A Fully-Priced Fed And The ‘Real’ Danger Zone

I’ve said this before, and it turned out to be wrong, so I hesitate to say it again. But I’m going to say it anyway: The Fed is fully priced.

Markets started to get anxious about the prospect of aggressive monetary tightening in October, when the BoE was stirring, the BoC was pivoting and the bond market was testing the RBA’s resolve on yield-curve control. Tightening bets took a breather when the BoE balked at hiking in November, and the arrival of Omicron briefly raised the specter of a return to 2020-style lockdowns, but once Jerome Powell formally jettisoned “transitory,” the die was cast. Inflation wasn’t going away anytime soon, and policymakers in developed markets had acquiesced to the necessity of fighting a battle they suspected they might lose, not for lack of fortitude, but for lack of wherewithal — rate hikes and quantitative tightening can’t repair supply chains or coax workers off the sidelines. Not directly, anyway. Only indirectly, through demand destruction.

In the months that followed, there were innumerable occasions when it felt like there was nowhere else for market pricing to go — we’d reached “max-hawkishness.” Or so everyone thought. Then another data point would make the case for even more tightening.

Notwithstanding calls from some pundits for what, in the post-GFC era, would count as laughably draconian hikes, it’s difficult now to see how markets could realistically push the issue much further. As detailed here extensively, delivering on the dots and/or market pricing and implementing balance sheet rundown already means the Fed is destined to overdo it. Indeed, the market already knows this, which is why rates are pricing a dovish pivot as early as midway through next year.

“The market focus is transitioning from a ‘front-loaded tightening cycle’ obsession which began in Q4 2021,” Nomura’s Charlie McElligott said, on the way to suggesting that “in the absence of new upside inflation data surprises, [the Fed] looks increasingly priced-in after such an impulsive shift anticipating restrictive policy in extremely short order, with a much higher terminal level in 2023 than anybody thought was possible just weeks ago.”

Consider that back-to-back 50bps moves are now (basically) priced for May and June, and as McElligott went on to note, as of late last week, the market was “pushing towards three consecutive 50bps hikes by mid-summer, while also expecting QT to hit ‘max caps’ by August.” The figures (below, from Nomura) underscore the point.

That’s why stocks have started preemptively trading a hard landing. Equities, Charlie wrote, “are now operating under an assumption of US economic contraction / recession eventuality.”

It’s going to be very difficult for stocks to break substantially higher at the index level against those kinds of policy expectations. And even if equities did manage to make a run at new records, the Fed would dial up the hawkishness in order to prevent the easing impulse from higher stocks from overwhelming the tightening impulse from surging real rates (for example).

Previously, such rhetoric forced markets to price-in additional hikes and compelled analysts to bring forward their calls for balance sheet runoff. Now, any new hawkish verbiage will likely just serve to cement expectations for a policy-induced downturn.

The Fed hasn’t had much success recently in capping stocks, but I’d reiterate that the rally into quarter-end was a positioning- / flows-driven squeeze, not a fundamentals-based vote of confidence in the market. Indeed, stocks are now disconnected from the reality of real rates.

One problem for the Fed was the mechanical impact of rising breakevens that accompanied the onset of hostilities in Ukraine. Higher inflation expectations pushed real yields lower, providing a tailwind for equities.

But, as the updated figures (above) show, reals are now trekking relentlessly higher, up nearly 90bps in a month.

I’d gently suggest that positive 10-year real yields could be a severe psychological impediment for equities, especially in the event earnings season is accompanied by more margin contraction than expected and/or guidance that’s too cautious for comfort.