Maybe Jerome Powell Sent Stocks Exactly The Right Message After All

On Wednesday, during Jerome Powell’s already infamous July press conference, the beleaguered Fed chair made the mistake of characterizing the first rate cut since the crisis as a “mid-cycle adjustment”.

That was problematic for one simple reason: Markets want (and were priced for) multiple rate cuts. Spoiled traders and an irritated president want a full-on, yearslong easing push.

Communicating effectively with markets is more art than science, and Powell is no Mario Draghi in that regard. We endeavored on Wednesday to explain what went wrong. To wit, from “Jerome Powell Turns In Disastrous Performance As ‘Plain English’ Goes Awry Yet Again“:

To be sure, everyone knew the cut would be couched in terms of “insurance”. Analysts across desks as well as current and former officials spent the better part of two months drawing parallels to historical “insurance cuts” and extolling the virtues of being proactive — especially when operating near the zero lower bound.

Powell’s task was to make sure that the obligatory “insurance cut” narrative (necessary to give the committee plausible deniability for a cut when the economy is still strong) was accompanied by enough hints and **wink, wink**-type soundbites to placate markets that are expecting at least two additional cuts.

Suffice to say Powell didn’t do any winking. In fact, he said explicitly that “this isn’t the start of a long series of rate cuts” and he said it out loud, to people with working ears.

The irony in all of this, though, is that there’s a sense in which markets should hope Powell is correct – that even if another cut is coming in September (and perhaps a third in December), they are, together, just a “mid-cycle adjustment”.

That’s because the alternative is an all-out easing push at the end of the cycle, and given the excesses which have built up over the course of the longest expansion in US history, nobody is particularly excited about seeing what happens when the cycle finally turns.

One of the biggest challenges for monetary policymakers in 2019 has been telegraphing imminent easing without scaring markets to death by overstating the case when it comes to explaining why more easing is necessary. As BofA’s Hans Mikkelsen put it in March, “communicating dovishness is always tricky as there is a delicate balance between the benefit of stimulus and the underlying driver, which is economic weakness”.

In that context, part of Powell’s challenge involved walking the fine line between justifying the insurance cut without overplaying the rationale for fear of “confirming” market worries about growth and inflation.

With that in mind, note that the S&P performs markedly better following mid-cycle rate cuts than it does late-cycle easing. In fact, it’s not even close.

(SocGen)

That isn’t hard to explain. “Market performance after late-cycle rate cuts may not be as strong [because] rate cuts in a late cycle after a monetary tightening peak coincide with periods of economic slowdown, contraction in aggregate demand and falling corporate profitability”, SocGen’s Andrew Lapthorne and Solomon Tadesse write, in a note dated August 2, adding that “periods of slowdown are also characterized by significant uncertainty and risk, and so are not supportive of market rallies”.

That’s almost tautological. Rate cuts at the end of the cycle are not generally followed by ebullient equity market performance because we’re talking about the end of the cycle.

As you can see from the yellow line in the chart above, eventually things turn around, but it takes quite a while. Here’s the breakdown of late-cycle cuts:

(SocGen)

Later in the same note, Lapthorne and Tadesse underscore the points made above about the delicate balancing act for central banks between pivoting dovish and spooking markets by putting too much emphasis on the rationale behind that dovish pivot.

“A late cycle easing, while providing an economic stimulus that could help sustain markets, can also act as a signal of underlying economic weakness, and so instead winds up shaping negative market sentiment”, SocGen goes on to caution.

Of course, the ideal situation for markets is a “have your cake and eat it too” scenario, wherein the Fed embarks on an all-out easing push midway through the cycle in an effort to turbocharge the economy (or “make it take off like a rocket ship“, to employ Donald Trump’s toddler vernacular).

But that kind of monetary largesse isn’t prudent. If market participants are being honest with themselves, the best case scenario is one or two cuts from the Fed to underwrite the expansion and then back to business as usual for the economy.

Seen in that light (and judging by history) equity bulls should hope Powell’s “mid-cycle adjustment” characterization was correct. Indeed, the Fed chair’s job last week was almost impossible, in that he was effectively being asked to argue out of both sides of his mouth, by claiming i) this is an “insurance” cut and thereby everyone can expect the expansion to continue and risk assets to be firm, but also ii) we’re going to be cutting at least twice more, but don’t worry, that doesn’t mean we think the outlook is particularly grim.

In their Friday note, Lapthorne and Tadesse list one more reason why equities don’t perform as well around late-cycle rate cuts.

“Late cycle cuts are highly predictable and often get priced in ahead of the policy event, with a potential for market participants to overshoot the size, number and timing of potential cuts, which may then cause an eventual correction”, they write.