Traders, Fed Confront ‘Utterly Mad’ Reality

“Where’s my bear market rally gone?” BofA’s Michael Hartnett wondered, somewhat sarcastically.

The bank’s semi-famous Bull & Bear Indicator flashed an “unambiguous” contrarian “buy” signal weeks ago, presaging the largest weekly gain for the S&P since November of 2020, but Hartnett was reluctant to countenance anything more than a hollow rally.

He wasn’t alone. Morgan Stanley’s Mike Wilson was likewise skeptical that equities could sustain a rebound, even as he suggested this week that the next big leg lower might have to wait for Q2 earnings season.

For Hartnett, stocks’ inability to hold gains (figure below) is easy to explain. “In short, the inflation shock isn’t over and the rates shock is just starting,” he wrote, in the latest installment of his popular weekly “Flow Show” series.

US shares have fallen in nine of the last ten weeks. Friday’s fireworks on Wall Street were accompanied by a dramatic surge in two-year yields, which responded violently to another red-hot CPI report.

Hartnett’s contention that neither the inflation shock nor the rates shock are behind us proved prescient. His latest was published on Thursday evening, around 8:30 ET, 12 hours prior to Friday’s inflation data. “[There’s] no release valve from the peak in yields and the bear market rally is too consensus,” he said.

Barclays on Friday changed their Fed call to reflect a 75bps surprise at next week’s meeting. Bloomberg’s Cameron Crise called the notion that the Fed isn’t badly behind the curve “increasingly laughable.”

And yet, despite inflation saying the Committee should probably be hiking rates today — as in, right now, at an unscheduled meeting — there’s evidence of acute stress which, ostensibly anyway, argues against an overzealous approach. Consumer sentiment printed a record low Friday, for example. Yes, that’s due to inflation, which is what rate hikes are aimed at ameliorating, but as Neel Kashkari readily admitted, the medicine for what ails everyday Americans is likely to make them even sicker in the interim. Meanwhile, mortgage activity is collapsing, as is junk issuance (figures below, from BofA).

Although equities have ample room to fall further before anyone can plausibly claim for this bear market anything other than a long overdue correction, it’s somewhat concerning that we’re just 75bps into the hiking cycle and already there are signs of acute concern and stress, both anecdotal and otherwise. I’d also note that Turkey is teetering precariously on the brink of a full-blown currency crisis — a barrage of Fed hikes won’t help.

It’s hard to know how markets would respond to a 75bps surprise increment from Jerome Powell.

You might argue, as Bill Ackman did, that such a move would help restore confidence by injecting credibility into what, so far, is still viewed by too many market participants as a weak-willed commitment to bringing down inflation. Hartnett alluded to that. “Markets stop panicking when policymakers start panicking,” he wrote.

On the other hand, there’s no recent precedent for Fed actions which represent the complete withdrawal of transparency and the unequivocal reclamation of their sole discretion to set policy in pursuit of their mandate(s) without the market’s consent. If they chanced such a thing, it could trigger a cross-asset meltdown.

I’ll leave you with one particularly poignant passage from BofA’s Hartnett:

Wham! On June 8th, 2020, NYC announced stage 1 “reopening” after a 13-week COVID lockdown, permitting curbside pickup from retail outlets. If you had said then that two years later US retail sales would be up 67%, unemployment would fall by 17 million, inflation would surge from 0.1% to 8.3%, oil would soar from $12 to $120 and that a pandemic would be followed by war and famine, you would have been thought utterly mad. But that’s what happened. 2020 marked a secular low in inflation and yields, the beginning of regime change and a decade of social, political, economic and financial volatility.