Discussion
If you watched yesterday’s cross-asset price action closely, it was actually quite similar to Thursday, with a morning rally halted by rising rates and XLU selling off ahead of the broad market1. But here’s a very specific reason the day did not end like it did Thursday: The Fed sold a put into the market at 1:51pm EST via Nick Timiraos, 8 minutes after SPX bottomed.
The put was sold via the following from Timiraos:
Wage growth and inflation remain elevated and faster than the Fed would prefer. But Friday’s figures offered the clearest signs yet of a long-anticipated slowdown in price pressures that, if they are sustained in the coming months, would allow the central bank to hold rates steady at its next meeting in September and possibly through the end of the year.
Floating a permanent pause just two days after a hawkish message from Powell, with the Fed Funds futures market pricing at least some chance of another hike? There was no reason for that at that very specific time other than to arrest a more problematic decline in markets heading into the weekend.
As discussed in the footnotes below, I believe the Fed is playing a very dangerous game here trying to massage financial conditions just tight enough to take care of inflation while not causing a crash. They are ultimately going to cause a crash via this controlled demolition policy because their lack of true resoluteness is underwriting a reacceleration in growth and/or inflation, as evidenced by rising TIPS break-evens. History and logic dictate that it’s not possible to remove sticky, demand-driven above-2% inflation with surgical rates hikes and a finely tuned tightening of financial conditions. If the Fed is serious about bringing inflation back to 2%, which I think they are, this surgical approach will ultimately result in even greater economic and financial market pain down the road (how far down the road is the billion dollar question).
My read of Thursday’s price action (see Market Journal update here) was that it was a fakeout to the downside as evidenced by weak defensive sector relative strength. But I’m starting to question that given XLU’s very specific weakness the last two days in response to higher rates. This needs to be monitored closely, as XLU could be sniffing out a much more serious breakout in 10s than is currently appreciated by anyone, me included. Reason I say that is because during the 2022 bond sell-off XLU was one of the best performing sectors as investors used it as a defensive vehicle to protect against the damage from higher rates; and even as recently as early this month when rates spiked on a better-than-expected ADP report, XLU ripped relative to the market going into and after the report. With TIPS break-evens starting to move, perhaps in anticipation of a pick-up in growth and/or inflation in the coming months, we very well could be staring down something along the lines of a very XLU-unfriendly 5-6% level in 10s (see discussion here and below). A pick-up in growth and/or inflation that leads to rising rates and a higher USD alongside a last gasp higher in equities on weak breadth is the 1987-like scenario I floated in yesterday’s Market Journal update - more to come on this front.