Tightening the Noose

The lagged reaction function of the global central banks is wreaking havoc on historical patterns of the economic cycle and stock and bond market prices.  In a typical economic cycle, you see the central banks steadily raise interest rates after the recovery is well underway, with unemployment rate going down and inflation going up.  This allows for the economy to slow down more gradually.  This time, due to political reasons, Powell disseminated the lie of transitory inflation in order to keep rates low and ensure another term as Fed chair.  He had to fight off Lael Brainard for the spot so he put on a very dovish front in order to seal the nomination last fall.  That delay only exacerbated the bubbly animal spirits at the time and extended this high inflation period by several months.  

Remember, inflation acts with a lag, especially core inflation, so whatever fiscal and monetary policy enacted in 2021 will still have lasting effects well into 2022.  The unprecedented rise in M2 money supply in 2020, coming mainly from monetized stimmy checks, forgiveable PPP loans, giant child tax credits, and huge pork packages was the rocket fuel to feed the inflationary fire that's lasted for the past 20 months.  Forget about what the 15 minute macro experts say.  Inflation didn't come from Putin's war or from supply chain issues.  It came from a massive printing of money and enormous stimmy packages.  If you don't hand out free money to fuel record breaking demand for goods, you don't have supply chain problems.   

Just 5 months ago, the Fed funds rate was 0.25-0.5%.  Interest rate increases work quickly in the financial markets, but act much more slowly in the real economy.  The real economy will feel the brunt of the rate hikes in 2023, well after the top in bond yields.  This lag effect will be especially painful this time around, due to the speed of the rate hikes, going from 0 to 400 bps in 9 months (assuming market pricing is correct and the next 3 meetings have hikes of 75 bps-50bps-50bps).  Really the only way for the tighter monetary policy to quickly affect the real economy is by tightening financial conditions so much that you start seeing much lower stock prices and real credit stress,  which quickly leaks into the economy as corporations have to sell bonds at abnormally high yields to raise capital, and cost cutting becomes more urgent.  We're not quite there yet, but that's the direction we're heading.  And more quickly than people think.

I am already hearing anecdotes about corporations issuing high yield debt having a hard time getting deals done.  Fedex earnings warning was just the tip of the iceberg.  There will be more canaries in the coal mine, as higher rates, tighter monetary conditions, and much weaker global growth start to weigh on corporate earnings.  In this type of toxic environment, where the central banks are tightening the noose on the neck of the bulls, you have to throw out the 2009 to 2021 playbook.  Sentiment will be bearish, and you have to accept that as the norm now, as bearish sentiment is the default stance of market participants in this environment.  Bearish is the new neutral.  Neutral is the new bullish.  Only when things look really horrible, and after extreme price moves, can you lean on bearish sentiment as a tell for an imminent rally.  In the past, this kind of bearish talk among the investment community usually led to a big rally that lasted weeks, but these are not normal times.  75 bps for 3 straight meetings is NOT normal.

I covered yesterday after seeing some signs of dip buying and short covering, and to avoid the upward drift that is common a day or two ahead of the FOMC meeting.  Big selloffs going into the meeting often result in short covering rallies a day or two ahead of the event.  Once the event is over, the shorts usually come back to sell what they covered.  We've rallied big in the past 4 FOMC meetings.  That will be on the mind of the short sellers who are still short, and I expect some short covering from them heading into the meeting.  

Its a little bit of game theory, but this FOMC meeting should play out a bit differently than the others, just because Powell has put himself in a box by his hawkish words at Jackson Hole.  He almost has to come out and put on his most hawkish act, just so he doesn't look like a pivoting pansy again.  That could pour cold water on any expectations of him doing his usual dovish mealy mouth press conference, leading to a selloff during his press conference.  

The shorts I covered yesterday, I will probably put back on tomorrow ahead of the FOMC meeting.  I feel empty without having shorts on in this environment. 

Bonds are weak again today, I'm long a bit from late last week, and not too eager to add more right way.  After such huge losses in bonds this year, its going to take a while to consolidate at these higher yields before you get the change in trend.  There will have to be more overt signs of recession before you can get more investors selling equities and buying fixed income.  Equities have been the place to be for so long in the US, that its going to take some time to shake that BTFD psychology.  As that psychology changes, you will see retail equity holdings as a percentage of assets go down.  Its still near the highs of the past few years.  That will be the future supply that fuels the next leg down of this bear market.  The first leg down was fueled by hedge funds reducing equity exposure.  The next leg down will be retail reducing equity exposure.