Two weeks ago (give or take), I detailed the “the simple reason” US equities needed to fall another 15%.
At the time, the S&P was around 4,270, or 3.5% above where it was trading on Thursday afternoon, amid one of the worst single-session routs since March of 2020.
But the important level for our purposes here isn’t where the S&P closed on Thursday, but rather where it closed the day before, when Jerome Powell triggered a monumental surge by effectively ruling out rate hike increments larger than 50bps.
Wednesday’s rally, a 3% barnburner, put the benchmark at 4,300. So, above where it was trading on April 23, when, according to Goldman’s David Kostin, the Fed still needed to generate an additional 75bps of tightening in financial conditions “in order to slow wage growth to [a] pace that would be consistent” with 2% inflation.
That additional FCI tightening would come on top of what, at the time, was 138bps of YTD tightening on Goldman’s index (figure below).
If history is any guide, a 75bps tightening impulse would include a 9% drop in equities, but as Kostin wrote, “bears point out that stocks have driven most of the FCI easing in recent years and argue that equities should therefore account for most of the tightening going forward.”
Whether you buy that argument (that equities, not credit spreads or the dollar or long-end yields or rate hikes) should shoulder the burden is irrelevant for this brief recap because, again, Wednesday’s rally served to offset (partially anyway) incremental tightening seen over the past 10 or so sessions.
Note also that the post-FOMC trade included a big move lower in the otherwise buoyant dollar (figure below) which, again, works at cross purposes with the Fed’s efforts to tighten things up.
The Fed needs some combination of lower stocks, higher yields, wider credit spreads and a stronger dollar. All conspiracy theories aside, stocks are, to a certain extent, expendable when the alternatives are a disorderly rise in bond yields, sharply wider credit spreads or an unruly surge in the greenback. A malfunctioning Treasury market is a total non-starter. Credit turmoil can spill over into the real economy fast. And while everyone claims they want a strong dollar, too much of a “good” thing can be destabilizing, especially if it’s driven by rapidly rising real yields.
In essence, Powell may have viewed the market reaction to Wednesday’s press conference as counterproductive. If so, Thursday’s reversal might have been welcome news at the Fed. Relatedly, you could suggest Thursday’s bond rout was the market telling Powell that although Wednesday was fun, it’s going to take more than predictable, well-telegraphed 50bps hikes to slay the inflation dragon. (That comes with the caveat that there was notable nuance in Thursday’s bond fireworks — I discussed it here for those interested.)
Bloomberg’s Katherine Greifeld and Vildana Hajric captured it well. “When US stocks staged their biggest rally in two years Wednesday after the Fed enacted its first half-point rate hike since 2000, was Jerome Powell happy or sad?” they wondered. “And what about today, when the entirety of that advance went poof in 90 minutes?”
Merely tightening FCI will not be enough to make the Fed happy, in this sense.
FCI tightening needs to feed into the real economy, in weaker consumer spending, slowing investment spending, declining property value, falling rents, fewer job openings, and so on.
It might be acceptable for some of these things to merely slow or stall (low or no inflation) rather than outright decline (deflation), but others probably have to decline outright (how do you get from job openings-to-job seekers from 2:1 to 1:1 absent fewer job openings?)
Perhaps we’ll get a feedback loop / negative spiral (negative FCI -> negative real economy -> negative FCI etc).
For a time, developments that “ordinary economic individuals” (I love that term) consider bad news will be what the Fed considers good news.
Eventually, I suppose investors will also see bad news as good news. But I think that is a significant distance away (in time and index points) because, as well-discussed here, the Fed has no influence over one the largest variables, that being war (on Ukraine and on Covid in China). When half the dials are out of reach, you’ll turn the accessible ones that much harder.
H-Man, Occam’s razor suggests this is simply a matter of markets repricing and the litany of negative factors will propel the repricing model down rather than up.
One thing that confuses me about this roller coaster is that supposedly the market already priced in the 50 bps hike, and Wednesday was therefore a euphoria that it was not 75 bps… so today is a prediction of next month?