Updated Thoughts: Payroll Report to Bring Market Back to the Fed's View on Economy. That's Not a Good Thing for Risk
Friday's payroll report likely to quickly bring the market back to realization that fighting the Fed still remains a fool's game
My framework continues to be the same. The timeline to the Fed adding liquidity will dictate whether or not markets are going up or down. In January, the risk-on, short-covering, beta chasing rally to start the year after an awful 2022 and December in particular was aided by a softer than expected CPI print that gave markets the idea that the Fed would be stopping its tightening sooner than was suggested by the December dot plot. When Fed members before the January meeting didn't push back against an aggressive easing of financial conditions to start the year, and the Powell offered no pushback ahead of the payrolls print, the market really felt comfortable that the Fed was more likely to be one hike and done rather than get to the dots because the market has a much more dour view on inflation and growth. This market behavior had taken the terminal rate down from Fed expected level of 5.1% (where they also expected to hold for the rest of 2023) to below 4.9% and priced in more than 2 cuts for 2023, which got the SPX up toward 4200. This also created conditions where the US$ became incredibly stretched to oversold levels and various cyclicals/China related names/most short names squeezed up to ridiculous levels, as I was pointing out in my oversold/overbought indicator. But then this payroll report on Friday comes in way hotter than expected and the wage growth figures get revised higher and the market starts to realize that it's forecast is way too dovish vs the dots and that this data point is more likely to have the Fed reconfirm the December dot plot in upcoming speeches (Daly did this on Friday, expect Powell to do this now on Tuesday). With the notion that the labor market remains too tight and that core services inflation ex-housing is unlikely to stop moving quickly lower, the markets finds itself way offsides again. So now we see the terminal rate marching back higher (above 5%) and as the timeline to Fed pivot lengthens again (rate cuts pushed out), the $ will rally further from its currently oversold as no one is positioned for $ strength and we are going to get risk off trading once again.
Ultimately, the Fed is going to feel like it needs to tighten even more aggressively to bring unemployment up enough (to 4.5% at YE23 from 3.4% now) in order to make sure that wages don't run away and that inflation expectations stay well anchored so core inflation returns to its 2% mandate. Because the Fed needs to tighten more to achieve its objectives given the current labor market momentum, I believe the US$ will rally further and risk assets are likely to get sold, I think quite aggressively (as discussed in my webinar last week, likely exacerbated by the impacts of the 0DTE options activity which is taking over the daily trading). It is possible that this risk off behavior gets so violent in coming weeks that it will lead inflation expectations down materially again and would let the Fed actually pause without doing at least 2 more hikes but the damage to the economy from them continuing to tighten liquidity rather than add it is going to lead us into recession, probably later in the second quarter.
Regarding, QT, I don't really think there is much change coming from the balance sheet plan except that Governor Waller recently has said that the Fed can continue to do QT while it is cutting rates, something that wasn't really expected by the market. Also, he said we should be thinking about optimal level of reserves as reserves + RRP which means there is plenty more draining of liquidity via QT that is coming this year. If banks feel their reserves are too low, they can pay higher deposit yields to attract the capital from the RRP. The Fed has discussed MBS sales outright to drain liquidity but it seems that with the housing market so weak, this has been ruled out for now. I believe the Fed is going to continue with QT for longer than the market realizes at this point, unless we get some violent risk-asset correction that necessitates a faster than expected return to liquidity.
I think Powell is likely to sound more hawkish in his speech coming up on Tuesday after this past labor report has reset expectations and then we have various Fed speakers in coming days who are likely to confirm that messaging. After that, we should look to the Friday UMich survey to see if inflation expectations have started to move higher again, likely in part due to the rise in gasoline that has started the year. That could act as the next catalyst for the market to become further concerned that the Fed remains behind the curve. Then on 2/13, we get the January CPI print which is going to show a re-acceleration of headline inflation (Cleveland Fed is looking for 0.6% mom figure, after -0.1% in December). A recognition by market participants that inflation is re-accelerating again is likely going to further push out this timeline to Fed pivot and act as a headwind for risk. If core services inflation ex-housing shows a re-acceleration as well, I think that could really be the catalyst that brings us materially lower as it would most probably accelerate the odds of both the May and June rate hikes and would force the market to push out the timing of rate cuts even further. This is the scenario that I think could take markets back toward the lows.
Below is a quick link to a 4 minute clip from my webinar last Tuesday which discussed the potential for the 0DTE craziness to lead to a violent risk off scenario on Friday and into this coming week
Below is the link to my full webinar from last Tuesday
*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.