All Aboard? More Like Abandon Ship
The Fed tightening train is leaving the station. Investors would be best served to get hedged up while liquidity is withdrawn to prevent inflation from running away.
We all know the Fed prefers to not surprise the markets when making policy decisions. They value their “communication strategy” as an important tool in making sure the market understands where they are going with future monetary policy. By the end of this week, we will have heard from just about every Fed governor and regional bank president (except Bowman) about how aggressive they would like to be over the coming months in tightening financial conditions in order to prevent inflation expectations from becoming “unanchored” or “entrenched.” Having all their members out speaking to start the year was part of the Fed’s communication strategy such that there are no surprises about their intentions. In addition, the NY Fed, responsible for executing the monetary policy objectives, issued a series of blog-posts this week explaining various dynamics of the inner plumbing of the financial system, as well as some of the recent changes the Fed has made to ensure that “smooth market functioning” will continue in the Treasury market (aka funding the US government) as these monetary policy tools to fight inflation are employed. Again, this is part of the communication strategy to spoon feed the market on what is coming. This is the equivalent of the Fed shouting from the rooftops: The Tightening is Coming, The Tightening is Coming!
Powell has explained that a tightening of financial conditions is now necessary to prevent inflation from running away, something that would harm the Fed’s ability to achieve maximum employment. While there are still a few million laborers that remain out of the workforce who were in the workforce prior to Covid, the Fed has finally realized that it is not the “cost of capital” that is the deterrent for these people coming back to work. Rather, there are health reasons that are preventing some from returning and there are also some structural/demographic reasons why various workers have permanently exited the workforce. Either way, the Fed realizes that keeping the cost of capital too low like it has been doing actually is harming the recovery by creating inflation dynamics that are beginning to become unanchored. The Fed now says it needs to create a more elongated business cycle that will give time to achieve maximum employment and in order to do that, they need to tighten financial conditions enough now to stymie demand and prevent inflation from running too hot, which is something that if left unattended to would run counter to their mandate.
At this point, the framework for tightening financial conditions sounds quiet orderly. First off, bond buying will cease by the middle of March, although I still think there is small risk they will announce at the January meeting in two weeks that bond buying ends in the middle of February because why is the Fed still buying assets for the next 8 weeks when they are trying to talk down inflation expectations via their on-the-come tightening agenda. Second, rate hikes will commence at the March meeting and while many forecasters are discussing the idea that rate hikes can only happen at quarterly meetings when a new Summary of Economic Projections (SEP) is given, Bullard reminded us this week that this quarterly construct makes little sense and he would likely prefer more hikes sooner rather than later if they are serious about fighting inflation, which gives rise to the idea that a March then May then June hiking cycle could be underway. Lastly, more Fed officials have discussed QT and the reduction of the Fed’s sizable balance sheet. There has been reasonable consensus from Fed members on this that given a stronger economy and bigger balance sheet this time vs. last time QT commenced, it is likely that balance sheet reductions will occur sooner and faster this cycle vs. last cycle. The only real question is when do they start. The market is probably looking for a second half start to the balance sheet reduction program. I am more in the camp with Bullard and Waller (both voters) that balance sheet reduction really should start imminently as there is simply too much stimulus and liquidity in the system today which is making it more difficult to control inflation with rate hikes alone. I think there is a small chance that the balance sheet reduction announcement comes at the March meeting and begins in April. That’s an out of consensus view but one that could pick up steam post the January Fed meeting when Powell needs to explain to reporters why the Fed is talking about balance sheet reductions later this year but still adding to the balance sheet now. It makes little sense.
Why is this so important? Well, we have all seen this chart of the Fed’s Balance Sheet size vs the SPX. The correlation is too high to be ignored. As the Fed starts to reduce the balance sheet, and liquidity is withdrawn, risk assets will suffer and the SPX is the biggest of them all. This is the K.I.S.S. approach for investing in 2022. As liquidity continues to contract, it is buyer beware. We have already seen the speculative edges of the market come under pressure with simply the pull-forward of the tightening agenda (SPACs, Crypto, micro-caps, high multiple growth stocks, etc.) One must continue to high-grade into only the best ideas in companies/sectors with true pricing power (including upstream commodity producers in tight supply/demand commodity markets) and be hedged with single name shorts in competitive industries and/or stock market indexes (we like being short small-caps) in order to prosper early this year. We remain net short equities here and as discussed in prior writeups, we believe the Fed “put” to change course back to a dovish construct is struck at a level that is materially lower than here.
Source: Bloomberg Data
*Important Disclaimer: This blog is for educational purposes only. I am not a financial advisor and nothing I post is investment advice. The securities I discuss are considered highly risk so do you own due diligence.