McElligott On What The ‘Fed Put World Order’ Hath Wrought

Over the weekend, I talked a bit (ok, a lot) about the prospect of the market rapidly pulling forward the assumed knock-on effects of Fed tightening on the way to essentially forcing policymakers to start walking (more precisely, talking) back the hawkish tilt from the June FOMC.

To be sure, the situation is still a bit difficult to parse. There’s a difference between the market getting caught wrong-footed (in steepeners, for example) and having to unwind and otherwise de-leverage, and leaning into new trades seen as consistent with the Fed’s pivot.

And then there’s the folly in ascribing a sense of “purpose” to traders as it relates to “forcing” the Fed to reverse course versus just trading the implications of the new dots after doing some quick SEP tasseography.

Read more: The Lollipop Emoji

Sill, I think it’s fair to say that a collapsing curve and an abrupt reversal of various reflation expressions isn’t quite what the Fed had in mind. Lower long-end yields can contribute to easier financial conditions, but not if the dollar is surging, real rates are rising and stocks are falling. All of that is conducive to tighter financial conditions, and could eventually equate to a de facto rate hike.

Writing Monday, Nomura’s Charlie McElligott talked a bit about this dynamic. “This is what the unspoken ‘third Fed mandate’ of maintaining ‘easy financial conditions at all costs’ hath wrought,” he wrote, describing the “absurd cycle” of the “‘Fed Put’ world order” in which “market forces now pull-ahead the negative economic slowdown implications of [expected] policy tightening” on the way to taper tantrums, which then “creat[e] market volatility, ultimately forcing the Fed to walk back hawkish tone shifts.”

Average inflation targeting supposes policymakers can overshoot their target for some period of time (several months, at least) in order to “make up” for previous shortfalls. It’s by no means obvious that US inflation prints from April and May should “count” in whatever math the Fed is using to make that calculation (they claim they aren’t using any math, which is probably true, but you get the point).

Rather, the assumption was that policymakers would simply write off April and May as anomalous and then start paying attention again once the base effects fall out of the comps and supply chain bottlenecks have a few months to work themselves out, presumably giving everyone a cleaner read on the MoM reads. Instead, the Committee appeared to panic. Or maybe they didn’t and we just think they did because in today’s world, a 50bps upward shift in the dot plot two years hence counts as a “hawkish shocker.”

Whatever the case, one thing seems pretty clear: The Fed needed to get beyond the data from April and May before telegraphing a shift in their thinking around inflation. Those were virtually guaranteed to be the two most distorted monthly CPI reports.

We should probably cut them some slack. After all, June was the last SEP “opportunity” before Jackson Hole and before what’s generally seen as a kind of “now or never” September meeting. But what does it say about the Fed’s commitment to the “transitory” narrative when they can’t even stomach the two prints everyone knew would be the quintessential examples of “transitory”?

One answer to that latter, italicized question is that it suggests policymakers really aren’t prepared to let the “overshoot” experiment get off the ground. That, in turn, raises questions about the macro implications of an accelerated tightening push, which in turn get priced into markets.

What you see in the visual (below) can become self-fulfilling. McElligott touched on that in the same Monday note mentioned above. “The risk this week then becomes that some portion of the very active calendar of Fed speakers will voice a ‘concern’ that last week’s dot plot and SEP will work against their previously stated FAIT desire and impede future growth and inflation expectations,” he remarked.

This, in essence, is what I attempted to communicate in the days since the June FOMC. The market is almost too “efficient” when it comes to pricing in policy expectations and the likely macro ramifications. It happens within days and sometimes even hours, in part due to unwinds of lopsided positions established based on prior policy expectations.

Now, at least some Fed speakers may be forced to “message just how ‘conditional'” the SEP forecasts are, McElligott went on to say.

He elaborated. The Fed, he suggested, might feel compelled to “downplay their forecasting ability in an attempt to reverse some of the market’s pull-forward of ‘tighter financial conditions.”

Of course, that pull-forward was attributable to the Fed’s own hawkish pivot, which, just a few days later, looked poised to at least partially offset their own belabored efforts to “reset future inflation expectations!” (The exclamation point is Charlie’s.)

All of this is speculation for now. We’ll see what the multitude of Fed speakers have to offer this week during a bevy of engagements.

But, if there’s a change in tone, McElligott noted that it would likely be accompanied by another “rinse and repeat” dynamic. “If the Fed again ‘bends the knee’ to market forces, the vol spike and forced deleveraging / hedging of risk assets is then reversed with ‘rich vols’ sold into, which in standard lagging-fashion will mean that as trailing rVol resets lower, a large covering of dynamic hedges (shorts) and/or mechanical re-leveraging of risk asset exposure from ‘Target Volatility / Vol Control” universe will then see markets resume their rise, as vols are smashed.”

“Crash-down,” then “crash-up.” Same as it ever was.