“Peak and Pause do not Mean Pivot”

Articles From: Interactive Brokers
Website: Interactive Brokers

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Chief Strategist

Interactive Brokers

We made it!  The latest FOMC meeting is now behind us, though not without its share of drama.  In an unusual scheduling coincidence, we had not only the current Fed Chair (Powell) but also his predecessor (Treasury Secretary Yellen) speaking simultaneously.  Each of them was blamed for harshing the stock market’s mellow in the last hour of the day.  There was more than enough blame to go around, not least of which can be placed upon the skittish traders themselves.

Quite frankly, I didn’t find many surprises in Chair Powell’s presser.  It played out along the lines of what we wrote yesterday:

My base case is for a 25bp hike.  The FOMC doesn’t typically surprise markets, and no hike would now be considered a surprise.  If they stand pat, there would be broad concerns along the lines of “What’s wrong?  What do they see that we don’t?”  In light of all the persistent commentary from Fed talking heads about no rate cuts before the end of the year, it seems reasonable to think that the “dot plot” would reflect the same.  It would be at odds with the new expectations of a cut.  I also expect the Chair to take a conciliatory tone, playing down concerns about a metastasizing bank crisis.  In theory, that should mollify investors, but it could disappoint those who are hoping for another dose of Fed liquidity.

That said, as we also noted yesterday, the base case – at least for options traders – was a bullish response.  Short-term SPY options all showed peak probability in above market strikes.  Markets have a nasty tendency to upset consensus views at the most inopportune times, and yesterday was one of them. 

As for who should get the blame, Powell or Yellen, it’s difficult to disentangle their comments.  In Yellen’s case, it was her testimony that the FDIC would not offer blanket protection on all deposits.  In Powell’s, it was that he had numerous opportunities to discuss the possibility of rate cuts in the near future but failed to take them.  It appeared as though traders wanted to rally the market shortly after the FOMC announcement, failed to get any real follow-through, and then had to deal with sequential unfriendly comments.  They led to a rush to the exits.

In many ways, the most curious outcome to the FOMC meeting is how Fed Funds futures traders thumbed their noses at the “dot plot”.  It shows a median projection of 5.1% for year-end funds, with only one participant anticipating rates below 5%.  Meanwhile, futures indicate a projection of about 4.15% for the December meeting and 4% for next January.  Someone is very wrong.  The question is whom.

Regarding the Fed’s projections, we know that they can be quite inaccurate.  At the March 2022 meeting the median end-of-year dot plots for 2022 and 2023 were 1.875% and 2.75%, respectively.  The FOMC failed to appreciate the inflationary forces that they helped unleash and the efforts required to tame them.  It is of course quite possible that they are failing to fully factor in the sort of risks that could cause them to cut rates sooner rather than later. 

But consider what factors could induce the Fed to deem it necessary to cut rates.  It won’t simply be that inflation ceases to be a problem.  That would indeed be a welcome development but would not spur rate cuts on its own.  It seems quite unrealistic to think that the FOMC would say, “Great, we beat inflation.  Now let’s cut rates and risk stoking it once more.”  In simple parlance, “Peak and Pause do not Mean Pivot.”  There is ample historical evidence that the Fed leaves its funds target at local peak levels for months, if not years, at a time. 

It means then that if we get a rate cut it would need to have some sort of catalyst.  I’m afraid that none of the most likely catalysts would be particularly good for equities.  We could either have a recession severe enough for the Fed to need to switch its stance in order to spur the economy or have the current banking crisis persist and metastasize sufficiently to require extraordinary measures. 

With generations of investors trained to see any monetary stimulus as positive for stocks, it is easy to see why stock traders remain unconcerned and even welcoming the prospect of lower rates, regardless of their amount or rationale.  It’s worked well throughout their investment experience.  But the degree of difficulty for central bankers increases considerably when inflation is a problem.  That’s something we haven’t needed to reckon with for decades.  Be careful what you wish for.

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