Onomatopoeia: The Guaranteed Dovish Fed Pivot

This is a bit of a broken record, but I’d be remiss not to emphasize it on the first day of a new year: Fed tightening cycles usually don’t end well.

That’s not to say they always end in disaster, nor is to suggest that equities will necessarily be the casualty this time around.

Rather, it’s just to say what BofA’s Michael Hartnett says whenever the opportunity presents itself. The familiar figure (below) illustrates the point and provides some useful historical context. Many readers have seen it before, here and elsewhere.

We can quibble about cause and effect. And some historians would surely take issue with the somewhat simplistic narrative suggested by that annotated visual. But the overarching point — that something, somewhere is likely to “break” or “snap” or [insert onomatopoeia] — stands.

Coming out of a year that found US (and global) equities putting on quite the show, it’s reasonable to ask whether the persistence (and scope) of monetary accommodation delivered over the pandemic has further reduced the threshold beyond which stocks are unable to digest rate rise with anything approximating alacrity.

While acknowledging it’s the rapidity of rate rise that matters (figure on the right, below) more so than the absolute level, there’s certainly an argument to be made that the longer accommodation persisted (and the further asset prices drifted from levels consistent with real price discovery), the lower the bar for rate rise to trigger a dramatic repricing, especially when real rates climb in an environment of elevated multiples.

As I never tire of reminding readers, Jerome Powell discovered in Q4 2018 that 1% on reals was the breaking point (figure on the left above). Anyone care to venture a guess what the threshold might be now?

This is problematic in 2022 not just because US equities entered the year trading on some of the highest multiples since the dot-com era. It’s also potentially perilous due to the read-through for reals of any additional moderation in breakevens catalyzed by, for example, an abatement of inflation, a failure of commodities to deliver an encore after rising 27% in 2021 and/or additional dollar strength.

If anything, one might suggest the above argues for a less aggressive tightening cycle, lest Powell wants to begin his second term the same way his first term began — namely, by overestimating the amount of tightening the market can handle.

Note that the December vintage of BofA’s Global Fund Manager survey showed short rate expectations are the highest since November of 2018.

The last time the net percentage of survey respondents expecting higher short rates was this high, Powell was less than two months away from the dovish pivot that would’ve defined his tenure as Fed Chair had the pandemic not rewritten the script.

“Feel the market.”

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