“Cash is seemingly burning a hole in the pocket of investors again,” Nomura’s Charlie McElligott said Tuesday.

US equities notched additional gains following an as-expected CPI report seen as friendly to the Fed leaderships’ preference for a pause at this week’s policy gathering.

At this point, with stocks up 22% from the October lows, the Committee has to be cautious about the rekindled wealth effect. As discussed in “The August Risk”+, US households’ stock gains in Q1 covered losses on property values four times over — during a quarter which featured multiple bank failures.

Simply put: The Fed can’t chance a “dovish pause” on Wednesday. The median 2023 dot has to shift up to indicate a preference for one additional hike, even if it’s a bluff. Anything less than a “hawkish skip” could be greeted by more equity upside.

McElligott emphasized that “Fear Of Cash Underperforming Stocks” — the “FOCUS” acronym he introduced into the discussion last month — is now squarely in play “as investors pivot from 2022’s extreme bias towards ‘return of capital’ to now, in 2023, a ‘return on capital’ prioritization.”

Note that discretionary positioning is, at least, not bearish anymore. On Deutsche Bank’s measure, it’s neutral for only the second time since the Fed began raising rates.

Neutral suggests scope for additional exposure adds in the event stocks keep running away higher. The figure above is an updated version of the discretionary/quant split. Regular readers will recall that as of mid-May, discretionary positioning still lagged systematic re-leveraging materially. Not anymore.

You could argue that the position rebuild diminishes the contrarian bull case — some of the squeeze fuel is now expended. Note that at the lows for stocks in October, the average cash allocation in BofA’s Global Fund Manager survey was 6.3%, higher than the COVID crash and the months around Lehman. As of June, it was down to 5.1%.

“Cash is still high-ish but no longer uber-high and no longer slam-dunk contrarian bullish,” BofA’s Michael Hartnett said Tuesday.

And yet, Hartnett was quick to note that there’s no evidence of “let’s go ‘risk-on’.” Allocators cut cash to a 19-month low, but also cut stocks “despite the FOMO bull price action.” Commodity allocations dropped to a 37-month low, and panelists were the most overweight IG relative to junk in eight years.

This isn’t an easy situation to read. Macro and policy caution are pervasive, but so is FOMO (or “FOCUS”). It’s a tug of war between, on one side, fear of recession, fear of no recession (because no recession could mean more rate hikes) and fear of sundry geopolitical “unknowns,” and, on the other side, fear of missing the rally.

“US equity index / ETF skew and put skew keep leaking into OpEx as has been the case the past two weeks,” McElligott wrote, in the same Tuesday note mentioned here at the outset, adding that “all those quarterly downside hedges put on [amid] the regional banks crisis [and] debt-ceiling saber-rattling” were toast when the “worst-case scenario fail[ed] to materialize on either.”

“All those puts get destroyed on the rally [and] the hedge unwind further propels us higher,” Charlie went on.

You’d think the (almost self-evidently) tenuous character of the rally would manifest in demand for downside (or pronounced demand for crash protection) but apparently not. At 92, VVIX hardly sticks out.

Morgan Stanley’s Mike Wilson, who isn’t buying the bull market story, panned the rally this week as “one of the most concentrated markets in history.”

“Liquidity improved greatly with the depositor bailouts at the same time A.I. began to gain momentum,” Wilson said. “The combination of perceived safety and a newfound open-ended growth opportunity was too much for investors to resist.”

Speaking of liquidity, Simon White (a Bloomberg blogger) on Tuesday pointed out that excess liquidity, defined as “the difference between real money growth and economic growth” is now rebounding. That, he suggested, is a “loud and clear” signal for risk assets.

“The logic is simple: Money is created by banks and central banks, and what is not used by the real economy is ‘excess,’ and therefore available to support risk assets,” White wrote, noting that this measure is contrarian by definition. When growth and inflation trough, it’s rising, which means  “sentiment is at its weakest precisely when markets unexpectedly rally due to a surfeit of liquidity.”

This is a decent counterpoint to the well socialized Q3 “liquidity drain” bear case discussed in these pages on so many occasions that even I’m bored of it. The interesting juxtaposition between the two wasn’t lost on White. “The risks were tilted toward [post-debt ceiling Treasury issuance] having a detrimental effect on liquidity conditions overall,” he said, before suggesting that so far anyway, money funds might be absorbing supply. He also pointed to BTFP usage (which hit a record above $100 billion last week+) as a “new source of reserves, providing another boost to… excess liquidity.”

In any event, you can be sure the Fed has noticed the stock melt-up. Whether Jerome Powell is concerned about it is an open question. Certainly, he’s not as worried about the inflationary read-through of stock gains as he was in August of last year.

Powell may or may not be queried on equities’ recent gains following the FOMC decision, but to the extent the Fed was already keen on preserving their optionality vis-à-vis a resumption of hikes in July, the rally should underscore the case for a hawkish statement, dot plot and press conference cadence. The CPI report wasn’t favorable enough to offset the clear risk of renewed animal spirits on Wall Street.