Pivot

Heisenberg Macro

The moves in central bank pricing and risk assets in a month in which Fed delivered its second consecutive 75bp hike and ECB hiked 50bp for the first time has truly been head scratching to put it mildly. Acknowledging it could simply amount to apophenia, I'm still going to attempt to offer an explanation. I think there are three drivers (not independent of each other) of the recent moves in markets -

Rising Recession Probability - Although the growth has been in deceleration since Q4 2021, the second derivative of growth turned more negative beginning Q2 2022. The two consecutive quarters of negative GDP has further heated up the recession discussion and the 1 year out probability of recession is increasing and the expected timing is being pulled forward. Yield curves have inverted and recession alarms are blaring across the financial media.

Receding Inflation Risks - Post Ukraine/Russia war, the supply side concerns dominated the pricing of commodities - particularly energy and food. The recent decline in commodity prices as a function of slowing global growth, tighter monetary policy globally, stronger dollar and expected future demand destruction associated with increase in recession risks, has created a sense of relief on inflation front after nearly a year of relentlessly increasing inflation. The high correlation between gasoline and consumer inflation expectations imply the risks of de-anchoring of inflation expectations have receded somewhat. Inflation breakevens have validated this view of peak inflation.

Expected Fed Pivot - Post the CPI release, the FOMC pushed back against market expectations of 100bp hike and instead chose to stick with the 75bp communicated at the May meeting. Powell's press conference further provided fodder for the narrative that the Fed is close to a pivot. He referenced neutral range multiple times indicating that it somewhat reduces the urgency to hike rates rapidly and allows calibration of future policy with higher degree of data dependence. Secondly, his emphasis on lagged impact of policy and that policy needs to be modestly restrictive opens the door to perhaps a pause on the horizon. Lastly, he acknowledged the slowdown in consumer and business demand which can be interpreted as a pre-cursor to a pivot down the road.

These factors combined with stretched positioning and levels across hawkish Fed trades created the concoction for sharp reversals as risk / reward for existing trends - higher rates, lower equities / credit, stronger dollar - became highly unfavorable. While the explanation outlined above is pretty rational but there are some flaws. Lets break apart each factor -

Rising Recession Probability - Growth is unambiguously slowing and its quite broad-based. However, from the Fed's perspective the labor market is key economic variable. And though initial claims and job openings are showing early signs of weakening, short-run NAIRU is conservatively in the vicinity of 4 - 4.5% and Powell has repeatedly emphasized the strength in the labor market and the need to slow it down to curb inflationary pressures. Secondly, there is an unprecedented divergence between real and nominal growth and even with real growth negative for the first half of 2022, nominal growth is well above trend. Company top-line revenues are a function of nominal growth and with labor supply still relatively tight, the knock-on effect of slower real growth to labor market could potentially take longer than has been the case typically.

Receding Inflation Risks - While the relief in oil prices, if sustained, would truncate the risks of a de-anchoring of inflation expectations in the short-run, the structural slower moving inflation indicators (as captured by trimmed mean or core sticky measures) are well above the Fed's 2% target and showing no signs of easing so far. In a typical business cycle, the change in growth and inflation is the more relevant measure in forecasting the Fed but in this case the level of inflation is critical. Even with slowing of inflation, the structural trend looks to remain well above 2% for a while forcing the Fed to stay vigilant on inflation with growth being a distant secondary consideration.

Expected Fed Pivot - For sake of clarity, lets define what a Fed pivot actually means. In my opinion, the Fed pivot is a shift in the reaction function to emphasize the shortfall in the maximum employment side of the dual mandate relative to the inflation side. A shift from the uber-hawkish rate moves to a more normal tightening path is plausible by the next meeting and arguably even more likely than not. But a step down to 50bp and then subsequently to 25bp with Quantitative Tightening on full throttle cannot be really characterized as a dovish pivot. More importantly, monetary policy is cumulative. It is not just the size of the most recent move that matters but rather the integral of the cumulative move over the time for which policy is sustained. Even after the Fed pauses its tightening cycle, keeping policy rate at above neutral constitutes an ongoing tightening.

In trying to figure out the Fed reaction function, it is important to have a historical context and understand as to why Volcker has demi-god status in central banking and why Burns represents a posterchild of what constitute central bank policy mistakes and potential costs associated with them. In the chart below, the Burns Fed is highlighted in green and the Volcker Fed is highlighted in purple. The difference between Volcker and Burns wasn't just in their forcefulness of response to higher inflation. What really distinguished Volcker from Burns is that he resisted the political pressure to ease during the 1981 - 82 recession while Burns eased in response to the 1974 recession allowing inflationary pressures to resurface and set new highs as the economy recovered. Volcker's single-minded resolve to fight inflation at all costs was the defining phase that helped the Fed establish and maintain inflation fighting credibility for decades to come.

Powell and other members of the Fed are very much aware of Fed history and what it means to be invoking comparisons to Volcker. The Volcker test for Powell hasn't yet come - hiking aggressively when inflation was touching 9% and unemployment rate close to all time lows was hardly a test of the Fed's inflation fighting resolve. Rather, it was a test of their ability to break the shackles of self-imposed ill-conceived forward guidance which to their credit they did with flying colors. But the real challenge is going to be over the next 6 to 12 months when the unemployment rate moves higher and inflation while moving lower is still elevated and comfortably above their 2% target.

In my view, I don't believe the Fed has the resolve to keep hiking at even 25bp a meeting pace once cracks appear in the labor market (which I define as at least two successive negative payrolls and/or rise in unemployment rate by 10% i.e 0.36%). However, I do think the hurdle to ease policy is going to be extraordinarily high absent a large shock. This would be quite different to the swift policy response to weakening growth that we've gotten used to. One way for the Fed to keep policy tight enough to stamp out inflationary pressures would be to effectively implement forward guidance (without actually saying so or calling it that) i.e. maintain policy above neutral until inflation is close to target. Put another way, the Fed could be on-hold at above neutral rates for a lot longer this time around. The policy tightening feeds through pace, level and time. When the growth risks are undeniable, the Fed will shift to level and time to maintain tight policy.

The playbook for the first half of the year was to bet on an Fed aggressive tightening cycle to fight inflation and tighten financial conditions to slow the economy. Short rates, short equities and long dollar constructed with a long volatility bias made perfect sense to capture underpriced distributions as a result of misplaced faith in forward guidance and complacency in risk asset valuations.

The playbook now is to bet on a Fed measured in tightening further and extremely resistant to reverse policy to accommodate weakening of the economy. The distribution to much higher rates has shrunk but the probability of eases is also overpriced in the market. The trade is to bet against the easing priced in the front-end rates with a short volatility bias. For risk assets, it is likely going to be a a long drawn out decline as the markets repricing of a Fed put that is much further out-of-the-money relative to recent past is partly balanced by slowing rate of change of Fed policy moves. The evolution of the economy and earnings become more important in pricing the path of risk assets. The upside is still truncated as a buoyant economy or markets gives the Fed reason and more room to be aggressive in tightening financial conditions. At current levels, longer dated put spreads funded by calls are probably the right structure.