Jokes On Jay

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

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6 thoughts on “Jokes On Jay

  1. This is more about the imprecision and ambiguities of the English language than who is right, wrong, early, or late. Is inflation transitory? Well, what we have endured the past couple of years could be considered transitory, when compared to 1970 through 1982. Is it a recession, or a slowdown, or a strong economy plagued by supply chain issues, geoglobal politics, national politics, social networking, and the like? I don’t believe what you call it matters. Good traders trade the market they have in front of them, not the market they wish for.

    1. And with the bargains in the market as it is now the traders who have the majority of the stocks (and money) can pick and choose among them with a smile on their faces.

  2. The Wind blows from the Direction called Geopolitical.. This dimension is currently under reported and that those who have legitimate insights intend not to divulge what they know. I agree good traders trade the market in front of them. It pays to remember (for some of us ) that we are playing with only half the cards in the deck .

  3. Many stocks have been looking cheap for some months now. In my opinion this is more so downcap or in unsexy sectors, but also includes some growthy and large cap names. The megatechs are mixed, ranging from looking “cheap and very challenged” to “expensive but acting like they are somehow immune”, and you can probably figure which is which. But you can’t let AAPL’s aggravating action drive your entire investment strategy – that sort of fixation is no good (lecturing myself here).

    I’ve no problem buying stocks in a recession, that is normally a good time to start deploying previously raised cash. The recession-sector roadmap is pretty well known, and you can carefully leg in. I’ve been picking up some beaten down names over the past months, in various sectors, like a quarter or third of a position. I’ve so far not regretted more than the usual portion of those buys.

    I am anxious, however, about raising equity exposure when the Fed still has another 100+ bp of hikes to deliver and QT’s unpredictable (to me) effects have yet to become apparent. Can anyone recall precedent for market bottoms 100+ bp before FF peaks? Or have a cogent analysis of how QT will or won’t play nice with 2H UST issuance and liquidity?

    I am also pretty convinced that Powell et al will, in fact, drive the economy into recession if inflation forces their hand. They may have already done it, they are rehearsing the “must take the nasty medicine now so you can grow big and strong” lecture, and anyway they are pretty committed.

    It also feels seasonally nervy to significantly increase exposure going into Sep/Oct, months when bad things seem to happen. I think those months are fraught for a reason; by 3Q, it is no longer possible to hold onto too-rosy guides for the full year. But that could just be Farmers Almanac investing.

    What we really need is some clarity on inflation. A plausible roadmap to a Fed-pleasing level of MOM inflation by, say, Sep/Oct would be a very useful thing to see. That would reconcile all the conundrums outlined above. Conviction that there is no plausible roadmap would also be very useful.

    @RIA has commented that inflation can drop quickly as an economy slows and that the market is telling us there isn’t another 100+ bp coming (apologies if mischaracterizing). Has anyone seen more analysis that could help a macro-naive like me understand that better?

  4. Is the market pricing in a Republican win of the Congress?A deadlocked government (with weak oversight and regulation) would probably allow a lot of businesses to take advantage (e.g. Big Tech antitrust and Crypto)…

NEWSROOM crewneck & prints