Bad Optics

Traders will attempt to find their way back from “dark places” in the new week.

And I don’t mean waking up in the Hyatt Grand Central with no idea why you’re there, wandering down to the lobby, bleary-eyed, and catching the Harlem Line home.

Rather, I mean that place in our collective memory where a pandemic plunges the world into a fleeting depression, triggering one of the most harrowing (albeit equally ephemeral) market collapses in modern history.

“We know that the market hates unknowns, so in the absence of information, people often go to dark places,” Kara Murphy, CIO of Kestra Investment Management, told Bloomberg’s Vildana Hajric and Michael Regan for the latest episode of the “What Goes Up” podcast. “The market is assuming the worst about this new variant. At the same time, we’re seeing more evidence of inflationary pressures,” Murphy added.

In all likelihood, market participants will know something more definitive about the Omicron variant in the new week, although the only context in which “definitive” is a more relative term is if the conversation is about equities being “cheap” compared to an asset that spent the last four decades in a virtually uninterrupted rally (figure below).

At least on one benchmark, the bond bull market ended earlier this year, but market participants were too quick to write the obituary. 10-year yields are the lowest since the September Fed meeting, and 30-year yields the lowest since January.

Breakevens have come off the boil (figure below) as crude retreated from recent highs, while Omicron and the prospect of a Fed policy error weigh on the growth outlook.

For BMO’s Ian Lyngen and Ben Jeffery, the key nuance for rates headed into the new year is the extent to which expectations for policy tightening serve to preempt and otherwise forestall a “truly trending bear market” in Treasurys. “We suspect that as progress toward higher nominal yields is achieved, this will be accompanied by rising rate-hike expectations and a moderation of breakevens; after all, the forward risk of inflation lessens the more aggressively a central bank responds,” they wrote, in their year-ahead outlook.

They continued, noting that “this translates to higher real yields which correspond with the underperformance of risk assets.”

That speaks to some of the key dynamics discussed at length here in “Zeitgeist: Tightening Into A Slowdown.” As Lyngen put it, “a tighter monetary policy stance invariably leaves risk assets vulnerable, a feedback loop which will become particularly topical in the year ahead.”

Indeed, it’s topical in the week ahead. With Jerome Powell having jettisoned the “transitory” characterization of inflation, all eyes will be on November CPI. Consensus is looking for a 6.7% YoY print on the headline, up from 6.2% in October. The market expects to hear prices rose 0.7% MoM and 0.5% on the core gauge (figure below).

That isn’t any layperson’s definition of “transitory.” Powell last week acknowledged that most Americans think “transitory” means “short-term.” That wasn’t the Fed’s intended definition, he suggested, somewhat sheepishly.

If the headline print is 6.7%, it would be the highest print since March 1982 (figure below). But who’s counting, right?

Given the decidedly poor inflation optics, it’s highly unlikely that Fed officials will be inclined to cite November’s jobs report in deferring an announcement on an accelerated taper timeline. There was quite a bit to like about the report despite the headline miss, although the poor showing from leisure and hospitality raises questions about services sector hiring as the nation confronts a more transmissible virus variant.

The new week also brings October JOLTS which are guaranteed to show labor supply remains hopelessly inadequate. The preliminary read on University of Michigan sentiment for December is on deck as well.

Although a faster taper seems like a foregone conclusion, markets may be out ahead of themselves on liftoff timing, especially if the data begins to cool off as the new year dawns. “We continue to expect significant slowing in inflation and growth in 2022 as fiscal stimulus fades, and we believe even modest slowing will encourage officials to be patient in their quest for maximum employment,” TD’s Jim O’Sullivan and Priya Misra wrote last week, before conceding that “stronger than expected data in Q4 are helping move the economy a bit closer to maximum employment, and Chair Powell is showing new hawkishness following his renomination.”

The figures (above) are self-explanatory. If markets are overzealous about pricing the rates trajectory, it wouldn’t be the first time. And it’s not about the absolute level of fiscal largesse, it’s about the rate of change.

Finally, note that politics will come into play in the new year. Plainly, the Biden administration would like to avoid a scenario where Republicans can cite spiraling inflation ahead of the midterms as evidence that Democrats are mismanaging the economy.

“US inflation is up from 1.4% to 6.2% [while] Biden’s approval rating is down from 56% to 42% YTD,” BofA’s Michael Hartnett remarked, calling inflation “an economic and political problem.”

The Fed, Hartnett reckoned, is “set to be very hawkish [over the] next six months.”

Of course, a “very hawkish” Fed likely entails a rough ride for risk assets, including and especially stocks. Although equities are overwhelmingly concentrated in the hands of the wealthy, Donald Trump proved that untold millions of voters can easily be convinced that the economy is synonymous with stock prices.

In that respect, Powell will need walk a fine line between tightening enough to help improve the inflation optics, and not so much as to engineer a market crash.

But the Fed is independent. So he won’t concern himself with optics.