Powell talked tough, but equities still hope for a dovish Fed. With few rate hikes priced past December there is still room for tough action to be priced and that is a significant risk for risky assets heading into the fall
Chair Powell’s speech last week at Jackson hole was brief by design. However, even if you only read these two sentences, you would have understood Powell’s key message: “Restoring price stability will likely require maintaining a restrictive stance for some time. The historical record cautions strongly against prematurely loosening policy.”
Powell’s comments communicated to the market that the Fed is committed to bringing inflation under control, despite the actions required and consequences of doing so. As Powell bluntly stated “Our responsibility to deliver price stability is unconditional” and doing so will “bring some pain”. The secondary message was that “we must keep at it until the job is done” giving further support for the higher-for-longer message that we had heard from other Fed speakers.
This was a hawkish message with very little equivocation. Clearly, the Fed does not see their job nearing completion and right now they view the risks of embedded inflation as outweighing growth concerns. Indeed, it will require a period of weaker growth to achieve their inflation aims.
However, from our perspective, there was very little substantively new in what Powell said (one could say that the major innovation seems to have been the brevity and clarity of the message!). We had been surprised how quickly the market narrative had shifted to “soft landing” and a balanced Fed in June and July. We did not see any such shift, rather our view was that the market had misinterpreted the dovish implications of the phase shift from “expeditious policy moves” to a more data dependent stance. Indeed, the data that matters (employment, wages and CPI), all continued to show significant inflationary pressures. With this backdrop, we believed the idea that the Fed would dovishly pause in this scenario to be spurious. To us, the moves in equities on Friday were surprising, only insofar that equities had so far resolutely ignored any hawkish statements from the Fed.
At its essence, the problem that Powell faces is that the equity market, in particular, doesn’t fully believe that the Fed could actually be hawkish in the traditional sense. Equity investors have good reasons for holding this view. The market forced the Powell pivot in 2018 and since the GFC there has been a Fed put. Indeed, at the moment of peak inflation concern and equity weakness in June, there was a perceived Fed pivot which precipitated a 21% rally in the Nasdaq.
The fact that the equity market has responded to any equivocation or dovishness much more strongly than hawkish comments necessitated an unmistakably hawkish, stripped down speech. But even with that speech equity markets are still 10-15% higher than the June lows.
The risk for equities is that Powell is approaching the point where actions will need to follow words. Current market pricing indicates the Fed as having largely finished its hiking cycle by December (13bps priced for Q1) with a final 25bp hike in Dec. Time is running out. If inflation is not falling, Powell will need to open up the probability of either larger rate hikes to Dec or hikes into 2023. This would undermine definitively that we are approaching the end of the cycle which has been a key premise of broad equity market support. Further, it will drive upside in yields well above 4.00%, which will seriously undermine long duration equities. In turn we would expect the 2023-2025 curve to flatten by 75-100bps in this scenario and equities to come under significant pressure.
At the end of the day, the Fed has chipped away at its own credibility, but also it has served as a bulwark to equity market weakness for a decade. Words can only go so far; if inflation doesn't fall and FCI doesn't tighten significantly this credibility will need to be won back. The longer the equity market holds on to a belief of a soft landing and a non-hawkish Fed, the greater the pain if that reality doesn't play out. A 3.5% selloff in equity markets on hawkish comments is illustrative of this asymmetry, but it is only the opening act if the Fed needs to follow tough talk with tough action.
Finally a brief word on Europe following last week’s note. There are two key elements of the challenge facing Europe a) the European inflation crisis is a supply side shock and b) the unique structural weaknesses of the Eurozone. This means the European trade has a sequential element to it, with each policy action simply passing the risk to another part of the asset universe.
We saw this dynamic play out this week. In response to a weakening EUR and rising inflation pressures, we received leaks that a 75bp hike is on the table in the next ECB meeting. This helped support EUR, but resulted in a 2.8 stdev selloff in the March 23 Euribors, a 2.3 stdev curve flattening in 2023 / 25 pricing, peripheral and credit spread widening. Today, European inflation again surprised again to the upside driven by Italian inflation reaching 9%. Even with fiscal policy and energy price caps, there really are no good choices for European policy makers and there is a growing risk that policy makers never fully address any of the key issues. This would result in a correlated selloff in European assets, with equities, credit and fx all weakening, and is a meaningful tail risk in the outlook.