‘Man, This Is A Tough One’: Nomura’s McElligott Delivers Last Minute Fed Take

“Trust me, you have time to read before the FOMC”, Nomura’s Charlie McElligott promises, in the title of a Wednesday morning note.

You’ve gotta love Charlie – in case you were scanning various “hot takes” pre-Fed and you were trying to budget your time, he just lets you know in the subject line that you need to make time for his.

Right off the bat, McElligott reiterates the potentially dangerous unwind in crowded trades that would accompany a hawkish surprise. “The perceived ‘binary’ nature [of today’s Fed] is due to the view that anything less than ‘dovish surprise’ or cut could then create a ‘hawkish’ price impulse across the enormous length accumulated in Rates / USTs / Steepeners / Receivers & Curve Caps positions”, he writes, reiterating a point he’s made repeatedly over the past week. In addition to “sloppy” profit taking in rates, equities would likely see an unwind in the “‘slow-flation risk barbell” (mentioned here on Tuesday evening). There’s more on all of that here.

As far as what the Fed will actually do, Charlie is torn.

“Man, this has been a tough one”, he writes. “Without a doubt, a June cut is trending higher from ~2% less than a month ago to the current ~20% probability following Draghi’s ‘whatever it takes 2.0’ moment yesterday”, he adds, before putting his own subjective odds of a cut at “probably closer to 40%.” So, it’s still not his base case.

You’re reminded that Draghi’s Sintra comments on Tuesday effectively piled more pressure on Powell, and it seems at least possible (if not wholly likely) that the Trump administration leaked the news about the White House counsel having explored the legality of demoting Powell in an effort to influence the decision. Later on Tuesday, Bloomberg reported that Trump himself had asked for “options” on stripping Powell of the chairmanship.

So, he’s definitely feeling the heat and the Fed is doubtlessly (hopefully) aware of the possibility that a hawkish surprise could lead to an unwind at the front-end and a subsequent snowball effect that could ultimately approximate a “tantrum”-type scenario.

As far as the rationale for a June cut, McElligott notes that there’s a sense in which the risks of waiting are asymmetrically skewed to the downside, especially if a cut is inevitable anyway. To wit, from Charlie:

The logic with the “June Cut” is “why would the Fed delay the inevitable?” as 1) the market is giving it to them and their own dots will be dropping too; on top of fact that 2) they risk creating a “tantrum” of their own-making which ultimately makes their job even more difficult via “tighter” FCI with them already being so close to the zero bound as-is; said another way, what is the downside to cutting today vs the ‘financial conditions tantrum’ risks if they don’t?

This gets back to the argument that says Trump’s badgering of Powell has been counterproductive for the president, in that were it not for the perception that the Fed is under pressure from the White House, the Committee would have a much easier time justifying an insurance cut.

If you ask McElligott, Powell can “thread the needle” without pulling the trigger (to mix metaphors) “via a very clear message on Fed easing intentions going forward.”

By that he means the statement would drop the reference to “patience” (if they retain that it will be a disaster, by the way), by deploying the “insurance” language in the course of discussing the preparedness to act (Bernanke would call it “courage”), and by “dropping [the] dots to neutral/towards EFFR and potentially bringing forward the end of QT even sooner.”

What would that entail for markets? Well, according to McElligott, it would mean this:

This above scenario–no “cut” but powerful “dovish” guidance–would likely see Rates and Equities initially impulse selloff, before stabilizing again thereafter, as markets realize that cuts are even a greater inevitability–thus, those future Fed cuts simply get pushed out into 2020 with calendar spreads inverting further negative.