In a sea of Fata Morganas, at least one trade was better than chasing ghosts.
For weeks, equities and rates were more noise than signal, as a combination of systematic flows, short covering and stop-outs drove a July rally in stocks and bonds, which mainstream financial media outlets dutifully narrated with retrofitted market wraps purporting to explain the price action.
Such efforts were frustrated by recession fears, a somewhat ambiguous Q2 earnings season and the pitfalls of belabored attempts to interpret the ebb and flow of Fed rhetoric.
Through it all, one trade looked far more rational than others, according to Nomura’s Charlie McElligott. “In a market full of false optics and ‘noise’… the best looking trade around was to fade those early 2023 Fed rate cut bets which had been priced into STIRs,” he said Monday.
Since the July FOMC, when Jerome Powell inadvertently stoked bets on a pivot (or what would count as a pivot at a time when headline inflation is 9%), Fed officials have been very explicit about dispensing with the notion of rate cuts commencing any time soon. On that point, at least, they’ve demonstrated a willingness to forward-guide. Neel Kashkari last week called 2023 rate cuts “very unlikely,” for example, and Mary Daly likewise cast considerable doubt on market pricing, which she called “ahead of itself.”
Of course, the Fed isn’t the best predictor of Fed policy (and yes, that’s supposed to be funny), so you can take Kashkari and Daly with a grain of salt. The takeaway from their remarks (and similar comments from their colleagues) isn’t so much that a pivot (or even outright easing) is out of the question for 2023, but rather that it’s exceptionally unlikely in early 2023. Once you accept that premise, it follows that the more determined the Fed is to actually make it into restrictive territory and stay there until inflation is on a sustainable path lower, the larger (and more likely) the subsequent easing impulse will ultimately be.
“Dec22-Mar23 has since seen ~16bps of implied Fed cuts get removed over the past week from that Q1 2023 window, with the spread now appropriately pointing back towards zero for the first time since late June,” McElligott wrote, noting that market pricing for the terminal rate has moved back up considerably after beating a hasty (and unjustified) retreat on the dovish pivot canard.
At the same time, expectations for easing later are building (figure on the right, above). “The nuanced dynamic which remains clear is [that] the market continues to believe the longer the FOMC stays on [the] course to a higher terminal rate and runs ‘restrictive for longer,’ it will later lead to higher odds of a harder slowdown, which is why EDH3EDZ3 actually this morning sits at its most inverted level yet, implying ~64bps of Fed cuts thereafter,” Charlie went on to write, calling this the “more hiking / more restrictive now, bigger cutting / easing later” trade.
The question, of course, is whether the economy will “allow” the Fed to make it to neutral, let alone restrictive territory. You could argue we’re already near the low-end of neutral, but Daly last week ventured that rates aren’t there yet.
That’s where the strong jobs data and “resilient” consumer thesis come in. “Current labor strength and consumer balance sheet allows for ‘more rope’ to digest this forward state of accumulated / lagged ‘tightening-into-restriction'” trajectory, McElligott went on to say Monday.
Somewhat paradoxically (it’s actually not a paradox, but rather quite logical, which is the whole point), this setup is emboldening some market participants, or at least providing a foundation upon which to build a coherent fundamental bull case.
If the labor market and the consumer can hang in there, the Fed can get beyond neutral and run restrictive policy long enough to cement the nascent softening in price gauges and inflation expectations on the way to the realization of a slowdown, presaging what, at that point, would be a justified (as opposed to a foolhardy) dovish pivot.
That, McElligott said, “is the story I’m increasingly hearing from folks, as far as them getting more comfortably ‘bullish’ up here.”