‘‘We are now at levels broadly in line with our estimates of neutral interest rates, and after front-loading our hiking cycle until now we will be much more data dependent going forward.’’
Jerome Powell, July 2022 FOMC press conference
Hi all, and welcome back on The Macro Compass!
Despite admitting that economic growth is clearly slowing down, the Fed just hiked by another 75 basis points and reiterated the path of least resistance from here is well represented by the Dot Plot: more hikes ahead - all the way to Fed Funds at 3.75%!
And yet, markets have staged a humongous rally led by the most valuation intensive and risk sentiment driven asset classes: Nasdaq and Crypto.
So, what the heck?!
It all boils down to how one single sentence Powell pronounced was able to affect the probability distributions investors were projecting for different asset classes.
Does it sound complicated? Bear with me: it’s not!
In this article, we will:
Break down the FOMC meeting, and in particular discuss why that ‘‘one single sentence’’ spurred such a crazy rally;
Assess where this leaves us now: is the music changing?
Why Such a Humongous Rally?
When the FOMC meeting press release was out, it all looked like business as usual: a well telegraphed 75 bps hike with the only small surprise represented by an unanimous vote (George did not dissent) despite a clear acknowledgment that economic growth is softening.
But not even 15 minutes into the press conference, the fireworks went off!
And particularly when Powell said:
‘‘We are now at levels broadly in line with our estimates of neutral interest rates, and after front-loading our hiking cycle until now we will be much more data dependent going forward’’.
This is very important for several reasons.
The neutral rate is the prevailing rate at which the economy delivers its potential GDP growth rate - without overheating or excessively cooling down.
With this 75 bps hike, Powell told us the Fed just reached its estimate of neutral rate and hence from here they aren't contributing to economic overheating anymore.
But that also means any hikes from here are going to put the Fed in an actively restrictive territory.
And the bond market knows that every time the Fed became restrictive in the past, they ended up breaking something.
Until yesterday, you could be completely sure the Fed would have just pressed on the accelerator - inflation must come down: no space for nuances.
So journalists went on and asked questions to find out something more about the ‘‘new’’ forward guidance. It went roughly like this:
Journalist: ‘‘Mr. Powell, the bond market is pricing you to cut rates starting in early 2023 already: what are your comments?’’
Powell: ‘‘Hard to predict rates 6 months from now. We will be fully data dependent’’
Journalist: ‘‘Mr. Powell, due to the recent bond and equity market rally financial conditions have eased quite a lot: what’s your take?’’
Powell: ‘‘The appropriate level of financial conditions will be reflected in the economy with a lag and it’s hard to predict. We will be fully data dependent’’
He did it.
He totally ditched forward guidance.
And what happens when you do so?
You give markets the green light to freely design their probability distributions across all asset classes without any anchor - and that explains the gigantic risk rally.
Let’s see why.
If the Fed is so data dependent and there is basically one data they care about, it all boils down to how inflation will evolve in the near future - and the bond market has a very, very strong opinion about that.
Using CPI inflation swaps, I calculated the 1y forward, 1y inflation break-evens (CPI) in the US - basically the expected inflation between July 2023 and July 2024 which is represented in the chart above and sits at 2.9%.
Remember the Fed targets (core) PCE, which tends to historically be 30-40 bps below (core) CPI: basically, the bond markets expects inflation to slow down very aggressively and roughly hit the Fed target in the second half of 2023 already!
So if the Fed is not nearly on autopilot anymore, and markets have a strong opinion on inflation and growth collapsing then they can also price all other asset classes around this base case scenario: it starts to be more clear now, right?
This is what my Volatility Adjusted Market Dashboard (VAMD, here a short explainer) showed soon after Powell pronounced that one single sentence.
Reminder: the darker the color, the bigger the move in volatility-adjusted terms.
Notice how I highlighted three movers, but let’s start from US real rates.
If the Fed isn’t gonna blindly keep hiking but be more data-dependent, contingent on their view that CPI will quickly come down traders have a green light to price a more nuanced tightening cycle and hence still restrictive real yields but less so than before.
And indeed 5y forward, 5y US real yields rallied 11 bps and hit their lowest level in over two months.
When real yields decline, valuation intensive and risk sentiment driven asset classes generally tend to outperform.
That's because the marginal inflation-adjusted return for owning cash USDs (risk-free real yields) becomes less attractive and the (real) discounting rate for long-term cash flows becomes much less punitive.
Hence, the incentive to chase risk assets is larger - actually, following this narrative one could argue ‘‘the riskier the better’’.
Here is a chart showing the very tight relationship between real yields and equity market valuations.
So guess who were the two main characters of the Crazy Market Rally?
The most valuation intensive and risk sentiment driven asset classes of them all: US Tech and Crypto.
But let’s now answer the real question: in this giant puzzle called global macro, are all the pieces falling into the right place to fully support this narrative?
Hold Your Crazy Horses
In short, the Crazy Market Rally was spurred by Powell ditching its forward guidance and kickstarting ‘‘full data dependency’’ season - given the bond market’s strong opinion on inflation going forward and no autopilot Fed tightening anymore on the horizon, investors went ahead and repriced all other asset classes accordingly.
If the Fed isn’t gonna blindly hike us into a recession and contingent to inflation slowing down aggressively as priced in (?), then:
Less hikes now, less cuts later (curve steepening)
Lower real yields (Fed won’t keep policy ultra-tight for too long)
Multiple-intensive, risk sentiment driven asset classes can rally
So, does the new narrative pass the global macro consistency test?
Not really. Not yet.
And for two main reasons.
1. This is the most important inflation fight Central Bankers have engaged in over 35 years, and history suggests a ‘‘mildly’’ restrictive stance won’t be enough.
Slaying the inflation dragon is generally not done with baby steps, and that’s been true across different jurisdictions and historical circumstances.
For instance: last time inflation was stubbornly high in France, the Central Bank had to bring nominal yields (orange) all the way to 8% and keep them there for years to slow CPI down - way above my estimate of the prevailing neutral rate (blue) at 4.5%.
Assuming the Fed will be able to engineer significantly lower inflation while already taking the foot off the gas pedal seems very optimistic.
2. Ditching forward guidance increases volatility in bond markets even further, and a volatile bond market is an enemy for risk assets.
Let’s assume the next inflation print is worse than expected in absolute terms, momentum and composition.
A fully data-dependent Fed will have to consider a 100 bps hike in September: very likely to generate mayhem in markets all over again.
While ditching forward guidance might be the right monetary policy strategy amidst these uncertain times, when there is no anchor for bond markets implied volatility will have a hard time coming down.
And a higher volatility in one of the biggest, most liquid markets in the world generally requires higher (not lower) risk premia everywhere else.
To sum it all up: the Fed can’t and won’t stop until the job is done.
And the job will be done only when inflation has been killed - with likely big collateral damage inflicted to the labor market and the broad economy too.
Hold Your Horses.
And this was all for today, thanks for reading!
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