The Fed is subject to a lot of bad jokes in 2022.
Some are literal jokes — unimaginative “transitory” quips and associated jeering, which unfortunately pass for wit in an era when everyone thinks they’re clever but no one actually is. Others are figurative jokes — paradoxes born of an absurd predicament, wherein the path to saving Main Street from inflation goes through recession and joblessness.
Among the long list of figurative jokes vexing officials this year is a dynamic wherein markets undercut policymakers’ efforts to contain inflation, compelling further hawkish escalations (if only in word) to offset the easing impulse from equity rallies and knock-on effects across assets.
That was on full display Wednesday and Thursday, when markets pushed the “dovish nod” canard despite scant evidence to support the notion that Jerome Powell was anything other than hawkish in remarks to reporters following the Fed’s second consecutive 75bps hike. If the price action indeed represented a misread of Powell, that’s just insult to injury — price action that works at cross purposes with the inflation fight predicated on Powell’s failure to communicate, the market’s failure to listen or both.
“The issue is that the market’s ‘anticipatory’ dovish price action did the exact thing that makes the Fed’s inflation-stifling efforts that much more challenging,” Nomura’s Charlie McElligott said, pointing to higher stocks, wider breakevens, a weaker dollar, higher commodities, lower reals and tighter credit spreads (figure below).
Charlie called those moves “extremely counterproductive.” I’d be inclined to call them a nightmare for the Fed at this juncture. Higher stocks rekindle the wealth effect, a weaker dollar is inflationary, so are higher commodity prices and a sharp drop in real yields is a pure easing impulse. Do note that although the dollar weakness shown above looks small, Wednesday’s drop was among the largest single-session declines this year.
“This is how things can get awkward again in coming months,” McElligott went on to say, noting that Powell’s “repeated emphasis on the June SEP looked intentional, which would seemingly push back on the market’s ‘quick turn’ pricing of rate cuts” early next year.
Thursday’s lackluster read on Q2 GDP only added to the tension. The short-end rallied hard and Fed premium was aggressively priced out. At one point, less than 90bps of additional hikes were priced through the December gathering. Terminal rate pricing came in materially.
I’d look for Fed speakers to push back on any persistence in this decidedly unwelcome easing impulse. It’s just delaying the inevitable and making it more difficult for the Committee to achieve what it needs to achieve.
There’s one final paradox I should mention. It’s possible that stocks are smarter than they look and that some of the “feel good” vibes are the result of investors expressing a vote of confidence in the Fed’s commitment to controlling price growth. As McElligott wrote, such an ironclad commitment “cuts the left tail risk of out-of-control, unanchored inflation.”
If stocks are indeed trading higher on the idea that Powell is sticking to the hawkish script and unlikely to stray from it until inflation is clearly on a sustainable path lower, equities will need to be careful not to get too enthusiastic about it, lest they should inadvertently undermine the cause.
Summarizing on Thursday, McElligott wrote that “despite being counterintuitive to some,” a higher-for-longer scenario for rates is “ultimately the best case for stocks, especially as a larger slowdown in order to lean into inflation and cut the ‘left tail’ there, will eventually elicit a more powerful Fed easing thereafter.”
Read more: Price Discovery. Via Tasseography