If Stocks Don’t Get Him, The Curve Might

Thursday’s overarching narrative was that this time around, Jerome Powell isn’t going to bend the proverbial knee to equities.

The emphasis on “this time” is, of course, a nod to Powell’s dovish pivot on January 4, 2019, when, while seated next to Janet Yellen and Ben Bernanke, our shell-shocked protagonist took the first steps down the road to abandoning the rigid policy stance that contributed to the worst December for US equities since the Great Depression.

Were it not for the pandemic, that U-turn would’ve defined Powell’s first term as Fed Chair. It may have been his legacy. The familiar figures (below) offer a trip down memory lane.

Powell was mercilessly lampooned for the abrupt about-face illustrated by the figure on the left (above). Some critics conveniently omitted any reference to the angry president with the rogue Twitter account who spent the better part of two years arguing publicly for negative rates, aggressive debt monetization and competitive currency devaluation. At one point, he went so far as to suggest the Fed was actively seeking to subvert America’s economy by not easing fast enough, and reportedly explored avenues for “firing” Powell.

I bring that up because those with a penchant for poking fun at the Fed always seem to “forget” that it wasn’t just stock prices “asking” for a dovish pivot in 2018 and throughout 2019. In fairness, Twitter is a relatively new invention, so it’s possible that previous presidents would’ve been equally vocal about their own policy preferences, but somehow I doubt it. The only person more adamant than Donald Trump about the benefits of a beholden central bank is Recep Tayyip Erdogan.

In any case, politics is a factor this time around too, only now, political expediency demands rate hikes, not rate cuts. That puts politics at odds with markets. At least until the US slides into a technical recession, possibly as early as the advance read on Q2 GDP. (I’m just kidding. Or not.)

In the meantime, the vaunted “Fed put” does appear to be struck much lower. Powell did manage to get that across on Wednesday afternoon. Market participants now view equities as being “in the crosshairs,” Nomura’s Charlie McElligott wrote Thursday, noting that Powell’s emphasis on the difference between this cycle and last telegraphed an extreme hawkish asymmetry. “The Fed has shifted into an outright asymmetric view on inflation, with zero tolerance for further upside surprises from here,” he added.

It wasn’t obvious (to me anyway) that Powell meant to put so much emphasis on the “this time is different” point. Everyone understands current conditions are nothing like those that prevailed when the Fed last attempted to normalize policy (figure below). Powell wasn’t telling anyone anything new when he noted that CPI wasn’t 7% in 2015 (or in 2018), nor was it news to anyone that the labor market looks quite a bit different now than it did then.

Powell, bless him, may be “nimble” in his approach to making policy, but he’s the furthest thing from it when it comes to discussing policymaking in real time. On Wednesday, he seemed to run out of ways to deflect inquisitive reporters attempting to extract specifics about the timing, pace and scope of forthcoming rate hikes. Lacking the kind of deep mental Rolodex one needs in such a scenario, he repeatedly defaulted to a talking point about the differences between 2022 and yesteryear, making it seem as though the juxtaposition had somehow just dawned on the Committee — as if January was the first time it had occurred to them that economic conditions really are anomalous right now, and thus demand an appropriately aggressive policy response.

In any event, it doesn’t matter now. Markets heard what they heard. And what they heard was an acknowledgment that the Fed put, to the extent it still exists, is struck much lower than spot equities. That opened a trapdoor in Asia, but stateside, stocks are still caught up in the “mad Greeks,” and thus aren’t to be trusted.

It’s possible that, in our zeal to guesstimate where the Fed put might be struck in 2022, we’re overlooking the fact that US equities are already down 10% and the Fed hasn’t even started tightening yet. Indeed, they’re still actively easing. A 50bps rise in 10-year reals over four weeks was good for ~11% lower on the S&P (at the lows), with Fed funds still glued to the lower bound and QE flows still in the market.

Extrapolation is always spurious, so I’ll just pose this as a question: What does that say about the odds of the Fed being able to hike five (or six) times in 2022 while simultaneously running down the balance sheet? If that’s the plan, they stick to it and growth decelerates meaningfully, stocks will — how should I put this? — de-rate “like nobody’s ever seen before,” to hijack one former president’s bombastic cadence.

“The inability of stocks to retain a bid wasn’t particularly encouraging for the Fed’s potential to deliver more than the 100bps of hikes priced in for 2022,” BMO’s Ian Lyngen and Ben Jeffery wrote, in their characteristically measured tone. “As weakness in equities extends, concerns regarding overall financial conditions could leave investors apprehensive the Fed might lack the conviction to accelerate hiking if the inflation data dictates.”

Yes, indeed. And if stocks don’t get to Powell, maybe the curve will. “The one clear theme is in UST curves, where traders seem intent on twist-flattening these things until we invert into a (premature) ‘recession’ signal,” McElligott remarked. The 2s10s flattened aggressively on Thursday, for example (figure below).

That “put[s] the low from November 2020 at 57.8bps as a next logical target,” Alyce Andres wrote. “Beyond that, some are targeting the 40-50bps area.”

It also seems possible the Fed isn’t satisfied that reals have risen enough. They’re still deeply negative out to the 10-year. If the Committee’s hawkish bent exacerbates burgeoning growth concerns, putting further pressure on breakevens, they may not have to wait long for reals to make a run at positive territory.

I’d be concerned about Friday were it not for the distinct possibility that a lackluster read on personal consumption for December serves as an “offset” of sorts to what’s almost guaranteed to be another hot ECI print. PCE prices will come in scorching too, so it’ll be incumbent on University of Michigan sentiment to douse the flames with more dour commentary about the extent to which the consumer is discouraged by higher prices. Of course, if the Fed isn’t going to be deterred anyway, then the combination soaring labor costs, above-target inflation and a discouraged consumer could be the worst possible combination. It may not even matter depending on what Apple reports.

McElligott on Thursday wrote that Powell “effectively ‘co-signed’ recent financial conditions tightening.” “I’d say that any substantial rallies from these levels in equities gives the Fed further ‘hawkish clearance’ to bomb-out high strike calls,” he added.

Let’s see how brave Powell is if (or when) the curve inverts on him.

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9 thoughts on “If Stocks Don’t Get Him, The Curve Might

  1. I think we’ll see another 50bps rise in reals and 10% drop in the S&P before the first rate cut in March. After two quarter-point increases (March and April), I think the Fed will pause a month or two to reassess. Maybe it’ll pause on rate hikes and opt instead for a modest amount of QT. (No reason they need to do both at the same time.) I think a 20% drop in the S&P, two quarter-point hikes, and steady improvement in the supply chain situation should be enough to cap inflation expectations. But if inflation is still running at 7% and/or rising in March-April, all bets are off.

  2. H is correct about equity market not being the binding constraint for the Fed that it was. But the yield curve is- and even more important are credit conditions. If you see credit spreads widen significantly, I don’t really care what the stock market or yield curve does, the Fed will at least pause. My own guess is the curve flattening more will proceed a credit widening – if stocks somehow manage to escape the initial curve flattening a credit widening event will likely doom the stock market. Powell and the FOMC are talking dirty now- and the market is obliging by tightening financial conditions before the Fed even fires a shot. It really looks like the Fed will not want to or be able to tighten 5-6 times this year. Our economy is so leveraged that it won’t take that type of rapid tightening in a short time frame. You are already seeing an inventory build. That is the first step to supply chain normalizing. If you start to see nominal growth go down significantly the Fed won’t be tightening anything near the talk. For many moons I have been saying the Fed ought to target nominal growth as one of its metrics. Why? There is no argument over which is the right inflation number and the gross number is easier and more useful a figure anyway. Figure 6% is a good number- at that level growth should be ok, and inflation should be tolerable as well. When the nominal rates sinks much below 4.5% you are looking at stall speed for the economy.

  3. I am concerned about yield curve as well. 2Y-10Y of only 60 bp is full of pre-recession cues. Zoltan (CSFB) opined the Fed should actively sell Treasuries rather than passively let them run off, in order to target specific parts of the yield curve. The Fed’s $5.4TR of Treasuries is 20% 0-1Y, 38% 1-5Y, 18% 5-10Y, 24% 10+Y. So a passive run-off approach to its Treasuries would mean shedding only short maturities for some time. Seems that would push the short end up more than, or sooner than, the long end. Add economic slowdown fears and we could have a flat curve by mid-year. Since the market front-runs everything, make that “in a couple months”. Even if the Fed doesn’t care – and surely they do? – the banks and all manner of non-bank financial players sure will. Some big and hitherto unknown (at least to me) carry player blowing up could cause the widening credit spreads described by @RIA.

  4. H-Man, Powell just can’t say no to a question during a fed presser which is the reason he sends markets sky rocketing or diving. Mostly diving. Yes the inverted curve has preceded recessions but generally it takes time before the big R lands. The curve inverted in May of 2019 and then again in April of 2020 when Covid hit. But when the curve inverted then, the recession that started in February was over by April. The curve inverted in 2005 but the Great R didn’t show up until 2007. So if it inverts, not sure a R lands immediately. It would seem this market still has legs since Omicron appears to be in the rear view mirror.

    1. The problem is that this cycle is going a lot more rapidly than in recent years including the great moderation prior to the GFC and post GFC. That is partly by design- the governent stepped in with a bazooka gun of fiscal and monetary stimulus. Part of that stimulus, pulled forward demand for durables, especially housing and autos which were further supercharged by demand from a market basket shift by consumers. When car production picks up, and more housing gets built do you think there will be that much excess demand for those things. The only fact that might bail these sectors out after 2023 is demographics- the millenials are now in the ideal age range for those things. And it is a big demographic cohort. The rise in inventories is a hint of more of this to come.

      1. A typical late cycle performer is oil and gas. And perform it is, but a look at cycles would suggest that we are closer to the end of this one than the beginning.

        1. Oil and gas seem like THE under appreciated story at the moment. The market is perilously tight. The read through of any worsening imbalances could be quite severe for inflation, politicians careers, and most people’s budgets.

        2. IIRC other typical late cycle performers are in industrials sector, and that is working too. Another hiding place has sometimes been so-called “secular growth” names, but . . .

          I agree this cycle is looking super-speeded. I don’t have much conviction on whether we actually get a recession, or whether it is a “real economy recession” or a “technical recession” or a “growth recession” or whatever – I’m even confusing myself. But the late-cycle playbook needs to be dusted off. Will be hard because the last time I looked at it, a big part of it was “buy IG”.

      2. @Rolling-In-Assets: How “rapidly”? So “rapidly” they won’t even have time to resurrect FLAT (iPath U.S Treasury Flattener ETN) and STPP (iPath U.S. Treasury Steepener ETN) perchance?!?

        Rooting around, a habit wee worms share with bears, for fun facts not already covered about bear-flattening conditions, looking especially for graphics of such times in the wayback, I probably failed in the “fun” quest, but, at least I stumbled upon old interesting @H tracks deep down in his seekingalpha article stack. So many great headlines, alas, so little time.

        The key point @hookandgo might bear in mind, is that S&P500 returns are not likely to be stellar in 2022, with or without a “big R”, but, also bear in mind, degraded SPY performance will precede in real-time (now-time) any big R (which is only determined to be a Recession in hindsight, so not really all that interesting/useful to us in the present). A typical quote suggestive of the prevailing wisdom surrounding bear-flatteners then and now, is in this example from The Purchasing: The magazine for chief procurement officers and Supply Chain executives, February 3, 2005 Volume 134 Number 2 (“The Metals Edition!”), by none other than “Robert Doll, president and CIO at Merrill Lynch Investment Managers in New York”, presented as predictions for the year ahead:

        “4. Interest rates continue to move higher as the “bear flattener” takes the Fed’s rate to 3.5% and drives 10-year Treasury yields to 5%.
        5. U.S. stocks struggle, but outperform bonds and cash for the third year in a row.”

        Doll suggests poor stock performance is anticipated relative to prior years, but, not necessarily in absolute terms.

        The rub though is we are always in danger of getting to comfortable and confident with received ‘wisdom.’ It’s like a default setting our brains have. Every time I get my mind blown and have to push in the microscopic little red reset button I’m right back to “conventional reception” default. Yet another straightened paper-clip ruined! The path of least glucose burn I suppose. Conventional wisdom current sample,

        “The quick rise in Treasury yields, especially on the short end of the curve, has pushed us into a Bear Flattener regime. During those periods, the S&P 500 has showed the weakest growth. Other assets haven’t done much better. Real Estate, Financials, and Value stocks have typically performed the best.”

        How then to vigilantly mind the bear traps? How to avoid self-disarming in the presence of the comfortably conventional? How to remember to at least reconsider base rates? What system do we have in place to routinely revisit investment assumptions and re-test them? Not that “conventional” is all wrong all the time. It is often a ready made starting point and that can cut down on initial flailing around time while looking for some purchase on new/old problems. Guess that’s where the @H value-add comes in if we’re lucky enough to read/understand the right post(s).

NEWSROOM crewneck & prints