One Thing, One Last Scare, One Right-Tail

Jerome Powell isn’t likely to do the “one thing” that could durably tighten financial conditions.

Although equities have retreated from summer rally highs, there’s still palpable concern that Powell will fail to clear what’s now a very high bar for hawkishness in Jackson Hole, thereby accidentally imbuing risk assets with renewed joie de vivre, at cross purposes with the Fed’s inflation-fighting agenda. Indeed, the hawkish bar is now so high that he’s virtually guaranteed to fall short.

“I’d assign 90% probability that the Fed Chair can only disappoint versus hawkish expectations,” Nomura’s Charlie McElligott said Thursday, suggesting, correctly, that pretty much anything Powell says is at risk of being “de facto dovish.” Any allusion to moderating economic activity, even if warranted, would be construed as a nod to a possibly imminent de-escalation in the pace of rate hikes, for example. That’s especially true in the context of the July Fed minutes (which flagged the risk of overdoing it) and Powell’s post-FOMC press conference, where an ill-advised nod to the proximity of neutral and, “worse,” an acknowledgement that rate hike increments will eventually be smaller, sparked a rally.

So, what’s the one thing he could, but almost surely won’t, do to clear the bar? Well, he could endeavor to reset terminal rate expectations dramatically higher. In addition to the (sadly) far-fetched notion that a modern Fed chair would be so bold, there are three reasons Powell won’t go that route.

“He doesn’t have next month’s CPI or jobs data yet, so he wont risk a ‘bad guide’ [especially] now that they’re out of that business,” McElligott said Thursday, before suggesting Powell may attempt to soften the blow from the expected “stay the course” messaging by acknowledging evidence of a cooler economy, whether that means survey data or, more likely, pointing to the housing market, where activity has downshifted dramatically.

Importantly, Powell will have July’s personal spending and income report in hand, including, of course, updated PCE price gauges. Assuming those are consistent with July’s CPI report, he’ll have some plausible deniability to push the “peak inflation” narrative, which McElligott called a “feel-good comfort blanket” for markets.

The implication, in the near-term, is that you have to be open to the possibility of a local relief rally across the board — in equities, credit and bonds. Equity vol could get hit “providing further vanna support for the market via dealer hedging,” Charlie said, adding that the curve could see an impulse bout of bull steepening and the dollar could reverse sharply lower, à la the reaction to July’s “cool” CPI report.

That could set the stage for a perilous September, when a challenging seasonal meets what many analysts believe will be a (delayed) reckoning in profit expectations along with an imminent ratcheting higher in runoff caps, the “elephant in the room,” as BofA’s Savita Subramanian called QT.

McElligott continues to believe there may be “one last equities scare” left, where that means one major scare, perhaps early next year, when everyone (market participants and policymakers) suddenly realizes that inflation may remain stuck at uncomfortably high levels, validating the “tighter-for-longer” narrative. Charlie calls that the “Now What?!” scenario.

In that context, I’d note that on Wednesday, the Wall Street Journal‘s “Fed whisperer,” Nick Timiraos, penned an eyebrow-raising article (eyebrow-raising because he’s seen as a Fed mouthpiece) that began with this line: “Central bankers worry that the recent surge in inflation may represent not a temporary phenomenon but a transition to a new, lasting reality.”

Timiraos continued: “To counter the impact of a decline in global commerce and persistent shortages of labor, commodities and energy, central bankers might lift interest rates higher and for longer than in recent decades, which could result in weaker economic growth, higher unemployment and more frequent recessions.”

To make the obvious contrarian indicator joke: Given central banks’ recent track record for forecasting inflation, I suppose you could argue that if “transitory” has morphed into “a new, lasting reality” in their minds, it means inflation is guaranteed to plunge imminently.

In the same Thursday note cited above, McElligott described the right-tail scenario for stocks.

“Due to the magnitude of the existential shock that the war is creating in Europe [where] real lives are at risk this winter on energy dynamics, along with the [ramifications] from energy, fertilizer and food costs for consumers and political power, I think the worse it gets, it increases the odds of a right-tail ceasefire down the road,” he said.

He sketched out what such a development might entail. “Imagine waking up to reports overnight that high-level Ukrainian and Russian officials are sitting down for talks,” McElligott wrote. “It’s likely you’d see a market with crude and energy going ‘limit down,’ where global terminal rate forwards and central bank hiking expectations collapse, where vol is destroyed and where risk assets explode higher.”

That, Charlie remarked, “remains in the back of my mind — one of those ‘the worse it gets, the more asymmetrical the response will be’ scenarios that has me scheming.”

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10 thoughts on “One Thing, One Last Scare, One Right-Tail

  1. In addition to its dual mandate (stable prices, healthy employment), the Fed has to worry about a third thing: dollar strength. If anything is likely to get broken in the Fed’s tighter-for-longer regime, its EM. I think Powell and his colleagues are well aware of the risks and will try to strike a balance between uber-hawkish and merely aggressive — i.e., 50bps, 50 bps, 25bps, pause and see where things stand.

    1. Which could be okay if headline inflation falls steadily from 8.5% to the 5.5% level by year-end. Fed can’t stop there, but with inflation on a steady downward trajectory (fingers crossed) at that point, a pause to assess wouldn’t be the end of the world.

      1. I’m thnking energy prices may flip from a big MOM help (deflation) to a moderate MOM hurt (inflation) in 4Q, based on crude, NG, and storage – masked by crack spread for now.

  2. I found it somewhat ironic that the end of this post was followed directly by an ad showing a large blue-headed screw (assuming it was not targeted just to me personally).

    BTW, accepting “just” 5.5% inflation for even three years will knock 17.5% off the value of everyone’s assets. Money goes away in a rush with inflation.

  3. … “there’s still palpable concern that Powell will fail to clear what’s now a very high bar for hawkishness in Jackson Hole”

    I wonder how markets would react if Powell cancels his speech and makes no public comments at Jackson Hole.

  4. The speed and amount of tightening by the Fed this year is unprecedented, something H has documented well in his posts. The logical course of action would be to let some of the tightening filter into the economy and asses the impact before piling on another 100 bps in a rush, but the Fed won’t do that because they are under political and public pressure having fumbled their inflation forecast. In his wonderful book, Thinking Fast and Slow, Daniel Kahneman details how we humans tend to make a worst mistake when desperately trying to fix a prior error, Powell and the Fed are about to become a textbook example of such behavior in my opinion, my bet is tighter for longer will lead to longer economic pains for many even after inflation recedes to more tolerable levels. If we experience a nasty recession next year that all but guarantees a Trump second term and we still have sticky 3-4% yoy inflation, will it be worth it? Just to save the Fed’s credibility?

    1. The FF futures market appears to believe that the Fed will keep hiking aggressively through at least early 2023.

      The stock market appears to not believe it, or is willing to look through the next three quarters, or has otherwise lost its fear of the Fed.

      I’m not sure how Powell and the FOMC can get the equity players back in line, just by saying things.

  5. … and we still don’t know or understand inflation in all its granularity and at this time and place. Of global warming we have a much better understanding and a greater amount of data to support it. Inflation is interesting in how many and diverse are its descriptions. Soft or hard landings aside, we’d all gain if we came out of this situation with a much better understanding of inflation and how it can be managed for greatest economic benefit.

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