FOMC Preview – Betting Against Incremental Fed Hawkishness

Since the end of the December highs, the S&P 500 is off around 10% and the Nasdaq is down around 15%. Meanwhile, 10-year real yields have risen 50bps, and the front end of the yield curve is priced for four Fed rate hikes this year. Between real yields and the stock market, we have had a real tightening in financial conditions via the equity market channel. Indeed, it feels like a lot has changed since the December FOMC. I highlight three things.

1. The Fed Pivot Is Finished

The Fed’s rhetoric has not moved much more incrementally hawkish since the December meeting.

The Fed ‘pivot’ (or what I call the ‘Jason Furman pivot’) is complete. Going to three hikes next year in the 2022 dots along with an accelerated taper finalized it. Now the famous Jason Furman Peterson Institute presentation is the Fed’s base case. So, the bar to have a hawkish shift from here is high and would likely be on the inflation expectations side.

This is not to say inflation expectations are not a risk. But now, the bet on the Fed to ‘outhawk’ these 2022 dots are effectively a bet on inflation being out of control from Q2 on again. This is very possible, but not as compelling in Fed implieds (what is priced) terms relative to this new base case.

The hawkish trade was great because the Fed had to narrow the gap between them and Jason Furman. And then there was the question: ‘what if right-tail inflation realizes?’ Now the gap has been closed, and the only ‘what if’ remaining is right-tail inflation. That is still relevant but does not carry the same asymmetry anymore. This is all to say the Fed is now on-sides if their inflation forecast gets hit. There is no guarantee that happens, but ex ante, the Fed is in a very different place than they were in Q3 and Q4.

2. Quantitative Tightening Has Been a Shift

Fed Chair Jerome Powell will likely spend much time at the press conference discussing the balance sheet. That is because the Fed has shifted a lot on it, even since the December meeting.

Other than the Fed still buying bonds while discussing quantitative tightening (QT), one peculiarity is that this was a brief moment of the December press conference but the theme of the December meeting minutes. And that is why, thematically, QT has been so ‘scary’. The rate of change has mattered much more than the end game. That is, the path to QT has been very disruptive.

Think about where we started. At the November FOMC meeting, the Fed outlined a very benign tapering of quantitative easing (QE). Two months later, we are not only talking about a faster taper but unwinding the balance sheet – and not only unwinding the balance sheet this year instead of well after the first hike (last cycle), but faster than last time. The market is right to notice that rate of change in terms of a policy posture.

3. The Market Took Non-SEP Meeting Hikes Seriously, and the Front-End Math Changed

The market has now assumed that the inflation drop is 50-50 before the Q2 Consumer Price Index (CPI) data. And by inflation drop, I mean chances that year-end core Personal Consumption Expenditures (PCE) is above or below 3%.

A week ago (though it seems like a month), we had a 30bp drop in EDZ2 since the year began. And the market was pricing a bit more than four hikes.

If inflation being in line with the Fed SEP is 50-50, this is the math.

Five hikes are less likely than three in a modal case. The bar for the Fed to break quarterly is high, and likely higher than the bar for them skipping a meeting to announce QT if inflation is on track to align with the SEP estimate of 2.7%.

However, while three is more likely than five, the broader distribution has weights that make more hikes more likely than less in EV terms. That is, seven is more likely than one. And this is important. Say the market decides five hikes are right (critically, that would suggest a pace faster than quarterly). The market then has to take seriously the tail of seven hikes, that is, every meeting. In the reciprocal of three hikes, the market can ignore the tail of one because the Fed has a much stronger floor at three given the dots and the market’s knowledge they will hike in March.

Is the Fed at Peak Hawkish?

I think so for several reasons. Firstly, I think the Fed is done (for now) being incrementally more hawkish.50bps in March is not happening. Fed Governor Christopher Waller said so on Bloomberg TV. And the New York Fed’s John Williams suggested gradual rate increases in his interview with The Wall Street Journal.

All this came right before the January blackout. As Waller effectively said in his Bloomberg TV interview, 50bps is possible this cycle, but not now. The Fed is comfortable with its positioning ahead of the Q2 inflation data. If inflation in H2 shows four hikes are too few, they will do more. But it does not appear the Fed will pre-empt that at this point.

The second reason I think the Fed is at peak hawkishness is that it has got what it wanted. Over the past two months, Powell clarified he wanted tighter financial conditions on two distinct occasions.

• At Powell’s November Congressional Testimony, he said, ‘The recent rise in COVID-19 cases and the emergence of the Omicron variant pose downside risks to employment and economic activity and increased uncertainty for inflation.’

The implicit theme from Powell was, the Fed will now pre-emptively fight further deterioration in its price stability mandate instead of being pre-emptive on the growth side. In reaction function terms, upside risks to prices are more important to the Fed than downside risks to employment.

• At the December FOMC, Powell implicitly said the Fed could play catch up via financial conditions. During the press conference, Powell suggested the famous monetary policy view of ‘long and variable lags’ (Milton Freidman’s idea that monetary policy changes take time to affect the economy) was inaccurate. Specifically, he said ‘financial conditions affect the economy fairly rapidly’.

So, the Fed targeted financial conditions and have tightened them. But even if the Fed is comfortable with the direction, are they comfortable with the pace?

A huge problem for risk assets was that the market began to price more than four hikes. Critically, that is faster than quarterly, which opens up the tail of every meeting (seven hikes). But now, risk assets are seemingly reinforcing four as the ceiling via a financial conditions feedback loop.

That is, the stock market is saying every meeting is not live. So, by that very act, every meeting will not be live. The market apparently has no interest in pricing five hikes with the option of seven. It is too much. So even if the Fed says that every meeting is live, the circuit breaker (stocks) is now alive, and that changes the distribution for front-end shorts and may reinforce some sort of ‘peak hawkishness’.

The Bottom Line

Fed hikes seem fully priced in terms of the front end of the yield curve. Will that be the case if Q2 inflation is high again? No. But for now, before more data, the Fed is in a fine spot. Could they do more? Absolutely. They could do much more. But as I said in my past two notes, the bar to get to five hikes priced is very high and is unlikely unless the 2.7% core PCE dot is in jeopardy. It is too soon to say that.

I expect Powell to sound like Waller did before the blackout period: three to four is a good baseline, and it is too soon to say if we need to do more than that. Powell will likely make the point that balance sheet tightening will also shoulder some of the lifting. The Fed is much more comfortable with their current policy position than the current market narratives believe, and I expect that to come through in the press conference on Wednesday.

Jon Turek is author of the Cheap Convexity blog and CEO of JST Advisors.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)