The Big Picture

Published Jan 30, 2023

For as long as I can remember, “Don’t fight the Fed” has been a universally held axiom which means no matter how right you think you are, the Fed can do the opposite for a lot longer than you can stay solvent. And the Fed has issued many warnings that rates will remain high for a long time and that it sees the market’s continued optimism as “puzzling.” Yet the bond and stock markets continue to thumb their noses. 

Despite higher rates and a looming recession, stocks continue to trade at historically high valuations relative to GDP, and current earnings and valuations are extremely over-valued if we adjust future earnings for the recession will almost certainly precede a Fed pivot (see chart below). The inverted Treasury yield curve continues to signal that rates will be lower in the future, and Fed Funds futures indicate that reversal could come much sooner than the Fed’s forecasts. Yet every statement from the Fed is that this is a dangerously optimistic view of their intentions. Has everyone gone mad? Is this just a misunderstanding? Is the market calling the Fed’s bluff? How will it end?

What we’re witnessing is a momentous game of chicken in which Chairman Powell sees a historic opportunity and obligation to disabuse the market of the infamous “Fed put” that has for decades comforted investors that if assets lose value for any reason (bad economy, burst bubbles, liquidity crises, etc.), the Fed will come to the rescue. Markets, on the other hand, believe the Fed is bluffing; they see recession coming soon and inflation subsiding, and the employment bulwark cracking, which will force the Fed to cut rates. If the present value of stocks is the probability-weighted sum of the expected distribution of future prices, and the market believes the Fed will eliminate bad outcomes from the distribution, then the remaining outcomes will be positive and the probabilities must still sum to 100%. Thus, the “put” distorts markets and explains current market exuberance.

In recent speeches, Powell has made it clear that he understands that unemployment will rise but that the Fed must remain resolute until inflation returns to “target” (2%). But what if inflation starts to fall quickly? What if unemployment rises quickly? How much political capital is he willing to burn (perhaps even risking Fed independence) to correct market distortions? In the face of political pressure from certain members of Congress, Powell has used recent speeches to remind policymakers why the Fed members are unelected; a clear signal that he understands the stakes but also understands his responsibilities. 

It turns out that hindsight may, in fact, support Powell’s original position that COVID-related inflation is/was “transitory.” Resulting of supply shocks exacerbated by tons of fiscal stimulus, inflation is clearly receding. Stimulus money is spent, the burst supply pipes are being fixed, and if rates are held at current levels for too long as supply comes back, the Fed risks a downward inflation surprise (including deflation) if this game of chicken goes on too long. Yes, I’m suggesting that if the Fed takes the fight too far, the reversal when it comes could be sharper and more severe than even the optimistic markets are forecasting; we could be looking at a Fed responding to rampant deflation, which could lead to rates far lower than even what we saw during the pandemic.

The alternative path is a Fed that’s more like the middle-aged accountant who puts on leathers and rides his Harley on sunny weekends; all hat and no cowboy. In this scenario, the Fed will be looking for a ladder to climb down and could start messaging that the inflation “target” needs to change (“2% was arbitrary”), or they could start inventing new metrics that indicate their job is done before a collapse in asset prices or employment. They’ve already begun the latter by focusing on “CPI excluding food, energy, and housing” as the main inflation gauge, which basically eliminates the price of everything except chicklets and pencils. As DoubleLine Capital CEO Jeffrey Gundlach observes, the Fed no longer leads markets, the 2-year Treasury leads the Fed, and the 2Y is down 50 bps since November.

The markets are saying to Chairman Powell, “we don’t think you’ve got what it takes,” and history is on their side. Moreover, I don’t see the FOMC having enough consensus among its members to continue taking political body blows if/when unemployment is rising and home prices are falling. But how long the game of chicken continues after cracks develop in consumer spending and employment will determine how far the pendulum needs to swing back in the coming months/years. For now, nobody’s blinking.  

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