US equities were poised to “defy the naysayers” while “looking through” the hawkish set of Fed dots which accompanied the Committee’s decision to pause rate hikes in June, even as most officials eye a higher terminal rate.
While editorializing around the June FOMC and Jerome Powell’s press conference, I suggested the dots could be a bluff — a necessary precaution to avoid the appearance of a “dovish pause” in the face of an escalating stock rally and an apparent trough in housing.
There was a sense on Thursday that markets are inclined to think the Fed is done, even as the dots and Powell, when taken at face value, suggested no such thing. As usual, Powell reiterated that the dots are just projections, and that nobody really knows where Fed funds will end up, even over the medium-term. But he says that after every SEP meeting.
I’m not personally convinced the Fed is totally bluffing, although to Michael McKee’s question for Powell on Wednesday, hiking in July will present a communications challenge if nothing materially changes between now and then on the macro front. Unless of course the Fed would be content to say “That’s precisely the point” if protestations to a prospective July move revolve around the notion that “nothing’s changed” from June.
In any event, I do agree with the idea that the Fed is buying time to let the “lags” work, and also with the notion that, to the extent Fed officials are concerned about market developments, they’re fine with ignoring irrational stocks as long as rates continue to align with the Committee’s insistence that easing is highly unlikely this year. Note how sharp the re-steepening is in the visual below.
It may well be that the Fed believed the only way to convince markets that the Committee can hold rates at current levels through the December meeting was by suggesting a majority of officials want rates 50bps higher.
The overarching goal isn’t necessarily to achieve a higher terminal rate, unless it becomes glaringly obvious that five-handle Fed funds is nowhere near sufficient to tame inflation. Rather, the (unspoken) goal is to make it through 2023 without having to reverse course and cut rates with inflation still above target. Ideally, the Fed can get some market buy-in for that, and indeed H2 rate cut odds have been faded aggressively, as the chart above shows.
“Honestly, those are just rhetorical tools which allow the FOMC to keep financial conditions from easing while pausing, while also giv[ing] them back some optionality in case stuff gets squirrelly again later in the year, but without committing to tangible policy actions,” Nomura’s Charlie McElligott said Thursday, of the dot plot and Powell’s contention that rate cuts are a couple of years (not months) out. “The market is really just looking through the dots in an unconvinced fashion,” McElligott added. As one of Charlie’s colleagues in Nomura rates vol put it, the two additional 2023 hikes implied by the dots “were clearly not considered credible by the market.”
McElligott pointed to an “utter melt” in rates vol over the past three or so weeks. Apparently (i.e., if you believe markets), the distribution of near-term macro and policy outcomes has compressed materially.
The market is fading both hikes and cuts, “de facto selling straddles,” as Charlie put it, suggesting some might be tempted to view this as one final chance to short vol now that the Fed, ECB and US CPI event risks are in the rearview.
If the Fed does indeed extend the pause, that’d only serve to further compress the range of outcomes, and indeed McElligott said the hawkish dots and rhetoric might’ve reduced the odds of Powell needing to re-escalate at Jackson Hole (the “August risk,” as I called it).
But there’s a caveat, and an important one at that. “The longer the Fed holds above 5% due to ‘still too high inflation and too tight labor markets,’ we perversely have even more certainty of an even harder landing, especially into tighte[r] bank lending and credit conditions and the diminishing liquidity profile with bill issuance and ‘crowding-out’ risk, all while rest-of-world central banks re-escalate hikes.”
A repeat Jackson Hole performance may not, probably will not, impress the markets, who were once afeared of the Fed’s bark but now figure they’ve taken the worst of the Fed’s bite and, hey, party on.
No-one thinks the Fed will raise rates from 5% by more 100’s of bps, or even by another 100 bp. No-one thinks the Fed will do a BoC and let its balance sheet freefall with maturities. No-one thinks the Fed will risk another wave of bank failures, or UE rising to where it normally goes in a downturn. Investors might believe the Fed would like to see asset prices tumble, but since the Fed won’t do the things that would cause that, who cares?
The new reality is: inflation may stay high or go down; there may be a soft landing or no landing; new bubbles may inflate or not – and the Fed will be largely a spectator, feebly casting for more data and wringing its febrile hands over whether it daren’t burn its last two 25 bp matches.
Basically, I think that until and unless the Fed does something that shocks, frightens, and really hurts investors, the Fed is no longer a major factor in the equity market, and maybe a diminishing factor in the bond market away from the very short end.
Which is a sea change. No adults! No rules! No bedtime! We’re either in “Peter Pan” or “Lord of the Flies” now.