2023’s ‘Most Mispriced Tail Risk’

It’s unlikely that anything Jerome Powell has to say on Wednesday, following the conclusion of this week’s FOMC meeting, will dissuade markets from the idea that Fed cuts are coming in the back half of 2023.

Powell will surely hammer home a familiar list of talking points, one of which is that the “job isn’t done” and the Committee intends to finish it by keeping rates in “sufficiently restrictive” territory up to and until inflation is judged to be on a sustainable path back down to the Fed’s target.

Everyone expects that language, everyone knows the hike cadence is 25bps from here and everyone expects the final hike in May, at the latest. Some now suspect March’s hike will be the last of the cycle and, indeed, there’s speculation that March is in play for a pause, depending on the evolution of the data between now and then.

It’ll be very difficult for Powell to change that narrative during his chat with reporters this week. He’d need to push back more forcefully on market pricing than officials already have, which would mean explicitly calling that pricing wrong, a perilous thing to do given decelerating economic momentum in some corners.

Of course, not all indicators argue for a slowdown. The labor market remained bulletproof headed into 2023, and this week we’ll find out whether the teflon characterization held in January. At the same time, the equity and bond rally, alongside a weaker dollar and dramatically lower real yields, have served to ease financial conditions materially.

According to Goldman’s gauge, the financial conditions easing impulse seen this month is on par with those witnessed in November and July. Do take a moment to read the annotations in the chart shown above.

In addition to gains on Wall Street, you can see the impact in the housing market, where a multi-week decline in mortgage rates helped drive a surprise gain in pending home sales in December, according to data released late last week. From early November through late December, mortgage rates fell 80bps.

Although pending home sales obviously plunged on a YoY basis, December’s 2.5% monthly advance from November defied expectations for another drop. It was the first increase since May.

“This recent low point in home sales activity is likely over,” NAR Chief Economist Lawrence Yun remarked. “Mortgage rates are the dominant factor driving home sales, and recent declines in rates are clearly helping to stabilize the market.”

Pending home sales are one of the more timely indicators of housing market trends, and equities are, among other things, a real-time barometer of animal spirits. If those animal spirits become too lively, the result could be a self-fulfilling carousel of easier financial conditions, to the extreme detriment of the inflation fight.

In essence, the Fed could get pulled into a “defeat from the jaws of victory” scenario, forcing a second hawkish pivot following a brief pause over the summer, perhaps beginning at Jackson Hole. Or at least that’s one tail risk, as detailed on Monday by Nomura’s Charlie McElligott.

“I like to tell people that one part of my job I most enjoy is ‘reverse-engineering car crashes’ before they happen,” he wrote, before asking, “So what would be a massive 200-vehicle pile-up that shuts down a snowy highway for days as ‘my most mis-priced risk?'” He then answered his own question. Below, find that answer, and consider it in the context of everything said above.

The Fed is expected to soon enter their anticipated “pause and assess” phase, as recent labor- and wage- datapoints have shown signs of “cooling,” lending further credibility to the multi-month disinflation trend, which has the masses then reasonably assuming that the next trade is that seemingly obvious “Fed easing / rate cuts” into the economic slowdown / recession, as US labor and consumption finally “cracks” from the lagged policy tightening implications of 2022.

But, God forbid, we instead see the “animal spirits” flowing preemptively within the US economy due to the equally-preemptive “FCI easing” which is already well in motion in markets since late Q4, and with it, we see economic activity and price data resume surprising higher, versus this current “immaculate disinflation” / slowdown consensus view.

Last week’s pending home sales upside surprise and revision higher was a warning as to just how leveraged we are to an easing in financial conditions: This multi-month impulse “FCI easing” saw an almost immediate uptick in housing market activity, because of the structural demand-supply imbalance within the US market. The national average 30-year jumbo rate has fallen by ~90bps in two months, allowing for pending deals to clear and buyers to begin lining back up, as the volatility of mortgage rates, now settled, matters more than the absolute level of rates.

Same theme (from Redfin): “Redfin said Wednesday the housing market has begun to recover from a trough in the second week of November with buyers returning at a faster pace than sellers. The number of Redfin customers asking for first tours has improved by 17% from the November low, and the number of clients contacting Redfin agents to begin the home-buying process has improved by 13 points, according to a report. ‘I’ve seen more homes go under contract this month than in the entire fourth quarter,’ Angela Langone, a San Jose, California, agent, said.”

More from Redfin: “‘Bidding wars are back in Seattle,’ said local Redfin real estate agent Shoshana Godwin. ‘One of our Issaquah listings got 12 offers and is under contract for $155,000 over the $1.4 million list price. The buyer waived every contingency, handed over $300,000 of earnest money and is letting the seller stay for free for two months after closing.'”

Accordingly, the nightmare trade ends up being that after this telegraphed upcoming “Fed pause for ‘x’ months,” we get a shock resumption of Fed hikes thereafter, instead of everybody’s anticipated Fed easing as the purported next move.

So, yes, the more this “FCI easing” trade runs now, the deeper the hole the Fed would theorectically find themselves in due to the potential of “animal spirits = wealth effect = demand-side inflation uptick” scenario months down the road — particularly due to the housing market re-leveraging dynamic.


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16 thoughts on “2023’s ‘Most Mispriced Tail Risk’

  1. I know I sound like a broken record, but any attempt by the Fed to bring down housing prices in the near term are ultimately self-defeating. It’ll just stretch the rubber band farther and farther back until it either breaks (i.e. they crush the broader economy) or it snaps back even harder (i.e. prices will go even higher). The only way to bring down housing prices sustainably is more supply or a reduction in the population, and the Fed can’t do either of those things.

  2. My speculation is that Powell was stung by the size and duration of the inflation spike, and he is determined not to go down in history as the Fed chair who let inflation get out of control–or let it persist for too long because he lost his nerve. He probably also wants to make sure that the worst news for the economy comes in 2023, and not 2024 (an election year). I think those expecting easing in 2023 are wrong, and those starting to forecast a pause at the March meeting are giving Powell just the situation he needs: he can raise a relatively small 0.25%, and at the same time be seen as erring on the restrictive side.

  3. What if the greatest mis-priced tail risk is that in spite of the Fed emphatically stating that they want to squash inflation/ their top priority is to provide the American people with price stability;
    the Fed’s actual top priority is to allow as much inflation to occur as possible (without causing social and economic upheaval) because the Federal Reserve primarily wants to foster the efficiency of the nation’s monetary system (i.e. allow inflation to minimize the problem of too many “interest bearing USDs”).
    Let’s see what the Fed does and then compare that to what the Fed says/has been saying.
    The Federal Reserve was created in 1913. The USD has lost 97% of its value since 1913 – due to inflation.

    1. The average inflation rate for the period from 1914 to 2023 was 3.16% per year. The average rate of inflation between 1980 and 2023 was 3.13% (core) and 3.02% (all-CPI).
      2% is a “pipe dream”.

    1. Yes definitely 50bps. Let’s just get to 5% already. Commodity prices are already increasing and if the dollar softens further then commodities, particularly oil will get more expensive. Additionally Iran appears to have enough fissile material now and makes a conflagration with Israel+Saudis against Iran more likely perhaps ??

  4. I believe the only way to force housing to come down is to increase unemployment. People are demonstrating that they will overpay both in the price of the home and the cost to borrow that home, given that they are able to keep paying the mortgage. And this current housing bubble still feels very 2008ish to me, the prices that are being paid make no sense at all. So if the objective is to reduce housing inflation the only way the Fed can do that is to keep hiking us into a layoff filled recession.

    1. Back then, banks would give you a 0% down, interest only loan with no proof of income. They’d even throw in a fixer upper as a housewarming gift. These days, you get a financial colonoscopy if you so much as set foot in an open house.

  5. Academic economists are well meaning people, but in the interest of feasibility, they limit the number of moving parts in their models…They are also very coy on the subject of time horizons…As a former trader, I had to compensate for the limitations of this approach every day. I kept a lot of opinions to myself, because I couldn’t spare most of my day to arguing with the under-researched and overconfident…Thank God for the people who are explicit about their time horizon and their degree of leverage….

  6. A friend sent along a reminder this morning:

    “NEW YORK, Jan 31 (Reuters) – Federal Reserve officials believe their effort to shrink the U.S. central bank’s bond holdings is far from done, pushing back against some economists’ idea that dwindling financial sector liquidity would bring the drawdown to a close in coming months. Instead, Fed officials reckon there remains a lot of liquidity, properly measured, for them to remove as part of their push to tighten financial conditions and bring down inflation.”

    It seems that we are all solely focused on the headline lending rate rather than the supply of credit.

    1. Amen on the QT. (And M2).

      Feel like this is a press conference where Powell could really use H as his press sec. Keep it short and simple. Don’t push back and don’t concede. Basically repeat the last press conference. We’re slowing the cadence to digest, assessing the incoming data, and that will determine our future decisions. We’re doing what we said we’d do and we are seeing what we hope will be contining signs of improvement with inflation. But we haven’t seen enough to change our previous guidance on our expectations of the terminal rate or its future path. See you in March and go Eagles.

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