“The pause is likely to come too late,” Morgan Stanley’s Mike Wilson said Monday.
He was referring to a prospective pause in the Fed’s tightening campaign. Investors are infallibly discerning and equities famously efficient — casinos are bastions of rationality. Given that, you can trust stocks not to jump the gun when it comes to pulling forward an eventual deescalation from the Fed.
I’m kidding, of course. As discussed at some length in “Run Money, Run,” we’re a hopelessly excitable species, prone to irrational bouts of euphoria and despair, and virtually nowhere (other than actual casinos) is that more apparent than equity markets. So, to the extent the pause in 2022’s bear market (figure below) is a function of investors looking ahead to a Fed pause, you can be fairly confident it’s premature.
Some of the blame falls on policymakers. A dozen years of classical conditioning turned market participants into a Pavlovian pack of salivating dogs. Since Lehman, equity weakness was reliably met with dovish coos and, eventually, outright easing of some kind, so it’s only natural that investors expect it now — and are keen to front-run it.
Who knows, maybe that’s the right approach. After all, this week’s hike will take us back to December of 2018, when Jerome Powell wavered in the face of an equity selloff that was roughly as deep as the current bear market. “The last hike to this level was a 25bps move in mid-December 2018… late in an ugly Q4 equity selloff,” JonesTrading’s Mike O’Rourke said, of this week’s assumed 75bps move. “The Fed panicked shortly thereafter [and] by July of 2019 commenced a new policy easing cycle,” he added, noting that “prior to that seven-month window in 2019, one needs to go back to early 2008 for a fed funds rate of 2.375% or above.”
Seen in that light, it’d be fitting if this week’s hike proved to be Powell’s Waterloo. And given the distinct possibility that the advance read on Q2 GDP will be conducive to media headlines about a recession, the optics for a hyper-aggressive Fed are especially poor, even if, as Janet Yellen patiently explained to an impatient Chuck Todd over the weekend, it’s highly unlikely that the NBER will declare Q1/Q2 2022 an official recession.
But I don’t think market participants actually expect a Fed pause in September, let alone an outright dovish pivot. In fact, I’d be inclined to suggest that recent “stabilization” (a relative term in 2022) in equities is just a bear market rally juiced on some days by squeeze dynamics and bolstered by a systematic bid as spot moves through trigger levels for trend following strats. In other words, the whole “trading a pause” narrative could be something of a misnomer in the first place. If markets are trading a Fed deescalation, it’s predicated in part on inflation forwards, which have come in (figure below).
The idea, generally speaking, is that if the bond market has faith in the Fed’s capacity to achieve its price target over time (which is what falling longer-dated expectations convey), then the Committee may be less inclined to constantly up the ante with every incremental piece of evidence that suggests price growth is still percolating in the domestic economy.
Speaking of near-term percolating, any additional declines in commodity prices will help. Note that the war premium has come out of wheat and other key raw materials.
“The more than 20% rise in gasoline prices from mid-April to mid-June may have played a larger role than appreciated in the near-term data picture, raising inflationary expectations while squeezing consumer incomes and hurting sentiment,” Goldman’s Kamakshya Trivedi said. “A reversal in that spike is now well underway and may have more room to run,” the bank went on to write, adding that “given the outsized role that gas prices play for US consumer sentiment, the shift here has already started to provide some support for growth and relief to inflation expectations, and likely has room to do more [while] the prospect of broader goods supply relief in the coming months is also becoming more visible in the data.”
What you don’t want, obviously, is an intractable inflation impulse set against lackluster growth, but the virtuous feedback loop between falling commodity prices and the consumer, alongside a Fed that’s less concerned about its credibility thanks in part to receding market-based measures of longer-dated inflation expectations, could suggest a more favorable trade-off, at least in the very near-term.
“Bad data is starting to be seen as good news, as inflation forwards stall, with commodities pulling back,” JPMorgan’s Mislav Matejka remarked. Similarly, Goldman sees scope “for some relief from the more severe recession and overtightening fears that have been priced.”
There are (at least) two problems with that. First, it’s all suggestive of a nuanced reading of the growth-inflation tradeoff, and while I’m a fan of nuance in almost all circumstances, Powell isn’t. Or at least not right now. As he famously put it a few months ago, “this is not a time for tremendously-nuanced readings of inflation.”
Second, it ignores the other elephant in the room: Earnings. Although analysts have begun to temper expectations, Wilson gently reminded investors that it’s not generally a good idea to buy during the initial EPS cuts in a major revision cycle.
Plausible bull case- modest and fairly short term economic slowdown, earnings drop but not as much as feared, inflation moderates faster than market anticipates and FOMC stops raising rates earlier with a lower terminal rate than the hawks anticipate. Not my base case, but it is plausible and cannot be discounted.
I’m completely with you, Ria. I really like your take. The Fed is locked and loaded for the meeting. But if all goes well, I’ve had the conviction, spoken via my share purchases, that the short-term horizon will not be harsh, and the recession will not be prolonged.
What gives me greater pause is international. The war with Russia is upending fuel markets. And the rising economic chaos from the Chinese banking/property fiasco is showing the CCP’s cards. For now, Taiwan remains in the background. But China is taking actions that express growing value for the CCP and diminishing value for capital markets. I believe they are slowly and more overtly turning their backs to the west. Just my opinion, but they seem to think they can dominate, and they’re anxious to express it.