The Costanza Hiking Cycle

Heisenberg Macro

Seinfeld fans don't need an explanation but for the others (do they really exist?), this is a reference to the episode in which George Costanza does the exact opposite of his instincts

The historical framework for trading the Fed hiking cycle over the past two decades has been built upon a heuristic that Fed takes the elevator down and the stairs up i.e easing cycles are rapid and aggressive and hiking cycles are gradual and predictable. Nothing about this cycle so far is in line with the hiking playbook. But in many ways this is simply the opposite of a typical Fed easing cycle or a 'Costanza Hiking Cycle'.

The typical easing cycle has the following characteristics -

• Markets lead the central bank

• Aggressive front-loaded policy action to prevent inflation expectations from un-anchoring

• Central Bank is defending its inflation credibility and has to outdo the market expectations

• Financial conditions are an important barometer of the feedback loop to assess policy effectiveness

• Early signs of 'green shoots' are welcome and might slow but not sufficient to stop the policy cycle

• Risks of doing too much are seen as lower than doing too little

This hiking cycle is proceeding very much in a similar fashion and has important implications for markets

• Front-end will continue to stay volatile and market pricing will likely overshoot the eventual policy destination

• Financial conditions tightening is a prerequisite to any pause or slowdown in the hiking cycle

• Risks of policy induced hard landing are much higher than a typical hiking cycle

• 'Green shoots' in inflation or moderation in growth will not bring the cycle to an end but will probably slow the rate of policy tightening and dampen market volatility

The rates markets have figured most of this out with 9 hikes priced into 2022 and implied volatility on front-end at all time highs. But broader financial conditions have yet to appreciate the resolve of the Fed to tighten policy aggressively and its asymmetric reaction function to higher inflation versus slowing growth.