The Fed promised to curb inflation with higher interest rates. Then the stock market recovered. Here’s why. (This is not good news.) – MarketWatch | Region & Cash

“We are now at levels that are broadly consistent with our estimates of neutral interest rates, and having frontloaded our rate hike cycle so far, we will be much more data dependent going forward.”

The Federal Reserve hiked interest rates another 75 basis points on Wednesday, despite acknowledging that economic growth is slowing significantly. The Powell Fed reiterated that the path of least resistance is well illustrated by what is known as the dot plot: More rate hikes ahead – all the way to a 3.75% fed funds rate!

And yet the stock market has staged a tremendous rally, led by the most valuation-sensitive and risk-managed asset classes: Nasdaq Stocks COMP,
+1.08%
and crypto.

So… what the heck?!

It all boils down to how a single theorem could affect the probability distributions that investors projected for different asset classes.
Sound complicated? Bear with me: it is not!

In this article we will:

  • Pause the FOMC meeting and specifically discuss why this is so “a single sentence” spurred such a crazy rally.

  • Judge where that leaves us now: Is the music changing?

Why did stocks rally?

When the FOMC press release went out, it looked like business as usual: a well heralded 75 basis point hike with the only minor surprise represented by a unanimous vote, despite a clear acknowledgment that economic growth is slowing.

But the fireworks went off less than 15 minutes after the start of the press conference!
Specifically, as Powell said, “We are now at levels broadly consistent with our estimates of neutral interest rates, and having frontloaded our rate hike cycle so far, 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 is delivering its potential GDP growth rate – without overheating or excessively cooling. With that 75 basis point hike, Powell told us the Fed had just reached its estimate of a neutral interest rate and is therefore no longer contributing to the overheating economy.

However, this also means that any further rate hike will put the Fed in active hawkish territory.

And the bond market knows that whenever the Fed has turned hawkish in the past, it ended up breaking something.

By Wednesday you could be absolutely certain that the Fed would have just stepped on the accelerator – inflation needs to come down; no room for nuance.

So journalists asked questions to learn about the “new” Forward Guidance. It went something like this:

Reporter: “Mr. Powell, the bond market is touting you to start cutting rates as early as early 2023. What are your comments?”

Powell: “Interest rates six months from now are difficult to predict. We will be completely data dependent.”

Reporter: “Mr. Mr. Powell, financial conditions have eased significantly due to the recent rally in bond and equity markets. What is your opinion?”

Powell: “The reasonable level of financial conditions will be reflected in the economy with a lag and it is difficult to predict. We will be completely data dependent.”

He did it. He has completely dispensed with the forward lead.

And what happens when you do that? They give the markets the green light to freely shape their probability distributions across all asset classes without anchors – and this explains the gigantic risk rally – as well as the jump in the broader S&P 500 SPX,
+1.21%.

Let’s see why.

When the Fed is so data dependent and they really only care about a data value, it all boils down to how inflation is going to play out in the near future – and the bond market has a very strong opinion on that.

Using CPI inflation swaps, I calculated the one-year forward, one-year inflation breakevens – basically the expected inflation between July 2023 and July 2024 shown in the chart above and at 2.9% lies.

Remember that the Fed is targeting the (core) PCE, which historically tends to be 30-40 basis points below the (core) CPI: Essentially, the bond market expects inflation to slow very aggressively and the Fed’s target already roughly reached in the second half of 2023!

So when the Fed is no longer anywhere near on autopilot and markets have a strong view of a collapse in inflation and growth, then they can price all other asset classes around that baseline as well. It’s clearer now, isn’t it?

This is what my Volatility Adjusted Market Dashboard (VAMD – here’s a quick explanation) showed shortly after Powell announced this a single sentence.

As a reminder, the darker the color, the greater the movement in terms of volatility.
Notice how I’ve highlighted three price moves, but let’s start with US real interest rates.

If the Fed doesn’t blindly keep raising rates, but is more data dependent on its view that CPI will fall rapidly, traders have the green light to price in a more differentiated tightening cycle and therefore still expect hawkish real earnings, but less than before.

Indeed, US five-year real US five-year real yields rose 11 basis points to hit their lowest level in over two months.

When real yields fall, valuation-sensitive and risk-oriented asset classes generally tend to outperform.

That’s because the marginal inflation-adjusted rate of return for holding cash USDs (risk-free real returns) becomes less attractive, and the (real) discount rate becomes much less punishable for long-term cash flows.

Therefore, the incentive to chase risky assets is greater – actually, following this narrative, one could argue that “the riskier the better”.

Here is a chart showing the very close relationship between real returns and stock market valuations.

Guess who the two main characters of the crazy stock market rally were? US technology and crypto.

But now let’s answer the real question: in this giant puzzle called Global Macro, do all the pieces fall into place to fully support this narrative?

Keep your crazy horses

In short, the crazy market rally was spurred on by Powell, who dropped the Fed’s forward guidance and ushered in the season of “total data dependency.” Given the fixed income market’s strong view of future inflation and the Fed’s lack of autopilot in a tightening cycle, investors led the way and all other asset classes readjusted accordingly.

Unless the Fed blindly pushes us into recession and is dependent on inflation slowing rapidly as priced in, then:

  • Fewer hikes now, fewer cuts later (curve steepening)

  • Lower real yields (the Fed won’t keep policy ultra-tight for too long)

  • Asset classes driven by risk sentiment can rebound

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 battle central bankers have waged in over 35 years, and history shows that a “slightly” hawkish stance will not suffice.

Killing the inflation dragon isn’t generally done in small increments, and that’s true across different jurisdictions and historical circumstances.

For example, last time inflation in France was stubbornly high, the central bank had to raise nominal yields (orange) to 8% and hold them there for years in order to lower the CPI – well above my estimate of the prevailing neutral interest rate (blue) at 4.5%.

Assuming that the Fed will be able to deliver much lower inflation while it’s already taking its foot off the accelerator seems very optimistic.

2. Abandoning forward guidance further increases bond market volatility, and a volatile bond market is an enemy to risky assets.

Let’s assume the next inflationary pressures are worse than expected in absolute terms, momentum and composition.

A fully data dependent Fed must consider a 100 basis point hike in September: very likely to wreak havoc on markets again.

In these uncertain times, when there is no anchor for bond markets, while abandoning forward guidance might be the right policy strategy, implied volatility will struggle to come down.

And higher volatility in one of the largest and most liquid markets in the world generally requires higher (not lower) risk premia elsewhere.

To sum it up, the Fed cannot and will not stop until the job is done. And the work won’t get done until inflation has died down – with likely major collateral damage inflicted on the labor market and also on the broader economy.

So: keep your horses.

Alfonso Peccatiello writes The Macro Compass, a free newsletter on financial literacy, macro insights and investment ideas. He was Head of Investments at ING Germany. Keep following him Twitter.

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