FOMC Preview: The Market Is Short Growth and Short FAIT

Following the recent bond market rally, there is an interesting disconnect between market pricing and market narrative. The market narrative since the June FOMC, and the addition of two rate hikes in the 2023 dot plot, has been that FAIT is dead and the Fed is turning much less dovish as inflationary concerns build. However, on the market pricing side, following a meaningful selloff in the front end after the June FOMC, the market has returned. Looking at things like EDZ2, they now trade at about the same level as at the June meeting. So, while the market has made the trade of ‘faster hikes equals a lower terminal rate’, they have been slowly taking out positive term premium in the reds as well.

One of the more obvious themes has been that the market has been in the camp of ‘sooner hikes equals fewer hikes’. This is obvious in the Eurodollar strip, which flattened dramatically over the past few weeks, especially since the June FOMC. However, the market has also priced a strong element of what I call ‘Trichet’ risk, or the idea that the Fed is on this unavoidable path to overreacting to inflation next year. With EDZ2 pricing below 99.60 (75% chance of a hike) and the 30-year Treasury yield sub 2%, the market is essentially taking the view that the Fed will cave on inflation, and that will dent the scope of the coming economic cycle.

The problem is, outside of the market being extremely short FAIT right now, it is also very pessimistic on more medium-term growth. In other words, the market, with a 30-year at sub 2%, is essentially saying that if the Fed hikes next year, that guarantees a return to the secular stagnation days of last cycle. It might, but it is certainly no guarantee. It is very plausible to me that the Fed hikes next year and the economy is still much stronger than in the 2010s – the market is overly pessimistic on that potential outcome.

The Hawkish Bar for the July FOMC Seems a Bit High, Does Not Hawkish Equal Dovish?

There are no dots at this meeting, and the statement will likely look mostly unchanged. Given the emergence of the Delta variant, the balance of risks assessment will stay balanced. If Chair Jerome Powell’s press conference is much like his congressional testimonies, that will not move the needle so much – especially if Powell reiterates that the labour market is still not at ‘substantial further progress’. We have had another big inflation print since the June FOMC, but downside risks have also risen in the form of Delta. This should leave the Fed balanced into more clarity on the virus and into the payrolls report next week. Little reason exists for either Powell or the statement to sound much different than in June, and Powell’s congressional testimonies were likely a preview of that.

The problem now for the hawkish trades is, in market terms, we have had a reversal in skew. Until the June FOMC, the Fed had to be incrementally more dovish just to sound dovish to the market. Now, that is flipped: if the Fed is not incrementally more hawkish than in June, the market will likely read that as dovish. And I think that is sort of the setup at least until the September FOMC and the next SEP. That is, the market needs more on either taper timing or more FAIT academic context to beat the hawkish bar. I do not think the July meeting advances taper relative to the base case, and I do not think Jackson Hole lays the road for a post-ZIRP world within the context of FAIT (i.e., defining lookbacks, AIT calculations etc.).

The question this week is, if the status quo prevails for FOMC until September, is that dovish? I think it might be. At least for the July meeting and Jackson Hole, not hawkish equals dovish.

Is the Market Now Long Clarida and Short Powell?

The other framing I think will be interesting – and it is something to which I have been late – is, within FAIT, there are two camps, or what I call Clarida v Powell.

1. The Powell camp is that FAIT is a forward guidance tool that allows the Fed to fight the asymmetry of the ZLB via a pro-cyclical expansion of their policy posture. In a sense, to Powell, FAIT is very much a concept.
2. The Clarida camp is much more technical. Vice Chair Richard Clarida told us what FAIT is to him in a January speech. ‘I think of our new flexible average inflation-targeting framework as a combination of TPLT at the ELB with flexible inflation targeting, to which TPLT reverts once the conditions to commence policy normalization articulated in our most recent FOMC statement have been met. In this sense, our new framework indeed represents an evolution, not a revolution.’ For Clarida, FAIT is still a rules-based framework.

The market entered the June FOMC (me included) long Powell and short Clarida. In other words, FAIT is more a concept than a rule, and if so, the 2021 inflation reading would be taken with more of an asterisk than equal weight. That is no longer the case, and now the market must grapple with a Fed that will take inflation this year as seriously as it took disinflationary pressures last year. This means that, in terms of FAIT or one-year lookbacks (Clarida), it is almost inevitable the Fed will hit their markers in 2023.

However, the market has firmly made this adjustment now with a relentless flattening of the yield curve. For the first time since FAIT, the Fed has a low dovish bar to hit, and the market seems to be underestimating that. FAIT has been beaten up so much since June that it will only take a little to give it a pulse again, and the market may be underestimating Powell’s desire to do that.