It’s hard to overstate the significance of the apparent tone shift from the Fed regarding the prospects for rate cuts in 2024.
To be sure, so-called “insurance cuts” were always on the table and officials haven’t made a secret of their prospective willingness (note the emphasis) to cut rates in the presence of lower inflation.
On several occasions over the past nine or so months, officials alluded to the possibility of cuts to ensure the real policy rate doesn’t increase as inflation falls — cutting to stand still, so to speak.
The familiar figure above illustrates the point. If inflation continues to recede and the Fed doesn’t cut, the real policy rate will keep rising. That could be perilous, particularly if the economy is losing momentum: The Fed would be de facto hiking (in real terms) into the slowdown.
So, the idea of risk management cuts certainly isn’t new, but Chris Waller’s Tuesday remarks were (easily) the clearest indication yet that the Fed will, in fact, be inclined to cut should inflation keep falling, irrespective of whether the broader economy is struggling. So, rate cuts without a recession.
Before Tuesday, most market participants “didn’t really know” that scenario “had any delta,” Nomura’s Charlie McElligott said Wednesday, of rate cuts in the absence of a downturn. “He also put a time horizon on this sea change,” Charlie added, referencing Waller’s “three months, four months, five months” remark. That means markets “could hypothetically get ‘soft landing cuts’ as soon” as the March or May meetings, McElligott went on. Traders priced in almost one full additional cut for next year (i.e., from ~100bps to ~120bps) while pulling the first cut forward.
The implication for rates is a possible acceleration of November’s short squeeze. For equities, all of this — confirmation from a Fed official that cuts are indeed on the table, an escalating rates rally and so on — is almost too good to be true. The only thing that stopped stocks from rallying even harder was the fact that November’s gains were already well into blockbuster territory by this week.
Note that the near constant pressure on reals this month was a boon to risk.
Five-year reals were 2.60% in early October. They’re 2.14% now. They fell 12bps on Tuesday alone. That’s a huge FCI easing impulse.
“A further tilt towards more Fed easing and easier financial conditions — yet in the absence of a hard landing or growth scare shock — is pure elation for equities spot, while at the same time exacerbating the bleeding in the US dollar and vol space,” McElligott said.
Readers were apparently too busy reading about money market fund AUM and Elon Musk early this week to care about adventures in the vol-scape, but suffice to say my aside about vol risk premium harvesting becoming self-fulfilling (from the linked “vol-scape” article) appears to be realizing (no pun intended).
“All of this US equities options dealer ‘long gamma’ from being perpetually stuffed by the VRP premium income / overwriting crowd is also dealers choking on ‘long vega,’ hence they are part of the largest short vol (hedge) flow going, as they attempt to negate the PNL drain by having to short more near-dated vol the lower it goes,” Charlie wrote.
Of course, as realized vol bleeds it creates a latent bid from vol control. That universe accounted for nearly $30 billion in stock-buying over the last week, according to Nomura, and could add considerably more in an environment where the distribution (i.e., the range) of daily outcomes stays reasonably compressed.
While fully acknowledging that things could turn on a dime, vindicating sundry Grinches and bears (remember last December?), recent events are yet another reminder that if you’re going to trade tactically (or weigh in on the near-term direction of markets) you need to be a talented Fed tasseographer and you need to have a solid grasp on how positioning across investor cohorts (and across assets) interacts with the macro-policy nexus to drive price action in a vol-sensitive world.
We’re a long way from Mr. Powell’s “Persistence,” …it would seem…today I find myself fearing Fed hubris…
Since March 17, 2022 (the date of the Fed’s first interest raise- which was 25 basis points), the Fed seems to be navigating pretty well!
No reason not to think they will continue to do so.
Once again, thanks for your persistent coverage of the vol-driven traders and CTAs. Their flows absolutely dwarf retail and pension flows and even surpass buy-back volumes by a factor of three or four.
But people mostly seem to be obsessed with dot plots and the next quarter point change in short rates, ignoring what is driving the stock market on a weekly and even monthly basis.
It’s “follow the money, baby!”
Thanks for your comment. It takes reminding where the money really is. You, H, and John L keep us up on the key info. Good job.
I’m hoping that at least one Fed official has come to realize that their interest rate hikes are barely responsible for the drop in inflation. The only “success” I can see is that they helped to deflate office real estate prices, at a cost of imperiling many medium and smaller regional banks.
Besides that: how did higher rates help push down food prices? How about “rental equivalent” prices? Healthcare costs? Education costs? Childcare costs? Eldercare costs? And even energy prices?
A chorus of crickets seems appropriate, no?
One reason is that their models have proven well out of date, especially when it comes to the impact of interest rates on housing prices.
Even if the Fed’s rate hikes have had no effect in bringing inflation down – was it indeed all transitory? – it will be better to enter the next recession with 500 bps of rate cut potential than without, people can make a safe-ish return in HTM fixed income, various business practices/models needed to be starved of free money, and stocks look buyable away from some Megatechs. Maybe it’s the Calvinist on me, but things just feel more righteous when interest rates are not approximately zero.
Must be hard having a Calvinist on you…lol
You sound like another Calvinist-influenced buddy who I tease about that.
The only problem is that Main Street took the brunt of the “collateral damage” the rate hikes caused, though they weren’t a major cause of inflationary pressure.
Probably exposing my myopia here, but it feels to me like this cycle of rate hikes has done less damage to Main Street than typical. Just as it has done less damage to corporates and Wall Street than typical.
After 20+ months of rate hikes, employment is still strong, house prices ditto, household wealth ditto, consumer spending holding on, consumer credit delinquencies rising but not “high” yet, individual bankruptcies rising but still low compared to prior years, etc. Damage is mostly at the lower income levels, but more of that damage seems to be from inflation (food, services, etc) rather than rates (car loans, credit card rates, etc).
Housing is where rates seem most arguably culpable. Rents will be pressured upward in future years by today’s rates suppressing starts, but right now there’s a record number of units coming to market, started at prior low rates. New homebuyers are suffering, but that’s a small number of households compared to existing homeowners and renters.
Conventionally, by this point in the hiking cycle, we’d be in a recession and Main Street would be beset by layoffs, foreclosures, etc.
Perhaps the damage is just taking longer to manifest. Caution is moving up the income scale, as seen in retailer reports. Inventory correction is taking shape, see JBL etc, and capacity correction are as well, see most of transport sector.