The Federal Reserve on Wednesday raised interest rates a further 75 basis points, despite admitting that economic growth is slowing. This central bank led by Powell has reiterated that the path with the least resistance is clearly illustrated by the dot plot, also known as the dot graph. There are more hikes to come -until the Fed funds rate of 3.75 percent!
And yet, the stock market has staged a humongous rally, led by the most valuation-sensitive and risk-sentiment-driven asset classes: Nasdaq stocks COMP, +1.08%, and crypto.
Then … what’s is the matter?
It all comes down to the way that a single word could alter the probability distributions investors projected for various types of assets.
Does this sound like a lot of work? It’s not!
What caused the stock market to rally?
When the FOMC’s press announcement was published, it seemed similar to the norm with a well-publicized 75-bp increase with the only minor surprise being a unanimity vote despite the obvious recognition that the economy slows.
Not until 15 minutes after the conference does fireworks start to go off!
Particularly the context of Powell stated: “We have reached levels that are in line with the estimates we have of neutral rates. After frontloading our hike cycle up to now, we’ll be more dependent on data going forward.”
The neutral rate refers to the rate at which the economy is able to deliver its potential growth rate in GDP without overheating or cooling. With this 75-bp increase, Powell told us the Fed has reached its estimation that it is at a neutral level consequently, since this point, they won’t be making a difference to the overheated economy anymore.
However, any future increases are likely to place the Fed into a very restrictive zone.
The bond market also knows that each time the Fed had to tighten its rules before, they would end with breaking something.
As of Wednesday, you can be sure that the Fed had just stepped on the accelerator. Inflation must be reduced; there is no room for nuances.
Journalists sought answers to questions in order to discover what was new about the forward guidance. It was rough as follows:
Journalist: ”Mr. Powell The markets for bonds are pricing your rate to be cut in 2023. It’s already early. What do you think?
Powell says: “It is hard to determine rates in six months’ time. We’ll be totally dependent on data. Powell:
Journalist: ”Mr. Powell due to the recent equity and bond market rallies, financial conditions have been easing quite a bit. What’s your opinion?’
Powell said: “The proper degree in financial markets will show in the economy, but with some delay, and it’s difficult to forecast. We’ll be completely dependent on data.”
He did it. He completely discarded forward guidance.
What happens when you do that? Markets are given the liberty to make their own probability distributions for all asset classes, without an anchor. That could be the reason for the huge risk-taking rally and also the rise in the overall S&P 500 SPX. +1.21 percent.
Let’s find out why.
In the event that the Fed is that dependent on data, and there’s only one information they are concerned about, it all comes down to how inflation is likely to develop in the coming years which is why the bond market holds a positive view on this.
With the help of CPI inflation swaps, I calculated the one-year forward break-evens, and the one-year inflation which is basically the anticipated inflation rate from July 2023 to the end of July 2024, as shown in the above chart and is 2.9 percent.
Be aware that the Fed has a goal of (core) PCE, which tends to be typically 30-40 bps lower than (core) CPI. In essence, the bond market anticipates inflation to fall very rapidly and close to the Fed’s goal by the second half of 2023!
If the Fed isn’t on autopilot and the markets have a clear view regarding the collapse of growth and inflation and the economy is sagging, they could evaluate the other asset classes according to the same base scenario. The picture is becoming more apparent now, isn’t it?
That’s what the Volatility Monitored Adjusted Market (VAMD -Here’s a brief explanation) displayed shortly after Powell delivered that one sentence.
Remember That the darker the color is, the greater the change in terms of volatility-adjusted terms.
Notice the way I highlighted three movers But let’s start with U.S. real rates.
If the Fed will not just continue to hike rates, but is more dependent on data and based on their belief that CPI will rapidly fall and traders will have a option to price the more nuanced tightening process and, therefore, anticipate real yields that are restrictive, but much less than they did prior to.
In fact, with five years forward and five-year U.S. real yields rallied 11 bps before hitting their lowest in nearly two months.
This is because the marginal rate of return that is adjusted for inflation for holding dollars in cash (risk-free real returns) decreases that’s why the (real) discounting rates for cash flows that are long-term decrease.
Therefore, the motivation to seek out risky assets is higher than the risk of chasing them. In fact, following this particular narrative, one could say that “the riskier the riskier, the more secure.”
Here’s a chart illustrating the very close connection between real yields and valuations for equity markets.
Guess who the two main protagonists of the market’s wild rally were? U.S. tech and crypto.
Now let’s address the question that really matters in this huge puzzle known as global macro are all of the pieces in the right spot to justify this narrative?
Hold your crazy horses
The wild market rally was triggered by Powell dropping its forward forecast for the Fed at the start of a full data dependence season. With the bond market’s clear belief in the future of inflation and the absence of an autopilot from the Fed regarding an upcoming tightening cycle were able to reprice all other asset classes.
If the Fed doesn’t intend to simply raise us to recession and is contingent on inflation slowing according to the price the forecast, then
- There are fewer hikes in the present, and fewer cuts to come later (curve steepening)
- Real yields are lower (Fed will not keep policy tight over a long period of time)
- Risk-sentiment-driven asset classes can rally
Does the new narrative be able to pass the global macro-consistency test?
Really. But not quite yet.
There are two reasons.
- This is by far the most significant battle against inflation central bankers have fought for the past 35 years, and the past suggests that a mildly restrictive stance” won’t suffice.
The battle against inflation is not something you can do with small steps. This has been the case across various regions and different historical situations.
For example, the last time CPI was incredibly high in France the central bank was required to raise nominal rates (orange) up to 8% and hold them for a long time in order to lower CPI much more than my estimation of the current normal rates (blue) which was 4.5 percent.
The idea that the Fed is able to create a significant reduction in inflation and yet take its foot off of the gas pedal is a great idea.
- The removal of forwarding guidance can increase market volatility more, and a high-risk bond market is an adversary for risk assets.
Let’s suppose that the next inflation report is less than what we expect as a whole, in terms of momentum, and composition.
A completely dependent Fed will need to look at an increase of 100 basis points in September. It is very likely to cause havoc in the markets over and over.
Although removing forward guidance may be the best option for monetary policy in this uncertain time, if there is no foundation for the bond market implied volatility could have a difficult time declining.
A higher level of volatility in one largest and most liquid markets around the globe generally calls for greater (not lower) risk premiums than elsewhere.
In a nutshell To sum it all up: The Fed isn’t able to, and will not stop until it’s done. And it is done when inflation is gone — and with likely huge collateral damages to the economy as a whole. overall economy.