The market knows.
Traders are wise to the unenviable task confronting monetary policymakers, who, lacking the capacity to address the myriad supply side factors largely responsible for the overshoot in headline inflation, are left to bleed demand until price pressures abate.
“Hence recession gap-risk repricing hard and fast,” Nomura’s Charlie McElligott said Thursday, pointing to “destruction” across commodities and breakevens, as well as widening credit spreads.
It’s notable that 10-year breakevens and the 5y5y forward swap are now trying to catch up to the speed at which five-year breakevens plummeted from the peaks (figure below).
Oil is off the highs, but not enough to explain YTD lows in breakevens. Other commodity prices are down hard, though, and when you couple that with growth jitters tied to hard landing assumptions, it’s not surprising to see some capitulation.
The Fed would suggest that’s evidence of credibility — that the market trusts policy tightening will ultimately succeed in bringing inflation lower. You could also call it evidence that the market expects the Fed to “break something,” a contention that’s supported by STIRs, where traders are pricing more than 50bps of rate cuts next year.
Note that STIRs tend to push the issue. I wouldn’t be surprised if, assuming the US economy continues to decelerate (see Thursday’s lackluster personal spending data, for example), you start to see evidence of erosion in pricing for the November and December meetings.
There’s a tension here between a market that doubts the Fed’s fortitude and the existential necessity of preventing long-term inflation expectations from becoming unanchored.
The odds of a US recession this year are very elevated. Previously, a friendly Fed would quickly default to a growth-conscious policy bent that’s protective of risk assets, and in the post-GFC era, they’d have carte blanche due to subdued inflation. The market doubts this tiger can change its stripes. Put differently, the market still believes the Fed is a paper tiger in the inflation fight. As such, traders are reluctant to countenance the idea of a Fed that hikes all the way to ~4% into the teeth of a recession, especially given what that might entail for equities and credit.
The Fed, by contrast, insists they’ll get rates into restrictive territory and official rhetoric around longer-term inflation expectations has become noticeably more urgent over the past several weeks. As discussed here at some length across numerous recent articles, a de-anchoring of long-term inflation expectations in the US could have far-reaching consequences. If the situation were to spiral out of control, the Fed’s credibility would be the least of anyone’s concerns.
At some point later this year, this tension has to be resolved. For now, everyone hopes inflation will recede just enough to give the Fed plausible deniability to trim the pace of hikes to 25bps as part of a broader deescalation campaign aimed at pacifying markets while retaining something akin to a hawkish predisposition sufficient to preserve gains made in the war on inflation.
That may or may not work out, though. If it doesn’t, the Fed will be compelled to stare down, and ultimately disappoint, traders expecting a pivot. “In the absence of being able to print oil and gas, refinery capacity, very large crude carriers, fertilizers, grains, rare earth metals for EVs and so on, central banks are really left with no choice but to drive economies into recession in order to curtail demand [factors], even though they’re a much smaller [contributor] to inflation,” McElligott said, calling that “the brutal truth.”
Nomura’s weekly economic quadrant framework is “careening into Contraction,” as Charlie put it (figure above).
Note that after weeks of shrill media coverage, analysts are finally starting to move on profit forecasts. JPMorgan cut earnings estimates for mega-cap tech names on Wednesday, for example. The prospect of central banks tightening their respective economies into contraction “rhymes with that next shoe to drop of the long-overdue negative earnings revisions,” McElligott went on to write.
He described central banks’ dilemma (which is really everyone’s dilemma right now), as a “pick your poison” dynamic. “Stomp inflation from the demand side while global economies still show [some] semblance of ‘juice,’ but cause a recession and loss of employment” or risk the “alternative case,” where that means a de-anchoring of forward inflation and everything that goes along with it at a time when citizens across Western democracies are restive.
The Fed has chosen to be aggressive for now. There would be nothing wrong with a 50 bps point hike and then a pause or a 25 if the inflation clearly was decelerating. In other words, this is not a binary decision for them. They can throw the hawks one more large hike and then go slow if they choose should disinflation become obvious. And this is not a “cave”, it is smart policy making.
There’s virtually no chance of 50bps in July. 75 at next month’s meeting is a foregone conclusion. The gap between the July meeting and the September meeting is too large to allow for any kind of conciliatory stance. Doing anything other than the maximum next month leaves them exposed in the inter-meeting period with no options (short of an emergency meeting) if the inflation situation deteriorates. They’ll hike 75bps next month to cover their bases. There’s no downside to another 75bps increment. It’s well socialized. There’s plenty of downside to a 50bps increment, including and especially the possibility that stocks would take it as a green light to rally, easing financial conditions at cross purposes with their agenda. They won’t risk it.
I think that’s what RIA meant. He/she would be okay with 50 bps and seeing what happens but a 75 bps next month to appease the hawks and then going slow is perfectly acceptable too.
The biggest downside is having to pause in September or even cut rates shortly thereafter. They clearly have slowed things down. And they have said 50 or 75…This has the feel of the titanic picking up speed going into the iceberg flows. These decisions are not binary. If inflation stays high they can keep raising rates at the next meeting. Overconfidence is foolish…
+1
75 bps at July meeting, something will clearly break between then and September, when we’ll find out if the Fed is still a paper tiger or if the committee decides a recession + a Trump return is a fair price to pay to ensure inflation expectations remain anchored, pick your poison indeed.
You may get DeSantis but trump is finished…
I really hope you are right and Trump is finished, but to me it seems more likely than not he is the GOP nominee and returns to the WH, we might need a miracle bigger than the one needed for the Fed to achieve a soft landing
The fact that Trump as the nominee still being discussed is astonishing to me. The damage he did in four years is just now being felt!
He is a disaster. Period.
What will be interesting to see (although very depressing in a broader sense) is if Trump still has enough fanatics to pull off the nomination (only needs a plurality), and if he doesn’t, does he turn his “rigged election” guns on Desantis and the Republican party? As we’ve seen, Republicans will almost uniformly fall in line, but Democrats only hope in the 2024 election is that Trump is petty enough (and he most definitely is) to tell his voters to stay home.