McElligott On Reflation’s Fate, Kocic On Fed ‘Short Covering’

“We’ve got a lot of processing ahead of us,” Larry Summers mused, during remarks to Bloomberg’s “Wall Street Week.”

“There will probably be more turbulence,” he added.

That’s the kind of groundbreaking analysis you can count on Summers to deliver if you ever decide to pay him a “contributor” fee, as Bloomberg does.

Summers was referring to the market grappling with higher inflation, which he said should be “pretty close” to 5% at the end of the year.

For what it’s worth (which is very little) Jeremy Siegel also said Friday that he expects markets to do more “processing” as traders and investors attempt to sort out the implications of higher inflation and a Fed that’s perhaps not as excited about countenancing an overshoot as some officials suggested.

“I said we’d have some ‘taper tremors’ in the markets, and we’re going to have some more of those,” Siegel told CNBC. “I’m not as sanguine as Jay Powell that this is going to be fleeting,” he said, of inflation. “But at the same time, that’s not bad for stocks.”

What could be “bad for stocks,” though, is any kind of aggressive pull-forward, wherein markets price an accelerated tightening timeline. One saving grace continues to be the necessity of completing (or mostly completing) the taper prior to hiking rates. There’s no rule that says that must everywhere and always be the case, but as Jim Bullard acknowledged, markets aren’t prepared for a scenario where liftoff occurs prior to the end of tapering.

Summers’s “processing” and Siegel’s “taper tremors” are likely to manifest in more reflation “on/off” like that seen over the past eight sessions.

Nomura’s Charlie McElligott provided a bit of granular detail on how folks are thinking about this at the current juncture. Essentially, there are two camps.

For some, he said, “it was rational that rates would rally on the market’s adjustment to the perceived shift in the Fed’s reaction function, interpreting last week’s FOMC SEP and Dot update as indicating that the Committee has a lower tolerance for inflation overshoot and economic overheating risk than previously expected, which then accelerated the ‘tapping-out’ of ‘overheat’ / ‘overshoot’ trades.”

That’s the dynamic you saw when the curve dramatically bull-flattened in the wake of the June FOMC. That partially reversed this week (figure below).

For other market participants, though, the Fed’s messaging actually hasn’t changed. Rather, “they simply adjusted to the average inflation target > 2.0% trend being accomplished now or in Q3, depend[ing] on your trailing lookback period,” McElligott said.

Going forward, then, it’s all about the labor market. Although recent data suggests states which preemptively stopped providing enhanced unemployment benefits haven’t seen a sustained uptick in job searches, one imagines the complete rolling-off of pandemic programs will inject a sense of urgency into the situation for many workers, even as the contours of the post-pandemic labor-capital relationship continue to evolve in the context of a more Progressive political climate.

At some point later this year, labor market tensions should ease. Or so the story goes. At that point, the economy will move more swiftly back to full employment (assuming that term still has any meaning considering the tweaked language in the Fed’s mandate and the Phillips curve’s “Norwegian Blue” act), reigniting reflation momentum in the process.

“To many, ‘reflation’ trades aren’t necessarily dead at all,” McElligott went on to say. “Instead, the trades in ‘inflation upside’ are simply on hold until the next catalyst, which is likely labor market improvement anticipated into the Fall ‘turn’ on jobless benefits expiration [or] more data-dependency on continued strength and/or outlier ‘beats’ in core CPI/PCE.”

In his latest, Deutsche Bank’s Aleksandar Kocic elaborated a bit further on the FOMC’s credibility balancing act and, relatedly, the Fed’s management of the “flexibility” built into their deliberately ambiguous average inflation targeting calculus.

“To ensure its influence over financial markets, the Fed must maintain its credibility. In that context, it is effectively always short an OTM option,” Kocic wrote, adding that,

As inflation has rebounded from the dip in 2020, that option began to move closer to the strike, putting the Fed in a more negatively convex position. To cover that short exposure, the Fed acquired additional convexity by retaining an option (underwritten by the market) to choose a flexible averaging window in FAIT, which would enable it to (credibly) delay rate hikes. However, persistently strong CPI prints in the last three months have gone against that flexibility and the value of the Fed’s chosen option. [The June] dots release can be seen as another installment of short convexity covering by the Fed. Instead of a firm consensus around zero rates in 2023, as expressed by the March dot plot, the latest release shows an (approximately) even distribution of views between zero and six hikes. This means that the market has become vulnerable to data shocks, which could recenter the consensus anywhere within this relatively wide range of rates. Effectively, with this maneuver the Fed has withdrawn convexity from the market, while covering its short exposure.