One, among many, critical dynamics that most market participants either don’t understand or don’t fully appreciate, is how market pricing can become a self-fulfilling prophecy vis-à-vis Fed policy.
As market pricing begins to lean further in the direction of a given Fed outcome, the odds of that outcome materializing increase. That’s because Fed policy isn’t totally detached from markets. How could it be? It’s the price of money.
We’ve seen this time and again over the years, but usually in the opposite direction. So, markets start to price an outcome that’s more dovish than the Fed would prefer under the prevailing circumstances, but as market expectations solidify, disappointing those expectations risks a de facto tightening impulse, which could compel the very same dovish lean anyway, only on a delay.
In 2022, that dynamic has shown up in reverse. Markets, knowing the Fed is increasingly concerned about the prospect of inflation expectations becoming unanchored, and understanding that the Fed views its own actions as key to preventing that from happening, pushed the issue on rate hikes, not only in terms of testing the waters on ever higher increments, but on at least two occasions, toying with the notion of inter-meeting, emergency moves.
By and large, those episodes weren’t acute enough to force the Committee’s hand, and given the rapid pace of hikes actually delivered and the Fed’s zeal to channel Volcker, it didn’t much matter. Although the Fed didn’t resort to any emergency hikes or raise rates by a full percentage point at a single meeting, they nevertheless moved so rapidly that pricing for hikes beyond those delivered had no practical relevance, especially considering everyone knew another large hike was coming within a matter of weeks anyway.
The September meeting risked becoming the first example of a situation where the market leaned heavily enough in the direction of the more hawkish of two possible outcomes, that failing to deliver that outcome chanced a de facto easing impulse, which could be a disaster under the circumstances. Indeed, as Jerome Powell discovered after the July FOMC meeting, even delivering on the most hawkish outcome can still result in a de facto easing impulse if the messaging is “wrong.”
In short: The “coin toss” odds for September (between a 50bps move or a 75bps move) effectively meant the Fed had to go 75bps. Just by pushing the market-implied odds to 50-50, traders effectively made the odds for 75 100 (percent).
Think about it this way. If it’s a coin toss in the market’s estimation and you, as a policymaker, opt for the less aggressive of the two options, that’s dovish by definition. You had two choices, each seen as equally likely. Absent a clear, data-based rationale, favoring the smaller increment is tantamount to a willing dovish lean. Right now, the Fed can’t afford even the appearance of a dovish lean because it could catalyze a stock rally, a sharp correction in the dollar and a snap tightening in credit spreads, all of which would run counter to the Committee’s objectives.
As such, 50-50 odds are effectively 100% in favor of the hawkish option. That’s why the Fed was confident enough to effectively pre-announce (via speaking engagements and, if you believe Nick Timiraos in fact serves as a Fed mouthpiece, via The Wall Street Journal) a 75bps move, two full weeks ahead of the decision, without even seeing August’s inflation figures first.
On Tuesday, following August’s disastrous inflation data, traders pushed up the odds for 100bps next week to levels that, while not perilously close to the sort of consensus that’d risk boxing the Fed in, were still too close for comfort, unless you think Powell actually wants an excuse to hike by a full point. A 75bps hike is fully priced — and then some (figure below).
Here’s the risk: If retail sales come in hot (which they very well might considering the possibility that falling gas prices freed up discretionary income last month) and, for whatever reason, recent relief at the pump doesn’t manifest in another relatively benign read on medium-term inflation expectations in the University of Michigan survey, traders could push the issue on 100bps to the point of no return. That is: To the point where 75bps becomes the dovish option, as opposed to the only option (50bps was basically out the window even before the CPI figures).
I don’t personally think that’s likely. However, do note (and I’m repeating myself here on purpose) that 100bps doesn’t have to become the overwhelming consensus in terms of market-based odds to become the more likely choice for officials. It just has to pick up enough in the way of momentum to make it something other than a tail risk. At that point, the Fed has to consider the possibility that sticking to 75bps would be perceived as “dovish.”
BMO’s Ian Lyngen and Ben Jeffery alluded to all of this. “Calls for 100bps have already begun, although given the short-lived attempts to price in a full point ahead of the July meeting, we’ll continue to anticipate ‘unofficial official’ guidance via the financial media before the market pricing gets ahead of itself and creates a scenario in which a 75bps hike won’t be viewed as sufficiently hawkish,” they wrote. “What a difference an inflation update can make for policy expectations.”
Fortunately, September’s meeting is an SEP gathering, which means there are all manner of ways for officials to deliver a “hawkish 75” instead of a kitchen sink 100 which, all good arguments in favor aside, does carry at least some risk of being seen as a panic move.
On Tuesday, markets priced in more easing in the back-half of 2023 (figure below) on the assumption that the harder and higher the Fed goes now, the greater the risk of a crash landing and bigger pivot later.
“Today’s CPI print (and ensuing gap higher in terminal rate) is killing any hopes of a soft landing, as the Fed is now perceived as having to ‘slam the brakes’ with even tighter financial conditions into hot inflation and labor markets,” Nomura’s Charlie McElligott wrote.
Paradoxically, he went on to say, “the only real bid to US equities index vol is in upside / call skew, which I’m gonna take a leap of faith on and tie into the idea that ‘the sooner we crash it,’ and the larger the magnitude, the sooner the Fed can pivot.”