Fed, Markets Now ‘Paying The Price’ Of Infamous Powell Pivot

After a dozen years of accommodative monetary policy, markets have lost the capacity to fully conceptualize central banks.

Year after year of benevolence as manifested in the careful management of expectations vis-à-vis protective policy settings, reduced markets to an infantile state. Central banks are understood solely as a source of comfort and instant gratification, a condition policymakers “cultivated and maintained during the post-2008 recovery,” Deutsche Bank’s Aleksandar Kocic wrote. The market, then, “has changed its relationship with economic reality and sees only a part of it — not the whole,” he said.

The idea of central banks as partial objects, or part-objects, can be taken quite literally. For a twentysomething, Lehman was a long time ago. If you’re 28, 14 years is half your life. If we assume professional life starts upon being hired, many on Wall Street have never known central banks to be anything other than a wellspring of cheap money, abundant liquidity and vol-suppressing forward guidance.

As regular readers will doubtlessly recall, Kocic has described the post-2008 environment as a “state of exception” and 2018 as the culmination of a three-year effort to lift martial law and emancipate markets. As Jerome Powell learned during that fateful year, lifting the state of exception is synonymous with confronting an accumulated addiction liability. It’s not easy. 1% on 10-year reals turned out to be a bridge too far (figure below).

The rebound in equities from the lows hit in late 2018 came courtesy of Powell’s infamous “pivot,” executed during a January 4, 2019, event. During that speaking engagement, Powell was joined on stage by two chaperones: Janet Yellen and Ben Bernanke.

“From today’s perspective, one cannot help but think that in the previous cycle, the Fed had in mind the possibility that one day a moment like 2022 could arrive and that markets should be fully prepared for it,” Kocic went on to write, in a new note. “However, despite that apparent foresight, the Fed did not persist in its effort and relented too soon under the market’s pressure.”

Now, Kocic said, rates have “Volckerian expectations from a non-Volckerian Fed.” This is perhaps best understood by considering the recent behavior at the front-end. The combination of a highly disconcerting May CPI report (June 10) and the Wall Street Journal article tipping the Fed’s intention to deliver a 75bps hike (the piece was published on June 13), catalyzed the largest two-day increase in two-year US yields in four decades (figure below).

Following the largest rate hike since 1994 and Powell’s press conference, two-year yields plummeted as markets attempted to discern whether the June 10-13 repricing was too much, not enough or just right in consideration of Powell’s remarks and the new dot plot.

The pre-FOMC panic was mirrored in the curve (as a bear flattener) and in vol (as a bid for the upper-left corner). “As we saw post-FOMC on Wednesday, the market exhaled once the Fed committed to a particular rates path and inflation-fighting goal,” Kocic said, noting that 3M2Y vol relaxed nearly back to the prior week’s levels even as 3M10Y stayed stubborn.

“The distribution of volatility across the curve/surface should be a function of both the Fed’s commitment/communication and the inflation print,” he went on to write. “If the curve bear flattens, vol should rise in the upper left corner, and vice versa [as] more clarity and softer inflation shifts vol towards the right side.”

When viewed through the lens of expected tightening versus delivered rate hikes, the tension becomes clearer. Two-year yields are historically elevated vis-à-vis fed funds (black line and green level in the figure, below).

That contrasts markedly with the Volcker experience. The market expects an extremely aggressive rates path from an “all-in” Fed, as Christopher Waller put it on Saturday. So far, though, policymakers have only delivered a fraction of the tightening telegraphed in the dots and official communications.

We’re at an inflection point. Either inflation ebbs or it doesn’t. The risk premium at the front-end is a reflection of the uncertainty that goes along with an extremely indeterminate outlook. If inflation doesn’t recede, the Fed may need to overdeliver, where that means a markedly negative FF/2s.

In the meantime, selloffs at the front-end will continue to be highly vexing for risk assets. Stocks are vulnerable to higher front-end rates. “This vulnerability is likely to be tested with each new data release,” Kocic said, suggesting equities will, for the first time in the post-Lehman world, be compelled to form a more complete understanding of central banks and their role in the economy.

“We believe that this time around, the Fed will not heed the markets’ demands. It did in 2018, and there is a price to pay now,” Kocic wrote. “If we declare 2018 as a market victory, it was a Pyrrhic one.”