The WOTE Public: FED Risks Losing Control
The Fed is “going for” a soft landing on the belief soft June/July Core CPI prints will be the start of a durable trend. Bear steepening and weak USD are already calling BS.
The Destination
The destination for the S&P 500 has always been, and remains, crystal clear: Because above-2% inflation is the result of excess demand, not pandemic-related supply chain disruptions, the Fed must engineer a recession to bring inflation back to 2-3% on a structural basis; and since historically SPX doesn’t trough on average in and around recession until it falls to around 10-15 times peak earnings, the Index is unlikely to bottom until circa 3000 at best (~15 times $198 peak as-reported EPS), and 2000 at worst.
By far the most important assumption underlying this thesis is that Fed Chair Jerome Powell has the resolve to bring inflation back to 2-3% on a structural basis. The bulk of my macro analysis since December 2021 has been focused on answering this question, and while Powell certainly works hard to maintain the veneer of a soft landing dove, in my quantitative and qualitative opinion he is very much committed to doing whatever it takes to get back to 2-3% on a structural basis.
Assuming Powell has the resolve, the most important question then becomes: When does a recession hit the US economy?
Even Higher for Even Longer
I came into 2023 with the view that the economy was either in or soon headed into recession (clearly wrong, obviously) based on the following evidence:
Defensive sectors’ relative strength - up 20-30% off its late 2021/early 2022 lows - was precisely in line with the behavior heading into and early in the 2001 and 2007 recessions
Credit spreads and CDX levels and trends were precisely in line with early stage recessionary periods
The Ned David Research Global Recession Probability model was firmly in the 70-90% danger zone, and had been for most of 2022
ECRI’s business cycle analysis pointed to high recession probability
And last but not least, the bond market was beginning to behave in a recessionary manner with 2s trading close to Fed Funds and Fed Funds futures refusing to bless the Fed’s December SEP terminal rate of 500 bps
I am still surprised I was so wrong given the above set of evidence, but I have long maintained that the most bearish development for the economy and ultimately SPX was for me to be wrong on the economy, and that is exactly what is playing out here.
In a January 24 post (see below) I said:
“If The WOTE is wrong about the current state of the US economy - as strong equity market breadth, weak defensive sector relative strength, and healthier credit market conditions suggest could be the case - then the Fed will ultimately have to raise rates even more than expected in order to tighten financial conditions enough to contract the economy enough to bring inflation back to 2%.
“But, but, but…what if there is a “soft landing”? There is no possibility of a soft landing without the Fed capitulating on its 2% target, because inflation is not transitory.“
The bottom line is this: The longer it takes for a recession to hit, the higher the Fed will raise rates and the worse the ultimate economic downturn (and in turn, equity market downturn) will be.
With the recent firming of economic data we are now entering the “even higher for even longer” phase of the tightening cycle, which brings us to the likely path ahead.
The Path Ahead
This week was very clarifying for my assessment of the likely path ahead for FED policy and financial markets over the coming weeks and months:
Goldman published a CPI preview note highlighting that seasonal adjustments are likely to depress Core CPI readings in June and July
Through Nick Timiraos of the WSJ the Fed confirmed a July hike is baseline in response to Friday’s NFP report, but very specifically did not hint at which way it would go in September…despite 12 out of 18 FOMC members penciling in at least two more hikes this year and Chair Powell recently putting consecutive hikes back on the table
Following the NFP report the Fed sent Goolsbee out to discuss the positive outlook for a soft landing
Lastly, and most critically, a quasi-Fed insider told me the following:
“…inflation prints are going to help them out for a couple months.“
“The prospects for the soft-ish landing look a little better than they did a few months ago, so why wouldn't they go for it?”
The fact the nominal US Treasury curve bear steepened and the USD fell this week in response to a package of stronger than expected employment data, combined with the above, suggests to me that the Fed is in the process of “going for” a soft landing right when it should not, putting them at risk of losing control of the long end of the bond market on the back of rising break-even inflation protection.
Thinking fast and slow, how do we reconcile the “Powell has the resolve” thesis (thinking slow) with the fact the Fed is currently “going for” a soft landing that we know will not bring inflation durably back to 2-3% (thinking fast)?
Answer: Because the Powell Fed is dogmatically “data dependent”, they will wait until activity and inflation data firm up later this summer before guiding to at least three more rate hikes after hiking in July and bringing Fed Funds up to 600 by year-end. (This assumes of course that equity and credit risk premia don’t blow out in the meantime.)
In short, the long end of the curve is likely to drag the Fed to an even higher terminal rate via higher break-even inflation protection (as mentioned above).
Core CPI didn't bottom until 1995, well over a decade after Volcker famously declared victory over inflation. The FOMC 's actions going forward regarding Core CPI won't have anything to do with a pandemic retrace of equity prices.