This May Be Fed’s ‘Final Phase Shift’

On Thursday, in “Powell Didn’t Try To Kill The Rally. And That’s Notable,” I contextualized Jerome Powell’s closely-watched remarks at the Brookings Institution by the recent easing in financial conditions.

This is a critical discussion. When stocks rally, yields fall and the dollar retreats, it’s counterproductive for a Fed that, until very recently, was desperate to preserve every bit of the tightening impulse engineered this year over 375bps of rate hikes.

If inflation were 3.5%, or even 4%, intermittent equity bounces, dip-buying in bonds and reprieves from otherwise inexorable dollar strength wouldn’t be particularly vexing. But with headline CPI still perched near 8%, the rekindling of the wealth effect (through higher asset prices) and the “pure” financial conditions easing impulse emanating from large declines in US real yields and attendant dollar weakness, are anathema.

Or at least they were. But, as detailed and visualized in the first linked article above, Powell didn’t take the opportunity this week to push back against a sizable FCI easing impulse from the ongoing rebound in stocks, a dollar coming off its worst month in a dozen years and, critically, a very large drop in five-year reals over just two months (figure below).

Small wonder, considering that rather poignant visual, that stocks logged back-to-back banner months in October and November.

With all of that in mind, consider the color below from Nomura’s Charlie McElligott, who weighed in Thursday with his take on what could be a meaningful shift from the Powell Fed.

In my eyes, Powell 1) signaled a new and final phase in the Fed’s policy tightening journey — transitioning from the ongoing asymmetric risk of ‘Where absolute terminal rates could go’ to now simply ‘How long to hold restrictive before the tightening ends’ — which was then interpreted by the market as reducing the left tail risk of ‘over-tightening into an accident,’ while simultaneously 2) communicating a ‘new’ message on the Fed’s FCI reaction function, where for the first time in this tightening cycle, the recent financial conditions easing did not require Powell to browbeat the markets with a ‘threatening’ message in order to keep FCIs restrictive.

Powell clearly was not there [Wednesday] to punish markets for the monster easing seen in financial conditions experienced over the past month and a half with [the] doom-and-gloom hawkish message which had been the expectation for many coming in (i.e., a belief that Powell would repeat a Jackson Hole-like performance from August and ‘slap the taste’ out of the market’s mouth for misbehaving).

But he did no such thing this time around, and that is because this recently ‘slow play and buy time’ approach from the Fed is paying off: They are getting the right’ move in MoM core inflation lurching lower, while the recent labor, wages and ‘sticky’ inflation inputs [are] now too showing signs of ‘cooling,’ maybe even breathing some life into ‘soft landing’ right-tail scenarios, in a world where consensus is ‘hard recession.’

Mind you, this comes after the Fed had just recently transitioned out of the acute and high-risk ‘front-loaded tightening’ phase only a few months ago.

It seemed clear to me that Powell signed off on the next and final ‘phase shift’ in the Fed’s tightening cycle: His messaging felt like he was throwing the market a bone by also cutting the left-tail scenario on ‘over-tightening’ risk from here, via not really voicing any need to keep said ‘even higher’ terminal rate optionality — instead really just focusing on the length of time left where the Fed continues to hold rates in restrictive territory.