Dovish Hawks Or Hawkish Doves? McElligott On The Fed

Plainly, Jerome Powell risked further destabilizing fragile US equities at the January FOMC press conference.

Stocks wanted a “wink,” and while markets understood that Powell’s hands are tied given the inflation situation, a risk-friendly outcome would entail “merely” confirming the likelihood of a 25bps (so, not 50bps) March hike, an obligatory nod to balance sheet runoff commencing sometime thereafter (preferably not until, say, June) and an acknowledgment that financial conditions have tightened recently, in part due to falling stock prices.

The balance sheet discussion was particularly challenging. A decision to bring forward the end of the taper by a month would make (almost) no difference from a flows-perspective, but the signaling effect would matter. Arguably, it would convey panic.

Turning to the more nuanced (and more important) balance sheet debate, there’s pressure on the Committee to do something “different” with the MBS portfolio given the challenging optics of surging home prices. Markets aren’t necessarily averse to that idea. But (and this is key) it should be noted that equities were more sensitive to MBS during the last attempt at balance sheet normalization than they were to Treasurys (see the linked article below).

Read more: The Hidden Risk From QT 2022

I don’t want to spend too much time on the issue here, but suffice to say if the Fed is thinking of actively selling MBS, it would be best to socialize that carefully (and gradually) via prepared public remarks from other officials, not foist it on markets via ad hoc riffing from Powell two months before liftoff.

There were any number of other hawkish/bearish permutations. A lot could’ve gone wrong, with predictable consequences for risk assets. “Balance sheet commentary is the chief source of ‘hawkish risk,'” Nomura’s Charlie McElligott said Wednesday, prior the release of the new statement and press conference. “As it pertains to questions on FCI, Powell could also ‘disappoint’ equities in the sense that I would expect him to counterbalance any (hope-based) ‘dovish’ mention of recent equities volatility by simultaneously noting that more ‘economically important’ credit spreads remain near both post-COVID and post-GFC tights.”

As far as what could go “right” (for risk assets) and thereby slingshot stocks out of their unprecedented January malaise, McElligott talked a bit about the implications of a “dovish surprise” or a “dovish hawk” scenario.

“Any modicum of ‘dovish surprise’ versus already high and well-messaged ‘hawkish’ expectations… risks a ‘momentum shock,’ disrupting a currently crowded ‘trend-friendly’ market, as per CTA positioning in 1) bearish / hawkish bonds and rates, along with 2) ‘short’ equities,” he said. The figures (below) are instructive.


Speaking further to that, McElligott wrote that any kind of dovish permutation would present “a strong reversal risk versus current CTA Trend positioning, which is almost consensually ‘short’ G10 bonds and MMs alongside global equities futures.”

He went on to emphasize that the real upside catalyst for stocks in the event Powell’s hawkishness is dovish, would emanate from the vol space via “vanna- and gamma- impacts from client downside hedges being hammered and unwound.”

That’s the same dynamic discussed here at length on Tuesday. Charlie calls it the “slingshot” and while he walked through it step by step on Wednesday, he also summarized it.

“All of the grab for ‘crash-y downside’ hedges seen Friday and Monday has exacerbated the extreme ‘negative gamma’ dynamic that has been throwing us from one side of the boat to another, with hedge flows ‘chasing’ in both selloffs and rallies,” he wrote.


That combustible setup “could finally allow for a ‘vol crush’ if we clear the Fed with no new hawkish surprises or even a ‘dovish hawk’ message, and puts are precipitously unwound, sending vol lower and forcing dealers to buy back hedges,” McElligott said, spelling it out.

Do note that irrespective of how Wednesday turned out, the above is extremely relevant going forward, because until the tension between Fed policy, macro realities and “spoiled” risk assets is resolved, the rollercoaster will probably persist, notwithstanding the return of various stabilizing flows (e.g., buybacks).

As noted here on Tuesday, there really is no “right” way to approach the situation if you’re Powell. This would’ve been far easier last year, when growth was unequivocally strong enough to fund a few hikes. Now the risk is that the economy is teetering and the Fed accidentally hip-checks it off a cliff while shooting from the hip at inflation.

On the other hand, retreating now chances not just delaying the inevitable, but making the inevitable more risky than it already is. A dovish pivot could be “counter-productive to the goal of reining in ‘too loose’ financial conditions, which have facilitated excesses in markets,” McElligott wrote Wednesday, on the way to noting that the Fed also needs to be cognizant of the possibility that “crimp[ing] some of the demand impulse” might help mitigate at least one of the factors feeding inflation.

“The perverse thing is, the more bullishly equities trade, the more scope markets then have to price in [an even] more ‘hawkish’ Fed [that’s] forced to tighten FCI more aggressively” if inflation remains elevated, he cautioned, adding that one way or another, “this will remain a traders’ market as long as we remain in a tightening regime.”

NEWSROOM crewneck & prints