Guard Down, Towel Tossed
Doug Nolan
History will be the judge.
This period will be examined, analyzed, discussed, and debated for at least the next century.
My task after a week like this is to provide some facts and contemporaneous analysis to help future analysts and historians foil the revisionists.
Bloomberg: “Powell Pivots on Rates Toward a Happy New Year.”
WSJ: “Wall Street Traders Go All-In on Great Monetary Pivot of 2024.”
WSJ: “Fed Starts the Pivot Toward Lowering Rates.”
Bloomberg: “Nasdaq 100 Caps Pivotal Week at a Record High.”
CNN: “Dow Reaches Record High as Fed Pivots Toward Rate Cuts.”
Reuters: “‘Melt-Up’ as Fed Accelerates Pivot.”
Axios: “What the Fed’s Rate Policy Pivot Means for the Economy.”
FT: “Fed Pivot Piles Pressure on Europe’s Central Banks to Shift”
NYT: “The Debate on Wall Street: Did the Fed Pivot Too Soon?”
What a difference 12 days makes.
Chair Powell on December 1st: “Premature to speculate on when policy may ease” and “Fed prepared to tighten more if it becomes appropriate.”
To be sure, the Powell Pivot doused nitro on the Everything Squeeze, the Everything Rally, and the Everything “Melt-Up.”
And everyone is absolutely overjoyed – a holiday gift pack beyond imaginations.
As such, there is today sparse insightful market debate or pushback.
I’ll say it: the emperor is buck naked.
Did Powell even mean to signal “the great monetary pivot of 2024”?
If not, we witnessed Wednesday afternoon a communications cluster-snafu of historic significance.
If all went as planned, a line needs to be inserted in the top section of the list of major Fed policy blunders.
Parallels to the late twenties only get more unnerving.
Milton Friedman, Ben Bernanke, and other history revisionists point to Fed monetary tightening (all the way into the summer of 1929) as a primary explanation of the stock market crash and subsequent Great Depression.
The relative neophyte Federal Reserve was belatedly “leaning against the wind” of a conspicuously out of control speculative Bubble.
Exuberant market players, however, remained more focused on the inevitability of the Fed again coming to the market’s defense.
We now better appreciate the dynamics of markets turning hopelessly oblivious to risk.
Note to future historians: don’t pin blame on Fed tightening for an eventual financial crash.
Years of loose finance, Federal Reserve (central bank) accommodation, and resulting speculative Bubbles (and economic maladjustment) were the culprits.
For the record, the dovish pivot message was received with markets in the throes of a major speculative run, along with rapidly loosening conditions.
This week’s 3.2% gain pushed Nasdaq100 y-t-d returns to 52%.
Adding another 9.1%, the Semiconductors sport a 2023 return of 62.6%.
The S&P500 ended the week with a y-t-d return of 24.9%.
The Goldman Sachs most short index surged 14.4% Wednesday and Thursday, trading Friday morning up almost 40% from November 13th lows.
The KBW Regional Bank Index (KRX) posted a two-day melt-up of 10.2%, boosting the rally from October 25th lows to 40%.
The Wednesday/Thursday “pivot rally” saw the small cap Russell 2000 jump 6.3%, extending the rally off October 27th lows to 22%.
The loosening of conditions was already remarkable.
Then came the “pivot.”
Investment-grade CDS prices dropped another four this week to 57.5 bps, the low since January 2022.
High yield CDS sank 35 to 367 bps, the lowest since April 2022.
Investment-grade corporate spreads to Treasuries traded Friday below 100 bps for the first time since January 2022. High yield spreads narrowed to April 8, 2022, levels.
The iShares High Yield Corporate Bond ETF (HYG) has now returned 5.6% since the Fed’s first hike on March 16, 2022.
JPMorgan CDS fell this week to 44.65, the low back to November 2021.
Goldman Sachs CDS traded to lows since January 2022.
Let’s get to Powell.
From his prepared comments: “Our actions have moved our policy rate well into restrictive territory, meaning that tight policy is putting downward pressure on economic activity and inflation, and the full effects of our tightening likely have not yet been felt.”
I take exception with the fundamental premise of the policy rate being “well into restrictive territory” and “putting downward pressure on economic activity.”
Q3 GDP was reported at an exceptional 5.2% rate, with the Atlanta Fed GDPNow forecast placing Q4 at a still robust 2.6%.
Powell’s own comments are contradictory.
“GDP is on track to expand around 2-1/2 percent for the year as a whole, bolstered by strong consumer demand as well as improving supply conditions.”
“Committee participants revised up their assessments of GDP growth this year…”
“The labor market remains tight… labor demand still exceeds the supply of available workers.” “…
A very high proportion of forecasters predicted very weak growth or a recession.
Not only did that not happen, we actually had a very strong year…”
“So we’ve seen… strong growth, still a tight labor market…”
Bloomberg’s Michael McKee:
“Mr. Chairman, you were, by your own admission, behind the curve in starting to raise rates to fight inflation, and you said earlier, again, the full effects of our tightening cycle have not yet been felt.
How will you decide when to cut rates, and how will you ensure you’re not behind the curve there?”
Powell:
“So we’re aware of the risk that we would hang on too long.
We know that that’s a risk, and we’re very focused on not making that mistake.”
Markets salivate. Back to Greenspan's asymmetrical - slash rates aggressively, raise them timidly – market-accommodating approach, the Federal Reserve has maintained an err on the side of looseness institutional bias.
This policy framework has been instrumental in promoting asset inflation, leveraged speculation, Bubbles, and resulting incessant boom and bust dynamics.
The critical issue is whether the Fed, after having again fallen so far behind the curve in normalizing monetary policy, will now compound this latest major policy mistake by pivoting prematurely back to accommodation.
Whether he meant to be clear or not, markets heard loudly and clearly what they have always expected: Heck yeah, we prefer to be accommodative.
The Wall Street Journal’s Nick Timiraos:
“The market is now easing policy on your behalf by anticipating a funds rate by next September that’s a full point below the current level with cuts beginning around March. Is this something that you are broadly comfortable with?”
Powell:
“…What I would just say is that we focus on what we have to do and how we need to use our tools to achieve our goals, and that’s what we really focus on.
And people are going to have different forecasts about the economy, and they’re going to -- those are going to show up in market conditions, or they won’t, but in any case, we have to do what we think is right...
I’m just focused on what’s the right thing for us to do, and my colleagues are focused on that too.”
More saliva.
The Fed Chair just doesn’t possess the will to confront the markets – to even lean against a conspicuously speculative marketplace and loose conditions.
White towel tossed into the ring.
And please spare us ever again invoking the legacy of Paul Volcker.
It was all rather shocking.
Everyone was anxiously waiting for the answer to the obvious question: “How hard will Powell push back against frothy markets?”
Yet no one even had the right question: “Will he even bother?”
He certainly did not.
Highly speculative markets, braced to absorb Powell’s push back, erupted into melt-up after the Fed Chair’s unforeseen forward thrust.
December 14 – Bloomberg (Lu Wang):
“Wednesday’s sweeping rally across financial assets was something unseen in almost 15 years for a Federal Reserve policy decision day.
From stocks to Treasuries, credit to commodities, everything was up after the Fed projected more interest-rate cuts in 2024.
The scope and intensity can be illustrated by a measure that tracks the lowest return of the five major exchange-traded funds following these assets.
With gains of at least 1%, the pan-asset advance beat all other Fed days since March 2009.
The everything rally extends a trend from November, when economic data fueled optimism that the central bank has managed to cool inflation without dealing a blow to the economy.”
Surely Powell has been closely monitoring recent market dynamics.
He must have known his abrupt “premature to talk” to “now discussing rate cuts” pivot would generate a spirited market reaction.
And it seems impossible that he would be unaware of the impact such commentary would have two trading sessions ahead of “triple witch” quarterly derivatives expiration, a record one at that.
December 12 – Reuters (Saqib Iqbal Ahmed):
“Dealers squaring their books ahead of an options expiration that is set to be the largest on record for S&P 500-linked derivatives may be helping to tamp down swings in U.S. stocks…
Some $5 trillion in U.S. stock options are set to expire on Friday, 80% in S&P 500-linked contracts - the largest such expiration in at least 20 years - according to Asym500 MRA Institutional…
Options trading volume is on pace for a record year with average daily volume of 44 million contracts…
That volume has been boosted in part by the popularity of exchange-traded funds (ETFs) that sell options to generate income that have doubled in size in 2023 and now control about $60 billion, according to a Nomura analysis.
Robust options selling activity by these ETFs has left dealers loaded with options contracts going into the last expiration of the year.”
The contrast was striking between Powell’s Wednesday performance and the following day from the ECB’s Christine Lagarde.
Even under the weather (bronchitis), Lagarde made the presentation from our top central banker seem amateurish.
Central bankers around the world must be scratching their heads.
What was Powell thinking?
American central bankers doing what they do best.
Speculative excess and the dramatic loosening of conditions are global phenomena.
European bank (subordinated) CDS plunged 14 this week to 123 bps, the low since February 2022.
European High yield sank 36 to 332 bps, the lowest daily close since February 2022.
EM CDS fell 13 to the lowest daily close since September 2021.
Italian and Greek yields have collapsed more than 120 bps from October highs (down to 16-month lows).
“European Stocks Track Longest Weekly Winning Streak Since April.”
Germany’s “DAX Hits New Record After Fed Signals Rate Cuts Ahead.”
Up 12% from October 27th lows, France’s CAC40 closed the week at an all-time high.
It was fascinating to watch ECB President Christine Lagarde field questions related to the Fed’s dovish pivot.
Lagarde:
“Should we lower our guard?
We ask ourselves that question.
No, we should absolutely not lower our guard…
When we look at all the measurements of underlying inflation, there is one particular measurement which is hardly budging – it’s declining a little bit but not much.
And that is domestic inflation.
Domestic inflation is largely predicated by wage.
We need more data to better understand what happens there, and why is domestic inflation resisting.”
“We did not discuss rate cuts at all.
No discussion.
No debate on this issue. I think everyone in the room takes the view that between hike and cut there’s a whole plateau – a whole beach – of hold.
It’s like solid, liquid and gas.
You don’t go from solid to gas without going through the liquid phase.
This was just not discussed.
I think going forward we are going to continue to be data dependent.
We are going to continue to determine meeting by meeting what we see on a totality of data.
But, obviously, given the certain resistance of domestic inflation and the risk of second round effects - that we absolutely want to avoid – we are going to be very attentive to that category of data…”
Even more intriguing were Friday comments from the President of the powerful New York Federal Reserve Bank, John Williams, in a CNBC interview – the first substantive comments from a major Fed official post-Powell pivot (included at length for posterity).
CNBC’s Steve Liesman:
“What changed between, say, the end of November when it sounded like you and the Chair were both saying, “Hey, it wasn’t the time to talk about rate cuts” and then what happened at the meeting, where it sounded like the Committee was talking about rate cuts and now projecting more of them for next year?”
Williams:
“First of all, we aren’t really talking about rate cuts right now.
We’re very focused on the question in front of us, which as Chair Powell said: the question is have we gotten monetary policy to a sufficiently restrictive stance in order to ensure that inflation comes back down to 2%.
That’s the question in front of us. That’s what we’ve really been thinking about for the past five months.
And I think we’ll be continuing to think about it for some time.
So that’s the topic of discussion for the committee.
That’s the decision we made to hold the Fed funds target where it is.
Now, clearly, we all put in projections for interest rates and inflation and growth and unemployment, as well.
Those are individuals thinking about what may happen over the next three years on a baseline path.
But the discussion, really, at the FOMC right now is about ‘do we have monetary policy today in the right place’ – and not speculating on what will happen at some point in the future.”
Liesman: “But the Chair said you had a discussion about rate cuts.”
Williams:
“Well, we have the projections that we all submit.
The summary of those projections are shared with Committee participants.
Some Committee participants talk about their projections.
But this is not the topic of discussion about ‘what are we going to do?’ or plans around this.
Again, the Committee doesn’t have plans around that.
This is really each Committee participant thinking, ‘Okay, over the next three years, if the economy evolves in a certain way, what do you think the appropriate path for interest rates are.’”
Liesman: “So what was the answer to the question, ‘are you sufficiently restrictive?’”
Williams:
“Well, I think this gets to the uncertainties that we face.
It’s still a highly uncertain situation – both in terms of inflation, in terms of the progress of the economy.
So right now, I think the base case – I’ll speak for my own view – the base case is looking pretty good.
Inflation is coming down, the economy remains strong, unemployment is low.
And, so, when you think about ‘have we gotten policy to the kind of appropriate place?’, it’s looking like we are at or near that in terms of sufficiently restrictive.
But things can change.
One thing we’ve learned, even over the past year, is that the data can move in surprising ways.
We need to be ready to move to tighten policy further if the progress on inflation were to stall or reverse.
The Committee is clearly focused on making sure that we bring inflation back down 2% on a sustained basis.
We need to be data dependent and respond and take the right policy decisions depending on what transpires.”
Liesman:
“So the market sure thought you were talking about rate cuts and projecting rate cuts. What do you make of how the market reacted both in a huge downdraft in bond yields and an updraft in stock prices?”
Williams:
“One thing that’s been really interesting over the past year.
We track this obviously very closely here at the New York Fed.
The market reactions to all kinds of news, economic data – all types of events – has been much bigger in magnitude – much larger than is historically normal.
I think that reflects in large part the uncertainty, the unusual nature of the situation we face.
The fact we’re seeing big market reactions to pretty much everything has been a pattern that we’ve seen over the year.
In terms of what we’re seeing about the market saying, ‘well, the FOMC is going to do this - or so many rate cuts this year’ – I would just point people back to the economic projections that we put out.
If you look at the median projection, over the next three years, the median shows, basically, gradually over the next three years the policy restraint that we put in place dialing back gradually over three years.
That’s the view of the Committee.
I think that’s consistent with our view of how the economy is going to evolve.
I think the market in a way is reacting very strongly – maybe more strongly than what we are showing in terms of our projections.”
Liesman: “Do you believe the Federal Reserve can cut interest rates next year?”
Williams:
“Again, we of course can do whatever is appropriate for achieving our goals.
The way I think about this is, if we get the progress I’m hoping to see on inflation, on the economy, of course it will be kind of natural for us to move monetary policy over an extended period of time – over a few years – back to more normal levels.
That has to be in the context of us being confident that inflation is moving sustainably toward our 2% goal.
It’s absolutely essential to see that. But, under those conditions – which is my baseline forecast – of course we need to move policy back to normal levels over a period of time.
We got to be data dependent and able to adjust according to what we’re seeing.”
Liesman:
“I have to ask this question more directly.
The market sees rates coming down as soon as March.
How would you respond to that?”
Williams:
“It’s just premature to be even thinking about that question.
Right now, the question that we’re thinking about at the FOMC is, ‘Do we have the level of rates, right?'
As Chair Powell said, there are these phases of how we’ve thought about monetary policy.
Have we got the stance of monetary policy sufficiently restrictive?
And, of course, we’ll be watching the data to make sure we’re getting that appropriate policy.
To me, the debate is – it is premature to really think about what we will be doing sometime well into the future.
That’s not the question in front of us.”
If Williams' objective was to clarify things - some post-Powell pivot clean-up duty - his comments created more questions than answers.
For starters, did the Committee discuss rate cuts or not?
Did the Powell pivot convey a stronger dovish message than the Committee intended?
At this point, the damage is done; the horse bolted from the barn.
Pushback from Williams, Bostic and others will be swimming up a raging stream of market speculative fervor.
And I doubt it would make much difference if Powell tries to walk back his dovish pivot.
After all, the marketplace has received all the confirmation it needs to be convinced that the Fed doesn’t want to actually tighten conditions; that it’s comfortable with booming markets and loose conditions; and that it will, as always, err on the side of market accommodation.
It's hard to believe the Fed has tied rate policy so tightly to current inflation.
Inflation will ebb and flow – and right now it’s ebbing after the biggest spike in decades.
Evidence is already mounting that recent loosened conditions are supporting demand.
We should assume that economic resilience at this point will sustain tight labor markets and strong wage gains.
Beyond heightened prospects for elevated inflation, the Fed seemingly abandoned its overarching responsibility for maintaining financial stability.
To pivot when markets are in such an intensely speculative state is reckless.
It’s just unsound central banking to dismiss today’s upward wage pressures and second-round inflationary impacts.
And it’s unacceptable to disregard critical lessons from the late nineties “tech Bubble” and mortgage finance Bubble experiences: system stability risks associated with asset inflation and speculative Bubbles far overshadow those of consumer price inflation.
And I see the root of the Fed’s predicament in its narrow focus on “financial conditions”.
When Powell and Fed officials discuss “restrictive” policy rates, it’s as if we’ve time warped back to the eighties when bank lending provided the marginal source of finance for the economy.
To assert “restrictive” today - in the face of $2 TN federal deficits and elevated system Credit growth, booming securities markets, record options trading, Trillions of speculative leverage (including a record-sized “basis trade”), a Bubble in private Credit, record flows into junk bond funds, and ongoing enormous ($500bn plus) EFT flows - is nonsensical.
New York Fed President John Williams surely appreciates that “market reactions… much bigger in magnitude… than is historically normal” is the direct consequence of highly speculative markets with glaring structural abnormalities.
Unprecedented options trading, derivatives hedging-related instability, and massive momentum-chasing flows are fueling a “melt-up” overreaction to Powell’s pivot.
One of these days, these same dynamics will haunt on the downside.
And the longer the current Bubble blowoff inflates, the greater the likelihood of a destabilizing reversal and financial accident.
December 10 – Wall Street Journal (Gunjan Banerji):
“Oodles of risk.
Bold bets on artificial intelligence.
Round-the-clock activity.
The options market is booming like never before.
About 44 million options contracts have changed hands on an average day in 2023, on track for an annual record based on Options Clearing Corp. data going back to 1973 and more than double the figure from five years ago.
Activity in contracts expiring the same day… has helped turbocharge a mania that began in 2020 during the depths of the Covid-19 pandemic.
Volume has soared, hitting fresh highs in each of the following three years.
The explosion in activity suggests many traders are hungry to take big risks in markets, eager for fatter payouts than they think traditional buy-and-hold investments will offer.
The flourishing trades also show how the lines between trading and gambling have further blurred.
Some of the most popular trades this year resembled scratch-off lottery tickets.”
Especially considering the remarkable loosening of conditions and market melt-up dynamics, there is increasing likelihood the economy surprises to the upside.
From a growth surprise or any number of potential shocks, inflation could easily regain momentum.
And then we’ll learn how badly Federal Reserve credibility has been damaged.
It will not be easy to talk markets into tighter conditions.
Analysts and participants will scoff at any Fed stabs at tough talk or some half-baked “hawkish pivot”.
Powell Wednesday essentially passed off policymaking to feverish markets.
Efforts to regain control won’t go smoothly.
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