Nomura’s McElligott On What Can Go Wrong If The Fed Keeps Guiding Expectations Lower

The first Fed cut since the crisis is in the books, and the knee-jerk reaction from markets conveyed palpable disappointment.

“Changes to the post-meeting statement were mixed but slightly hawkish at the margin, with little changes to the growth and inflation characterizations and a slight watering down of the ‘will act as appropriate’ policy guidance”, Goldman wrote. Dissents from Esther George and Eric Rosengren underscored the notion that we are nowhere near a situation where policymakers are united in support of a full-on easing cycle.

Things got far worse during Jerome Powell’s press conference which was, for lack of a better description, a total debacle. Stocks dove, yields rose and the dollar moved higher, as Powell’s characterization of the cut as a “mid-cycle adjustment” suggested further easing is by no means assured.

Read more: Jerome Powell Turns In Disastrous Performance As ‘Plain English’ Goes Awry Yet Again

When the closing bell sounded, it was the worst session for US equities since May 31 and the third consecutive day in the red for the S&P.

If this is what happens when Powell fails to placate markets for a single afternoon, one can only imagine how dicey things might get if and when the Fed is forced to deliberately walk back expectations for further rate cuts.

Nomura’s Charlie McElligott underscored that on Wednesday.

“From the perspective of a ‘give ‘em an inch, they take a mile’ Rates market which continues to price in the outright ‘commencement of an easing cycle’ as opposed to the Fed’s far more modest ‘just an insurance cut’ talking points, this is where things get tricky for communications”, he wrote, just prior to the Fed decision.

“A 25bps +dovish setup post-today’s meeting into a September environment where the US economy maintains its current ‘still expansive’ pace will likely force the Fed to finally begin guiding Rates market expectations lower into accepting both a ‘no follow-up cut for September’ and likely ‘just’ one more cut in total thereafter, all over the course of August/September Fed-speak”, Charlie went on to caution, in a series of morning remarks that now look rather prescient.

Needless to say, the potentially precarious setup he described prior to the statement and press conference now looks even more perilous in light of Powell’s bungled communications effort.

What does this mean for markets? Well, nothing good assuming the data were to firm up, forcing officials to persist in the notion that what we got this week was just a “mid-cycle adjustment”.

“Relative to said ‘dovish’ expectations already priced in [and] crowding into front-end rates and curve steepeners, a messaging downshift then likely elicits an outsized hawkish market response and thus, incites rates vol. as that messaging is forced into becoming clearer as we proceed deeper into August”, McElligott warns.

And don’t forget about the dollar, which rose against every G10 peer save the pound on Wednesday, and is now set for a mammoth monthly gain.

“‘Just’ a 25bps cut today into (critically) a ‘still fine’ US economy out a few months will keep POTUS pounding on the Fed to ‘do more’ under the guise of potential for further USD currency headwind”, McElligott said.

Earlier this week, he delineated a series of factors that continue to contribute to tighter funding conditions. Now, you can add in a Fed that seems reluctant to endorse the market’s view that an easing cycle is necessary.

And all of this into a challenging seasonal. Here’s Charlie one more time, summing up:

Summarizing the risk then, there is potential for 1) Aug / Sep Rate vol jump (on the repricing of September cut odds lower and the likely beginning of the ‘walk down’), potential for 2) a USD breakout to fresh cycle highs (as rest of world accelerates their easing while the Fed seemingly then “stands pat”)–which then sets the table for 3) even greater escalation of political pressure from POTUS in light of this potential renewed Dollar strength (rest of world easing while Fed moderates message) and then 4) pushes this pressure on Fed to “do more” even-deeper into the election-cycle–which is nowhere the Fed wants to be. This scenario is dangerous because the month of August marks “peak illiquidity” after many funds effectively shut themselves with PMs in “gross-down” mode ahead- / into- their Summer holidays, and which is a large reason why over the past thirty years that we see August posts the highest average VIX return of any month.

One assumes the Fed is already thinking about how to “correct” the situation after Powell’s latest communications fail. They’d better hurry before Trump “fixes” it for them.

Now, risk assets will probably start rooting (hard) for lackluster data and hoping that the US economy doesn’t show convincing signs of ramping back up. Expect bad news to be good news (and vice versa) again.

In that context, it’s difficult to imagine that another blockbuster jobs report on Friday would be digested well. If AHE were to come in hot too, we could get an outright meltdown reminiscent of what happened on Friday, February 2.