Following an impressively durable summer rally aided and abetted by systematic flows and squeeze dynamics, markets went “back to the future” over the past week.
Consensus trades from the first half of 2022 are back en vogue both at the macro level and within equities.
Trend following strategies are short G10 bonds and STIRs again, for example, while this year’s pre-summer rally winners across equity factors and thematic expressions are “back into the top of the past five days performance tables,” Nomura’s Charlie McElligott noted on Tuesday.
At the same time (i.e., on the flipside), what worked during the summer “garbage squeeze,” as Charlie put it, is suddenly out of favor again, as tech and, more poignantly, speculative corners of the market, are once again compelled to face the reality of higher yields, a stronger dollar and the implied tightening in financial conditions.
Meanwhile, 2022’s “spot down, vol down” dynamic may be giving way to a more intuitive (and potentially more ominous) conjuncture. “Monday saw downside puts go bid for the first time in forever,” McElligott remarked, flagging a second straight session during which VIX futures outperformed meaningfully versus the move implied by stocks.
Remember: An orderly selloff is no selloff at all. Seen through that lens, 2022’s bear market is notable for the conspicuous absence of a crisis-style vol spike and/or sessions indicative of panic-selling and outright capitulation.
So, “Why all of these shifts in recent days?” McElligott asked, before positing a few answers.
“The market is scrambling back into hawkish expressions” in anticipation of Jerome Powell’s remarks at Jackson Hole, but at the same time, Europe’s energy crisis is threatening to prolong the bloc’s bout with nosebleed inflation, the Saudis are now claiming (somewhat implausibly, and, one might argue, very self-servingly) that the cure for volatility in oil markets might be less supply and the Biden administration may be poised for some manner of announcement on student debt relief in what, forgive me, will invariably be viewed as vote-buying-by-loan-forgiveness-proxy ahead of the midterms, inflation be damned.
“Hence another blast of ‘hawkishness’ due to concerns that various inflation overshoot impulses around the world remain structurally ‘sticky’ and will, in turn, see global central banks forced to run restrictive / ‘higher-for-longer’ policy,” McElligott wrote, noting that STIRs have now faded the early-2023 Fed pivot trades (figure below).
The bottom pane shows that easing expectations are now almost entirely concentrated in pricing for the back half of next year.
With all of the above in mind, McElligott said he’s “terrified” of Jackson Hole “due to Chair Powell’s consistent inability (or refusal) to meet hawkish market expectations.”
As I’ve suggested on any number of occasions over the past several days, “balanced” isn’t working for Powell in terms of tone and cadence. Markets expect that from him, and are thereby inclined to hear it even when it isn’t there. Set against overtly (and, in many cases, unapologetically) hawkish remarks from other Fed officials, anything other than an unequivocal commitment to kneecapping inflation, even at the cost of a recession, risks a counterproductive dovish reaction from markets.
The last thing the Fed needs is a repeat of the post-July FOMC stock rally and accompanying cross-asset price action (familiar figures above).
At this point, Powell has more than enough experience with this dynamic to put a stop to it. The market’s reaction to last month’s press conference should’ve been the last straw. Markets are testing him. Rates may care what Neel Kashkari (for example) says, but stocks clearly don’t. And nobody cares what Tom Barkin says (sorry, Tom). It’s Powell who needs to reiterate that a recession is acceptable if it’s necessary to curb inflation.
McElligott offered what he called some “not-so-tongue-in-cheek” commentary: “If Chair Powell were serious about slaying the demand-side feeding the inflation beast, he would go up there with a ticking Ethereum chart on his screen and talk about the potential for a terminal rate above current market pricing until it cratered and real yields were +25bps on the day — problem solved.”
Hope people understand that the main speaker at Jackson Hole this year will be Arthur Burns II …..victory over inflation will be declared in 2023 (as it was in 1970s) and come 2024/2025 we will have double digit inflation and no Paul Volker
As I was reading this a question suddenly hit me. Is it possible that the reason for the lack of “capitulation” and panic buying is a a function of the algos? Their AI is adjusted regularly and perhaps these programs are not acting like their human creators would have. The general public doesn’t know what nuances are now part of automated trading programs and are acting differently than in the past. Just a thought.
I agree with McElligott that the demand side feeds the inflation beast, and I don’t admire Powell’s execution as the Fed Chief. But on the other hand, I would not want to be Jerome Powell. The international issues that unfold every day like a long slow train wreck can impact the US economy, and Powell won’t be able to do much about it.
During the next 15 months the US economy and Europe will continue to face erratic oil and gas prices due to the war in Ukraine (unless “Fearless Leader” Putin is put out to pasture with his horse). In parallel, unless the CCP throws Xi Jinping out of office, the Chinese economy is likely to continue spinning in the wrong direction, due to the ongoing effects of the property and banking crisis, and growing unemployment.
These international matters will impact the US economy. If oil producers in the US and Middle East can fill the fuel gap, fuel pricing (and inflation, with help from the Fed) can be stabilized. But I don’t expect they’ll produce enough crude to drop prices and cushion the pain of US drivers. Producers are not sympathetic to complaints about consumer costs. They like high prices, actually.
Meanwhile, the ongoing supply issues in China will only continue to be exacerbated by social and economic turmoil from events in the property and banking sectors and (I would opine) party disfunction in addressing Covid and managing the Chinese economy. It’s quite sad for the people of China.
From the US perspective, one can imagine that Chinese suppliers can be replaced (fingers crossed), but it’s going to be a long and slow process. Then there will be ongoing indirect impacts on the US economy from the war in Ukraine. We can hope it all evolves in a manageable fashion. But like Jamie Dimon said, “There’s a hurricane coming.”
I would not want to be in Jerome Powell’s shoes.
H-Man, the spots of a leopard never change. Powell has had ample opportunity to be the inflation slayer but at every meeting, he walks away from the fight by selling “hope” by the barrel. I think Jackson Hole will simply be a repeat of those earlier performances. I can understand why Charlie is terrified.