The Fed put on what counted as a brave face this week, when the dot plot and Jerome Powell suggested not only that policymakers are willing to do what’s necessary to tame inflation but that the US economy is resilient enough to take the medicine, so to speak.
Suffice to say not everyone’s convinced. First, there’s some skepticism that even if the Fed delivers on the new rate path and manages to get policy into mildly restrictive territory, incremental, steady tightening won’t be sufficient to get inflation under control.
Second (and this is the more vociferous debate), there’s widespread doubt about the Fed’s conviction when it comes to staying the course in the face of what’s almost sure to be a choppy equity market, a decelerating economy and an inverted curve (figure below).
“The Fed has sealed the fate of the yield curve,” BMO’s Ian Lyngen said Wednesday, following the release of the new dots. “This is a credibility enhancing event for the Fed in terms of inflation fighting and we expect this will cement the flattening trend for the time being,” he added.
Writing Thursday, Nomura’s Charlie McElligott said that in his view, “the Fed did a very nice job… owning their past errors by moving forward into a front-loaded tightening trajectory and targeting a long overdue ‘restrictive’ policy to defeat inflation.”
That said, McElligott is just as skeptical as many other market participants when it comes to the prospect of the Fed actually managing to deliver.
“Realistically, will we ever ‘realize’ these hawkish forward levels? I simply do not see that happening,” he said, noting that “the economy can’t take that for long before [it] gets crunched.”
Of course, the whole idea is to “crunch” the economy, but it takes a masochist. And, as Bloomberg’s Ye Xie wrote Wednesday, “Jerome Powell Is not Paul Volcker.”
Given that, a dovish pivot is all but guaranteed. It’s just a matter of how long it takes, which in turn is a function of when the economy starts listening to all the slanderous things the yield curve is saying about it.
“Markets are rightfully anticipating widespread curve inversions and ultimately, recession, as they price in mid-2023 cessation of tightening and over a full Fed cut in 2024, which could very well be pulled into 2023,” McElligott went on to say Thursday.
As for the proximate cause of stocks’ three-session rally, Charlie was unequivocal. He cited the same options-related dynamics I’ve covered day after day, in the face of what I think it’s entirely fair to call asinine financial media coverage, some of which went to absurd lengths on Tuesday and Wednesday to find a Ukraine ceasefire that wasn’t there or some soundbite from Powell which wasn’t there either in order to “justify” and otherwise explain equity strength.
As ever, Charlie had the real story. “My Fed-week ‘rally into OpEx’ call was largely due to the certainty that so much of the epic ‘short / negative delta’ was front-week, and that as we cleared the Fed event risk, the market would begin to stop-hunt this mass of expiring puts,” he said Thursday. “As implied vols have been absolutely rinsed from highs over the past few days, the vanna impact has been enormous as those OTM puts / downside hedges have been destroyed and dealers have had to buy back their short hedges in equities futures.”
The bad news, from a near-term, tactical perspective, is that folks still aren’t aggressively playing offense. “We’re still not seeing a wholesale client shift to ‘chase,’ at least as of yet,” Charlie remarked. “In fact, contrarian signal or not, most conversations remain about timing the fade or putting hedges back on into the rally.”
“when the economy starts listening to all the slanderous things the yield curve is saying about it” – love of a good turn of phrase, that’s a keeper!
Powell needed to convince the markets that he’s serious about fighting inflation by delivering a hawkish surprise. He failed. Markets read the Fed move as dovish. Yields are down, dollar is down, stocks are up and analysts are touting buying opportunities. When you can’t tighten much, you front-load as much as possible. This was his opportunity and he blew it.
I’ve got a gut feeling there’s various shoes that haven’t been dropped yet, but of course there may be opportunities to ponder. Actually, that’s what I’d be saying about post COVID and Fed QT, but, I think it’s a bit early to be ramping up optimistic thinking as Ukraine burns. Furthermore, the dynamics related to Russia defaulting probably aren’t fully accounted for.
“S&P SAYS AT THIS POINT, WE CONSIDER THAT RUSSIA’S DEBT IS HIGHLY VULNERABLE TO NONPAYMENT”
Was easier to play offense when the starting QB was expanding his balance sheet.
I’m thinking the “put reload process” starts again next week (…try to avoid paying for the weekend, cross fingers for no major bombs (literally) until next week, maybe pick them up a bit cheaper if implied’s keep drifting lower).
Also, have longer-dated UST’s repriced enough to once again be good equity hedges for bad geopolitical events ?
The Fed would be wise to gradually increase short rates. The worst thing for them is to bray too much about tightening and shrinking the balance sheet aggresively and then have to do an about face 6 months later. But that seems to be what is the cards.
#RIA – It looks like Bullard strongly disagrees. Why do we entrust someone with zero.zero private sector experience with the economic well-being of hundreds of millions of people in the USA and around the world?
Lift your eyes from your models Jimmy– you are not playing a video game.
Perhaps Powell isn’t Volcker but he can certainly see what was done before and copy it if would be appropriate, so just saying he is not PV is nonsense. Powell is not a king, he is a committee chair. His FOMC is not the same as Volcker’s, nor it the Congress he faces or the economy. We need to remember when we throw all that love at the past guy the inflation he stopped dead in its tracks had been going on since the early 1970s. Nixon tried to attack it with price controls, which created black markets, massive corporate cheating and general chaos until the program was disbanded. There was still inflation for Volcker to tame ten years later.
Our 24-hour news cycle destroys the good sense of those who follow it. Today I constantly see stuff like, “wow, rates are the highest they’ve been all the way back to June, 2021 or some such crap. We’ve lost track of the reality of proper context. We’ve also lost our patience. COVID “surprised” us and found the weakness in the JIT strategies that firms had been employing for decades in a race to ratchet up their margins. The market loved that but each tightening of the JIT cycle raised the risk of a messy impact should the cycle be disrupted. COVID showed us the error of flying too close to the sun. It will take some time to repair what has happened and there is nothing Powell or Biden can do will fix this root cause, no more than Nixon’s damn price controls could do. There is no instant fix and I suspect business will think twice about returning to their recent high risk strategy. I already see firms adjusting plans for new plants, stockpiling scarce parts, and generally putting some slack back in the cycle. Let’s hope it works but before 2025, I doubt it.
Some great context there, Lucky One. How about the WIN (Whip Inflation Now) buttons we sported for a few months?
But your salient point about how we investors rewarded companies which outsourced and relentlessly sought out the cheapest producer and punished those who did not really nails it.