“The Fed is in an incredibly uncomfortable position,” Nomura’s Charlie McElligott said Tuesday, amid a spate of soundbites from policymakers committing and recommitting to an inflation fight they’re either winning or losing depending on what metric you choose to consult.
The curve bear flattened and market pricing for the September meeting firmed after Mary Daly declared the Fed “nowhere near almost done.”
Daly’s deliberately redundant phraseology was a hawkish version of Jerome Powell’s “not even thinking about thinking about raising rates” riposte from June of 2020. Daly called it “puzzling” that the market expects an accommodative Fed. The 2s10s inversion reached nearly 35bps on the heels of her comments.
Later, Loretta Mester said the US isn’t in a recession, reiterated that the Fed has “more work to do” and repeated her desire to see “compelling” evidence that inflation is receding where, for Mester anyway, that has to mean MoM declines. Currently the monthly prints are rising (figure below).
“I haven’t seen anything suggesting inflation is leveling off,” Mester remarked. “We have to get inflation under control,” she pressed, in case the message wasn’t getting through.
But that’s just it. The message either isn’t getting through to markets or else it’s getting through so much that the restoration of the Fed’s credibility is manifesting in firmer stock prices as investors become more comfortable with the notion that the US won’t become Turkey, let alone Venezuela.
If the latter is the case — if stock prices were rising and long-end yields falling in part due to confidence in the Fed’s capacity to rein in price growth — then it’s tragically ironic. The easing impulse from higher equities is counterproductive for officials who need to preserve every ounce of tightening they manage to engineer.
I discussed this at length last week in the two linked articles (above). McElligott elaborated on Tuesday. “The market has reflexively built in a message that not just ‘peak Fed tightening’ is behind us already, but that we’re about to cut rates in early 2023,” he wrote.
A dramatic decline in US reals “has dictated a wholesale risk asset explosion higher from equities to credit to long duration, as US financial conditions impulse-ease in an extremely counterproductive dynamic for the Fed’s inflation-fighting mandate,” Charlie added.
The figure (above) shows 10-year US real yields dropping the most since Russian tanks rumbled into Ukraine, prompting a sharp rise in commodity prices, which fed into breakevens, mechanically pushing reals lower.
“This recent spastic easing in FCI via the meltdown in real yields will only further build ‘animal spirits’ back into these key inflation inputs and risk markets, because [the Fed] simply has not caused enough of a slowdown to crimp the ‘demand’ input,” the only input the Fed can control, McElligott went on to write.
This is unimaginably vexing for officials. I can’t emphasize that enough. There are two key points to grasp in that regard.
First (and to reiterate the overarching message from the two linked articles above), there’s a distinct possibility that some small portion (let’s call it 15% for argument’s sake) of July’s rally in stocks and bonds was predicated not on dovish pivot speculation or recession fears, respectively, but rather on the notion that the Fed has demonstrated a firm commitment to chopping off the left-tail hyperinflation outcome. In that case, “success” is breeding failure to the extent higher stocks and lower long-end yields are easing financial conditions.
Second, the rally in stocks and bonds in July unfolded against a backdrop of 150bps of Fed hikes in just six weeks. Any more hawkish and they’d be moving at 100bps increments or hiking multiple times per month.
The final insult to injury is the prospect that easier financial conditions could forestall the demand destruction and economic slowdown policymakers intend to engineer. Indeed, that’s already happening on Nomura’s quadrant model (figure below).
“Critically, this easing of US financial conditions is actually seeing the hotly anticipated ‘Recession’ trade stall out a touch in our high-frequency quadrant monitor,” McElligott wrote.
Ostensibly, that’s exactly what the Fed wants — they want a slowdown, not a recession. But even if you assume policymakers don’t “secretly” (and this is the worst-kept secret in the world right now) want a shallow recession in the service of the inflation fight, they’d probably rather not have a soft-landing-by-stock-rally. That’s suboptimal.
What they want, rather, is a soft landing courtesy of a more balanced labor market and a consumer who retrenches just enough to cool aggregate demand but not enough to push the consumer spending component of GDP deeply negative.
“Below-trend growth is not a bad outcome,” Mester said Tuesday. And even if it is, it’s “necessary for price stability,” she added.