Overtightening Fears

The market teaches you a pattern and investors eventually adjust to it, and then the pattern changes again.  This year's lesson is that stocks and bonds can go down together, and that inflation was not transitory.  The Fed, always late to the game, finally realized that inflation wasn't going down and slowly reacted to the bond market signals in the spring which was pricing in many more hikes than the Fed was saying in their forward guidance.  If the bond AND stock market wasn't going down so much due to high inflation, you think Powell would have gone from 25 bps to 50 bps and eventually to 75 bps?  I doubt it.  The market was panicked about high CPI prints that kept beating expectations, and the Fed got the message, and reacted with bigger hikes and more hawkish talk.  

Fast forward to now.  The bond and stock market are both going down, but is it really because of high inflation?  The CPI number on Tuesday would have many believe that the market is going down again because inflation is way too high and not coming down fast enough.  But I think its for another reason.  The stock market is going down not because of inflation, which real-time reports show as slowing down, even housing.  The market is going down because they think Powell will now go unhinged, hell bent on trying to be Volcker Jr., and overtighten and make the recession even worse.  Its no longer inflation fears, its Fed overtightening fears.  A big difference. 

The whispers are beginning.  They aren't strong statements at the moment, but they will get louder and louder as time goes on.  Its the market's fear of a Fed policy error, this time, by being too hawkish and hiking rates too much.  I am already hearing some talk of a Fed policy error being discussed by those esteemed members of CNBC Fast Money.  I also heard a CEO come on CNBC saying that the Fed is hiking too fast, and should slow down, as the economy is weaker than most think.  

If you can sense when the Fed will pivot, you have the keys to the castle.  A Fed pivot at this point would just be to signal a pause, not even rate cuts.  Now that most market participants and analysts seem to have bought in to Powell's hawkish rhetoric, you are seeing some extreme pricing in the STIRs market.  The 2 biggest short term interest rate markets are now shared by Eurodollars and SOFR.  SOFR is a better representation of the Fed funds rate, as it removes bank credit risk.  

 

The SOFR futures are pricing in a Fed funds rate at 4.40% by March 2023 .  The current Fed funds rate is around 2.35%.  That's 205 bps of rate hikes priced over the next 6 months.  75 bps is basically guaranteed next week, so after the Fed goes to 3.00-3.25%, there is another 130 bps of hikes priced in.  During these big moves, when pricing starts looking irrational, its usually longs who are getting squeezed and having to dump their position to cut their losses.  Its mostly forced selling, as Eurodollars and SOFR longs are bleeding profusely.  

With Fed funds soon to be 3.00-3.25%, and some analysts and corporate CEOs on TV already saying that the Fed is going too fast, can you imagine what they will say if the Fed tries to take rates above 4%? 

If Powell tries to be Mr. Tough Guy, and hike to 4% and above, the stock market will revolt.  It probably revolts on the way there, not after you get there.  The market will give Powell a pass for 75 bps at this meeting, because its ready for it, and 3-3.25% is still a reasonable rate.  But if he tries to do 75 bps or more for the rest of the year, its going to be chaos out there. 

This much I can foresee:  if the SPX is making new yearly lows in the 3600s and below, stock investors will be complaining, loudly.  Especially if the economic data is coming in really weak.  And all the leading indicators are forecasting that scenario.  

Remember, the Fed follows the market, it doesn't lead the market.  But they usually act with a bit of a lag, which is where the opportunity arises.  I soon expect the equity market to really have a temper tantrum as short term cash will become quite an attractive alternative at above 3%, and especially at 4%+.  It will siphon more money out of equities and into cash, creating the conditions for a very weak stock market, and thus, a weak credit market, as the economy rapidly slows down.  Those are conditions when the Fed is cutting rates, not hiking rates.  I can't imagine Powell, who has a history of caving to the markets, trying to fight the credit and stock market by continuing to hike when things break. 

Things breaking will probably happening sometime within the next 2 months, a seasonally weak period after mid September when you have corporate buyback blackout period, thus fewer buyers, and also earnings coming up, which I expect to be gloomier than last quarter.  As time passes, the leading indicators will start showing up in the coincident indicators, and that's when the stock market gets really worried about a Fed that's too tight.  

Staying short here, not a huge position, so I'll let it ride and see how it goes into the traditionally weak Friday opex and post opex Monday.  Now that SPX has broken 3900, I don't see much technical support till you get towards 3800-3820.  Also with hawk Powell waiting on deck for Wednesday, I have a feeling there will be some more selling ahead of that event, and without options protection, the institutions will be likely do some selling today and early next week.  Bonds are getting interesting here, you are starting to see a slow motion capitulation in fixed income, especially in the short end of the curve.  Starting to slowly put on longs in Treasuries, with 10 year yields close to year highs at 3.50%.  I expect stocks and bond correlations to revert back to being negative in the coming months, as future equity weakness will force the Fed to pause rate hikes.