Fed is a Follower Not a Leader

Jackson Hole is now the event where Powell is supposedly going to put on his hawk costume and scare the markets into believing that he's going to be very aggressive hiking rates to control inflation.  I'm not holding my breath for that.  Powell has proven to be just another cookie cutter dovish Fed chair who seems more concerned about breaking something than about runaway inflation.  I know I am in the minority view, as most people now believe, unlike 6 months ago, that the Fed will keep hiking until the CPI comes way down, closer to the 2% level.  Balderdash.  

The Fed was only hiking big the past 3 meetings because the bond market was having a fit over the Fed sleeping at the wheel and not doing much about 8%+ inflation.  If the STIRs market wasn't aggressively pricing in hikes for 2022, and the stock market wasn't dropping big because it was afraid that the Fed was not doing enough to control inflation,  Powell would still likely be twiddling his thumbs.   The Fed are market slaves.  They are not thought leaders.  They are followers of the market.  

The Fed didn't raise rates 50 bps in May, 75 bps in June and July despite a falling stock market, it was because of a falling stock market, which was panicking over the Fed doing too little to fight inflation.  From what I read on Twitter and sell side research reports, it seems most are of the view that the Fed has to raise rates because year over year CPI is too high, even if inflation has peaked and month over month #s are going down sharply.  They ignored the fixed income market as rates went up earlier in the year, skeptical that Powell would go more than 25 bps a meeting, even as the bond market was screaming to the Fed to get on with the Fed hiking, and quickly.  Now they are ignoring the message from the bond market again, this time believing the Fed hawkish talk over what the bond market is saying.  

2s-10s are inverted 31 bps.  The STIRs market is pricing in a high in Fed funds rates in March 2023, and then 100 bps of cuts over the next 2 years into March 2025.  Its pricing in a long term neutral Fed funds rate of 2.5%.  It betting that whatever hikes that the Fed does from now on, will not be sustainable and will eventually be taken back starting from 2023.  The Fed is fighting back on this projection, saying they will keep rates restrictive and not cut so as to keep it at a higher "plateau" to fight inflation.  I don't buy it for a second. 

For the rest of 2022, the Fed projections and the STIRs pricing is similar, so there has been no temper tantrum in the stock market.  But if/when the bond market starts to price in rate cuts (wouldn't surprise me if the rate cut pricing gets pulled forwarded as the economy continues to weaken), and the Fed pauses at 3.5%+, the stock market will not be happy.  If the Fed deviates too far from market pricing, especially if it keeps rates higher than the bond market prices in, it will just exacerbate the yield curve inversion as the bond market prices in even more future economic weakness due to the tightness and the stock market will weaken as it starts projecting lower earnings coming from future economic weakness.  

After thinking about the markets and doing some reading, I've adjusted my strategy for the next few months.  My main view is that there will be a deep recession and I thought it would be best to play that by being short SPX or NDX.  But the cleaner and more direct expression of that view is to just get long Treasuries rather than short SPX or NDX.  With inflation having peaked and all leading indicators showing disinflation for the next several months, along with a rapidly slowing economy, I don't see a lasting scenario of bond market weakness + stock market weakness.  

And the advantage of being long bonds over being short stocks is that bonds will benefit greatly from a dovish pivot, while being short stocks could be quite risky when that pivot happens.  Considering how low net equity exposure is among systematic and CTA funds, there is a non negligible risk of stocks going up while the economic data comes in weaker as it tries to front run a dovish pivot. 

The bond market is making the initial steps in moving on from inflation to focus more on economic growth being the main variable for Fed policy going forward.  It started happening from mid June, as 10 year yields dropped from 3.48% to 2.52% as the economic numbers started coming in weaker (all except the NFP).  Now we've got a big pullback in Treasuries as the Fed tries to talk down the bond market with hawkish talk.  In the long run, the bond market always wins over the Fed.  The Fed can try to talk it down and keep rates higher than the market wants, but it eventually throws in the towel and pivots when credit markets starts to tighten up and stock markets have a temper tantrum. 

We are getting closer to the late 2018 stage of the Fed hiking cycle where each incremental rate hike and continued hawkish rhetoric starts to weigh on the stock market, and the bond market stops going down on hawkish Fed jawboning.  

We may have another few weeks of a choppy uptrend due to crowded short positioning but the stock market can't fight fundamentals forever.  During this economic interregnum, the stock market will feel like Goldilocks, as rates are coming down while the economy still seems resilient, the best of both worlds.  That doesn't last long, as it soon gives way to obvious signs of a recession and an increase in earnings warnings, which will fuel stock market weakness and bond market strength.  Soon enough, as SPX resumes its downtrend, the stock market will be demanding a dovish pivot, not skeptical of one as it is now.   

Covered some NDX shorts on Friday, to get to a more moderate position, and will be covering the rest today as I transition from being short equities to being long bonds.  Many are expecting a lot of hawkish talk from Powell at Jackson Hole, and the stock and bond markets have been pricing that in since late last week.  Now I very much see a possible sell the rumor, buy the news event at Jackson Hole.  This current bond selloff could last a few more weeks into mid September, as the stock market chops around, but eventually, I see a big bond rally waiting to happen later this year and into early 2023.