Perfect Bullish Storm

“One month of data does not a victory make,” Mary Daly said Thursday, speaking during a Q&A for an event hosted by the European Economics and Financial Center.

Daly was, of course, referring to the October CPI report. While policymakers were keen to avoid suggesting that 6.3% annual core inflation counts as any kind of “win,” markets took a victory lap. Or maybe a victory sprint is more apt.

The Nasdaq was an astounding 7.4% higher headed into the closing bell, the S&P 5.5%. The NYSE FANG+ Index put up a Hang Seng Tech-style rally, rising a mind boggling 9% on the day (figure below).

You don’t see that every day from a US benchmark. Maybe it’s a stretch to call the FANG+ gauge a “benchmark,” but you get the point. Thursday will live forever on daily change bar charts as an anomalous spike, visible from space, so to speak.

The dollar’s dramatic decline ended up exceeding 2.2%. That too was anomalous. Indeed, pretty much everything about Thursday’s price action was anomalous.

The Fed would’ve probably rather this didn’t happen. Stocks up 6%, the dollar down 2% and 10-year US yields down 32bps, together represent a significant financial conditions easing impulse. According to Mortgage News Daily, mortgage rates plunged 60bps. Five-year US reals dove 26bps (figure below).

Again, that’s a pure financial conditions easing impulse. Thursday was a perfect bullish storm for risk assets, and it was doubtlessly turbocharged by a veritable incineration of puts and other downside expressions, panicked grabbing into upside and associated dealer hedging.

As detailed here earlier Thursday, terminal rate pricing came down materially, and traders priced out any chance of a 75bps hike next month. Daly attempted to talk markets back from their most bullish impulses, as did Lorie Logan, but both confirmed the “step-down.”

“Stepping down is an appropriate thing to think about,” Daly said. “Pausing is not the discussion, the discussion is stepping down.”

“While I believe it may soon be appropriate to slow the pace of rate increases so we can better assess how financial and economic conditions are evolving, I also believe a slower pace should not be taken to represent easier policy,” Logan chimed in. “This morning’s CPI data were a welcome relief, but there is still a long way to go.”

The figure (below) gives you a sense of how market pricing has shifted.

Effectively, all of the progress Jerome Powell made towards convincing the market of the Fed’s “higher for longer” narrative during his hawkish November press conference, is gone. That’s suboptimal (a word I’ve used a lot this week in various contexts) for a Fed determined to avoid a scenario wherein asset prices and the dollar work at cross purposes with efforts to tighten policy.

“What it really points to is that the days of accelerating core inflation are behind us, and now the Fed would like to see compelling evidence that disinflation is running at an acceptable pace,” TD’s Oscar Munoz remarked, commenting on the data. “The road to sustained monthly core inflation rates at an annualized 3% or lower is still long and the Fed will attempt to carefully grind down the labor market to align wage and household spending growth with those kinds of inflation rates.”

The problem, again, is that “these kinds” of rallies, to paraphrase Munoz, aren’t consistent with “those kinds of inflation rates” if the resurrection of the vaunted wealth effect forestalls consumer retrenchment. If yields continue to fall (i.e., if bonds continue to rally), mortgage rates will trek lower, very likely bringing buyers off the sidelines and supporting home prices, which have just begun to fall.

Simply put: Days like Thursday are a double edged sword for the Fed. On one hand, any good news on the inflation front is welcomed with open arms. On the other hand, if progress towards lower inflation conjures animal spirits among wild-eyed traders, it’s counterproductive.

“In keeping with investors’ perception that policy is nearing an inflection point, the lower terminal pricing has taken off the quarter-point that the September core surprise and Powell press conference added,” BMO’s Ian Lyngen and Ben Jeffery said late Thursday. “The Chair’s endpoint estimate was sensitive to a single upside inflation print; the question now becomes whether the opposite also holds true.”