. On that score, I’ll leave you with a couple of excerpts from something I wrote Monday:
The idea of Powell striking an overtly hawkish tone this week in the face of current market pricing in front-end rates is almost unthinkable. He has a dastardly track record when it comes to S&P moves on Fed decision days. He is surely aware that his “plain English” approach hasn’t played well despite the rave reviews it received early in his tenure from those who insisted the new chair’s style was a “breath of fresh air” after the academic doublespeak of his predecessors. Come December, you would have needed to be Lieutenant Colonel Bill Kilgore to enjoy the smell of that same “air” (“napalm in the morning“).