Volcker Or Bust: What To Expect From June’s Fed Meeting

The June FOMC meeting will dominate the news reel this week.

Let’s be clear about one thing: There’s no ironclad institutional impediment to stop the Fed from hiking 75bps or even 100bps. In fact, because the Fed has definitively achieved one side of its mandate (maximum employment) and is missing wildly on the other (price stability), you could assert an ironclad institutional imperative to hike rates by more than the market expects.

On the heels of a highly disconcerting CPI report, the arguments for not going that route are, perhaps for the first time, decidedly less compelling than the arguments in favor of an increment larger than the 50bps cadence officials have telegraphed ad nauseam. As TD’s Oscar Munoz and Priya Misra put it, riffing on a demographic trope, “50 is the new 25.”

In my opinion, the Fed has a lot to lose and very little to gain from underwhelming. Equities are dying a slow, painful death. A coup de grâce may be the best outcome. The negative response to incremental evidence of economic overheating is a reflection of expectations for policy tightening, but the lack of outright capitulation in stocks isn’t just summer drudgery. It’s indicative of what Morgan Stanley called “a mixture of confusion and frustration” among investors and traders, who aren’t convinced of the Fed’s willingness, capacity or, more to the point, both, when it comes to doing what’s necessary in the face of highly corrosive inflation.

In effect, the Fed and markets are stringing one another along on the assumption of rate hikes just large enough for policymakers to claim they’re trying, but not large enough to risk triggering capitulation in risk assets or a rapid demolition of the pandemic housing bubble.

At this point, gradualism is bleeding both market and consumer sentiment. The fact that 50bps increments now count as “gradual” speaks to the urgency of the problem. You might argue that the Fed thus has a free pass to be dovish while being simultaneously hawkish (i.e., if “50 is the new 25,” and consecutive 50bps moves would count as highly aggressive in any other context, then the Fed has free rein to “dovishly” hike 50bps all the way up to neutral). But it still feels suspiciously like everyone is waiting, wishing and doubting. Waiting and wishing for signs of “peak inflation,” all the while doubting that any such evidence is forthcoming. Hence the tension.

Friday’s acute front-end tantrum and accompanying stock selloff underscored palpable angst, but also rampant uncertainty. The Fed may need to prioritize the latter over the former going forward. That is: They may want to address the uncertainty irrespective of what doing so could mean for short-term price action.

Two-year yields rose the most since 2009 on the eve of FOMC week. May’s inflation data unleashed a 25bps, one-day surge (figure above). The bear flattening impulse was also evidenced in the 5s30s, which re-inverted.

As alluded to above, the debate in market circles can be summarized very succinctly: Either the demonstrable angst in equities on days like Friday is the result of policy worries or it’s the result of policy uncertainty. There are doubtlessly elements of both in play. Rising rates and tighter financial conditions are (self-evidently) a headwind for risk assets, and rising real rates are kryptonite for a decade of market leadership from long-duration, high-growth, richly-valued tech shares. On the other hand, it’s likely that some of the consternation evident in stocks is a product of ambiguity around the Fed’s resolve.

It’s not quite as simple as suggesting Jerome Powell should resort to draconian rate hikes. Monetary policy acts on a lag. So, there’s an argument to made that policymakers need time to assess the impact of the tightening already delivered (and the 100bps of guaranteed tightening over the June and July meetings) before it makes sense to go all-in with a hawkish “Whatever it takes” moment.

“This year’s monetary policy action is to combat next year’s inflation, and despite the higher-than-expected May CPI data, we are skeptical that the benefit of a more aggressive tone from Powell outweighs the costs associated with a renewed round of surging volatility,” BMO’s Ian Lyngen and Ben Jeffery said, speaking to that point and calling Friday’s stock rout an example of “precisely this risk as the selloff in Treasurys and higher rates once again pushed the S&P 500 below 4,000.” That “feedback loop,” Lyngen and Jeffery said, “will continue to define trading as summer liquidity conditions become more pronounced.”

It’s possible, though, that both bonds and stocks would rally if the Fed resorted to draconian measures now. Obviously, the first few sessions following such a broadside would be rough, and maybe even the first couple of weeks. But at some point, the Fed needs to end the speculation. Every, single day someone, somewhere writes an editorial questioning the Fed’s resolve. In many cases, those editorials emanate from former officials, monetary or otherwise. They’re not all attention seekers, nor do they all have ulterior motives. Some of them are genuinely concerned. And you could (easily) argue that short-end selloffs like Friday’s are evidence of a market that’s prodding (begging, even) the Fed for clarity, even if that means a decisive, heavy-handed rate hike.

The preceptive among you might point to a conundrum. 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.

So, here’s the paradox: What counts as transparency? Is it delivering a 75bps or even a 100bps hike, and adopting an unexpectedly firm cadence in the interest of removing all doubt? Or is continuing to “listen” to the market and meandering along with 50bps increments while allowing OIS and stocks to help guide the way?

I don’t know. Neither does anyone else. But those are key — if vexingly metaphysical — questions.

In any case, the Fed will either hike 50bps or 75bps, with the odds squarely in favor of the former. If they go for a bigger increment, then the game has well and truly changed and Powell’s press conference will go down in policy history irrespective of what he says. The dots would reflect heavy front-loading, and reporters would press for answers about how the Fed views the tradeoff between inflation and the recession they’re suddenly keen to engineer.

If, on the other hand, the Fed sticks with 50bps, the statement language will need to acknowledge inflation realities, preferably in language that doesn’t call into question the lack of a more aggressive policy response. The growth outlook has plainly deteriorated, so that’ll have to find expression somewhere. Powell will be pressed over and over again on what it would take to compel the Fed to lean in more forcefully.

As for the new economic projections, markets will try to gauge the extent to which the Fed expects stagflation. So: How large are any growth downgrades versus the size of upward inflation revisions? And crucially for the inflation fight: Are the unemployment rate projections higher? If not, why not? Doesn’t the Fed need to cool the labor market? If so, why is a recession not the base case? After all, the Sahm Rule is infallible.

On the dots, markets want to know if the Fed is penciling in a rate cut down the road. If they are, what does that say about the Committee’s faith in the “soft landing” narrative, which Powell will doubtlessly attempt to perpetuate in any scenario other than the out-of-consensus Volcker pivot thesis. “Markets are already penciling in cuts between mid-2023 and mid-2025, but Fed dot pricing could make markets more nervous and lead this pricing to increase,” TD’s Misra said. As for the near-term, she wrote that “the market could price in more hikes if [Powell] doesn’t take [a 75bps] move off the table [but] he may remain vague about the Fed’s plans for rates in coming meetings, likely continuing to hint that much will depend on the data.” She also included a nod to the possibility that Powell might “stress that a few months of declining monthly inflation prints will be sufficient for the Fed to moderate the pace of tightening or even stop hikes altogether once rates reach higher levels.”

For my money, I simply can’t imagine a scenario where Powell hints at a pause, or at least not in a way that doesn’t present it as purely hypothetical. On June 2, Lael Brainard explicitly walked back the “Bostic pause” narrative during her first interview since being confirmed as Vice Chair. The Fed doesn’t want a stock rally predicated on expectations for a break in the hiking cycle. That’s counterproductive. If Powell telegraphs such a break, it’ll be by accident.

Remember: Powell was criticized for shooting down the idea of 75bps hikes during his last press conference. Stocks initially cheered, then promptly sold off the very next day, a development some observers suggested was indicative of market angst around the Fed’s level of commitment. If it was a mistake to rule out 75bps increments last month, Powell won’t likely make it again this month.