To Step Down or Not to Step Down? That is the Question

Fed has another important decision tomorrow and the market is running with the idea that they are ready to "step down" the hiking path. As Lee Corso would say: "Not So Fast My Friends"

Let’s cut right to the chase. We have another Fed meeting tomorrow and there has been a growing belief in markets, exacerbated by comments from the WSJ’s “Fed Whisperer," that a step-down in the Fed’s rate hiking agenda is imminent come the next Fed meeting in December. The equity market has run hard on this idea that a step down in hiking is akin to bringing forward the end of the tightening cycle. Stocks have bounced hard off the lows from last month’s once again hot CPI print on back of this belief, which has come along with discussions of stepping down rate hiking cycles in Europe, Canada, Australia and more dovishness from the BOJ and BOE. There is a dovish smell in the air and the equity market has picked up the scent. When you add in stronger seasonality, the prospect of a Republican sweep next week which will bring about gridlock in DC (something equity investors tend to love) and the potential for yet another Santa Claus rally, many believe the bottom is in. Shorts have been covered, puts are gone, skew is back to the lows and the FOMO chase is starting to resume. But what justification would the Fed really have to tell investors tomorrow that a step down in tightening is coming at the next meeting? Have we seen any momentum that has gotten them closer to their goal of stomping out inflation? In the words of ESPN’s Lee Corso, I think the Chairman Powell is ready to deliver a “Not So Fast My Friends” moment to equity markets. Proceed with caution.

While the Fed has a dual mandate seeking maximum employment and price stability, it is clear that they are failing to achieve the price stability goal with flying colors. And with the labor market continuing to show strength and signs of shortages (especially as long covid has led to a pick-up in long-term disability figures and more people leaving the labor force), we run the risk that a wage/price spiral will accelerate into 2023, despite what seems to be a baked in the cake slowdown in growth. While we have seen some fall in core goods inflation over the last few months, services inflation moving higher continues to rear its head and amidst a tight labor market that shows limited signs of slowing down, it is hard to see the conditions by which services inflation will slow down enough to bring down core PCE any time soon. There is across the board inflation in the economy today as signalled by various readings the Fed looks at: Cleveland and Dallas Trimmed Means as well as the Atlanta Sticky Inflation index. There are still two inflation prints between tomorrow’s meeting and the December meeting. Why would the Fed choose to limit its flexibility ahead of that data, particularly as the Cleveland Fed Inflation Nowcast is looking for yet another 8% CPI print in both October and November and core PCE above 5%? Signaling now that they will step down the hiking next meeting and then staring down the possibility of another hot inflation print would put their credibility as inflation fighters at risk again. Stocks would rally, financial conditions would loosen, inflation expectations would move higher. Also the Fed would be seen as bowing to the knee of an increasingly irritated Democratic wing in Congress that wants the Fed to slow down its rate hiking agenda despite full employment and no progress on the inflation fighting front. What would be the point of that right now? It seems too soon to signal this message.

So if there is no macro data from the current inflation readings or from the labor market (especially after another strong JOLTS reading today showed a pickup in job openings to labor available and a higher quit rate which is often a forward leading indicator for wage gains as job quitters get higher pay in their next job than their last job), where is this confidence that it is time to step down going to come from? While the Fed often changes the goal posts, it is unclear they can this time around. One place they could look to would be if they were to observe a material fall in inflation expectations and breakeven yields, which could be signalling that inflation was becoming “unanchored” again from the downside. However, since the last Fed meeting, inflation expectations, both market based measures and survey based measures, have only moved higher and given the move higher in oil off the lows, are threatening to break out higher from multi-month ranges. This is not a market that is worried about deflation risks now. There is no “there there” for the Fed to move on inflation expectations at this point.

That brings up the last point for them to suggest a step down and that would be from financial stability risks. Clearly, a rising dollar and bond yields this year have done plenty of damage in various places around the world. But when asked several times about this, Fed members have continued to say that the current mandate remains bringing down domestic inflation and there is just no domestic appetite to bail out the eurodollar market at this point without solving the domestic inflation riddle. Both Bullard and Waller have made reference to the St. Louis Fed’s Financial Stress Index which is near the lows of the year and materially lower than stress observed at the heights of Covid and the GFC. In the Fed’s view, there is no stress. If Powell really does not want to be Arthur Burns 2.0, something various reporters have picked up on, he won’t be delivering any dovish message tomorrow.

The dollar and bond market seem to be erring on the side of the Fed continuing to be resolute in its rate path agenda with the prospects of an even higher terminal rate likely in order to solve the inflation riddle however the equity market is singing a different tune. In my view, equities have come too far ahead of the Fed's reaction function here and thus, there is a good probability of a reasonable check back in stocks if the Fed disappoints the market’s belief on an imminent step down. If they do go ahead and signal the step down, look for the dollar to weaken, gold/bitcoin/oil to rally and while front end of rates curve by move lower in yields, I would think the long end of bond market sells off (curve steepens) as bond investors start to worry about Fed credibility and whether they are going to see this through in the end. I am set up long gold/bitcoin/oil and short equity indices into tomorrow.

*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 risky so do your own due diligence.