Dr. Jekyll and Mr. Hyde
Doug Nolan
Bloomberg’s Jonathan Ferro:
“What is it that Chairman Powell did on Wednesday that you disagree with?”
Mohamed El-Erian:
“I said it contributed to undue market volatility.
It’s the undue part -excessive market volatility.
I think, once again, the Fed did not understand the technicals.
Once again, the Fed didn’t understand the behavioral aspect of markets.
So, while Chair Powell went out of his way to be balanced, he did a few things that made the markets hear just what it wanted to hear.
First, confirm that we are downshifting in December.
Second, do this ahead of the labor report – suggesting that maybe he knew something that others did not know.
Third, talk about risks being now balanced – two-sided – and bring in his colleagues on the Fed.
And then what he didn’t mention, John, he did not push back in any way against what already was a significant rally in markets – and significant loosening of financial conditions.
So, while he said other things – and he was right to say other things including warning about inflation staying [elevated] – warning about our job [tightening] not being done – he didn’t realize where the technicals of this marketplace were.
And he didn’t realize the behavioral aspects.
And that’s why you got this overreaction.”
Jonathan Ferro referred to “the brilliant Mohamed El-Erian.”
Yes, Mr. El-Erian is unequaled in consistently providing adept analysis.
Powell on Wednesday was not appropriately hawkish, especially compared to his November 2nd press conference.
Recall the S&P500 sank about 5% between the start of his press conference and the following day’s market open.
I have to assume Powell was uncomfortable that his comments had such a market impact.
I commented at the time that Powell likely planned on a balanced approach.
But the more he spoke (replying to questions), the more his inner hawk took over.
“I control those messages, and that’s my job,” stated Powell in November.
My hunch: On his commute home on November 2nd, a restless Fed Chair thought to himself: “I’ve got to do a better job controlling my mouth.”
Powell was determined to hold a balanced line Wednesday.
And, to be sure, balanced Powell conflicts with press conference forthright hawkish Powell.
Dr. Jekyll and Mr. Hyde.
And markets fancy balanced Powell.
He’s a cautious team player.
That hawkish Powell can be a little scary: On occasion, he gets that intrepid look in his eyes that he might go rogue Volcker.
Balanced Powell, giving a nod to his dovish vice chair and her contingent, refers to “monetary policy works with long and variable lags.”
“I don't want to overtighten.
My colleagues and I do not want to overtighten…”
Hawkish Powell, from his November press conference, “if we over tighten, then we have the ability with our tools, which are powerful, to… support economic activity strongly.”
Jekyll Powell leans on “risk management” to avoid breaking things.
“So, we have a risk management balance to strike, and we think that slowing down at this point is a good way to balance the risks of over tightening.”
Hyde Powell, principled, bold and assertive, views the risk of things breaking as an inescapable facet of managing through a serious inflation threat.
“And trying to make good decisions from a risk management standpoint, remembering of course that if we were to over-tighten, we could then use our tools strongly to support the economy.”
I guess Powell could check in with options and derivatives market positioning before he speaks.
In preparing his speeches, he might consider “risk on” and “risk off” versions to choose from as he approaches the podium.
The Fed these days must contend with wildly unstable markets of its own making, and surely Powell has no interest in trying to adapt messaging to the vagaries of today’s capricious markets.
And, subconsciously or otherwise, there’s always this innate central banker soft spot for seeing those betting against system stability disincentivized (with losses).
To be sure, system stability would have been better served had hawkish Powell leaned against the market rally and attendant loosened financial conditions.
I’ll assume he was more focused on tweaking his message to be more balanced and guarded.
He seeks consistency and reduced market impact.
Good luck.
Poor timing was a problem.
“Risk on” markets - relishing cross-market short squeezes and the unwind of hedges, lower market yields, narrowed Credit spreads, reduced derivative premiums (cheaper risk protection) and the appearance of newfound liquidity abundance - looked straight through (invisible) balanced Powell and fixated on Jekyll.
Jekyll is not going to cut it.
Friday’s November employment data provided a timely reminder that the Fed’s tightening cycle has yet to make significant headway.
The economy created a stronger-than-expected 263,000 jobs last month (October revised up to 284k).
For the year, non-farm payrolls are up 4.3 million.
Importantly, Average Hourly Earnings jumped a strong 0.6% (estimate 0.3%), with one-year growth of 5.1%.
Moving opposite of expectations, the Labor Force Participation Rate slipped a tenth to 62.1%.
This followed Thursday’s stronger-than-expect 10.334 million October job vacancies (JOLTS).
Despite mounting layoffs, unusually tight labor markets remain inconsistent with stable prices.
It has been long understood that failing to address accelerating inflation early – so-called “falling behind the curve” – ensures a more challenging and painful tightening cycle.
The familiar “slamming on the brakes” terminology is apt.
Throw Trillions of monetary inflation at a late-cycle boom, while holding rates at zero, and one should anticipate a uniquely challenging tightening cycle.
So far, the Fed has moved to normalize rates more rapidly than expected.
Perhaps the more consequential surprise has been that financial conditions remain relatively loose.
Securities markets conditions tightened, yet bank and “non-bank” lending booms and ongoing enormous deficit spending sustained elevated system Credit growth.
And between robust Credit growth and residuals from the Fed’s $5 TN pandemic QE program (i.e. corporate and household cash balances), there has been more than ample monetary fuel to reinforce inflationary dynamics.
Responding to a question regarding the Fed’s efforts to shrink its balance sheet, Powell offered a telling perspective.
“You know, having a lot of reserves in the system is really a good thing.
It’s really a public benefit to have plenty of reserves, plenty of liquidity in the markets, in the banking system, in the financial system generally.
So that’s how we would do it.”
Sounds like the antithesis of the degree of tight “money” necessary to get the inflation genie back in the bottle.
The Fed’s tightening cycle is somewhat of a mess right now.
Officials feel compelled to get off the 75 bps per meeting train.
Okay, but the Fed’s practice of clearly communicating its intentions muddies the waters.
“Risk on” markets interpret the FOMC’s downshifting as a prelude to a dovish pivot.
Ten-year Treasury yields ended the week at 3.49%, down 73 bps from the November 7th high to the low since September 16th.
Corporate Credit spreads (to Treasuries) traded Friday at their narrowest margins in months, with investment-grade spreads not narrower since April.
The upshot is that financial conditions have loosened meaningfully.
An effective inflation fight requires major tightening.
It may be too strong to assert that the Fed is losing its inflation battle.
Fed officials and market pundits point to market indicators (i.e. yields and swap rates) as corroborating the Federal Reserve’s inflation-fighting credentials.
They keep telling us that inflation expectations are well anchored.
But I continue to believe that low market yields are more a reflection of bursting global Bubbles (i.e. China) and the inevitability of accidents.
The Fed’s inability to orchestrate a significant and timely tightening of system financial conditions is a major issue.
It has allowed inflationary forces to become entrenched.
Companies have grown comfortable raising prices, while workers are emboldened to demand higher compensation.
Failure to quickly quash inflation resulted in an 8.7% 2023 Social Security COLA (cost of living allowance), the largest since 1981.
And each month that loose financial conditions further accommodate these dynamics only ensures inflation becomes more deeply ingrained throughout the economy.
It’s as if markets are saying “no harm, no foul.”
At least in the eyes of the Treasury market, Fed inflation ineffectiveness is virtually moot.
No worries, all will be resolved by bursting global Bubbles.
And as a last resort, a desperate “slamming on the brakes” would surely burst the inflation Bubble.
At least for now, the bond market vigilantes have retreated back into their caves.
And without bond market discipline, it’s a challenge to envisage the type of tough decisions - at the FOMC and Washington - necessary to rein inflation in.
This suggests stubborn upward pricing pressures.
Moreover, the backdrop seems to ensure that, when crisis dynamics return to global markets, elevated inflation will have the Fed and global central bankers responding cautiously when markets come demanding massive additional liquidity (QE).
But for risk markets dominated by short-term options, derivatives trading and speculative dynamics, future inflation rates and policy risks are irrelevant.
What mattered was Powell took a December hawkish surprise off the table.
Greed and fear have been left to run their fateful courses into year-end, with the greedy bulls in command and the fearful bears – stocks, Treasuries, corporate Credit, the yen and renminbi – in full retreat.
And while on the subject of retreat:
November 30 – Associated Press:
“China’s ruling Communist Party has vowed to ‘resolutely crack down on infiltration and sabotage activities by hostile forces,’ following the largest street demonstrations in decades by citizens fed up with strict anti-virus restrictions.
A massive show of force by the security services Wednesday sought to deter further protests.
The statement from the Central Political and Legal Affairs Commission… followed protests that broke out over the weekend in Beijing, Shanghai, Guangzhou and several other cities.
While it did not directly address the protests, the statement was a reminder of the party’s determination to enforce its rule.”
Last weekend’s protests in a number of Chinese cities were extraordinary.
It is inspiring to see the demonstration of such courage, especially from Chinese students and youth.
The Chinese people have been through so much, an economic downturn coupled with draconian “zero Covid.”
People are clearly at the ends of their ropes.
Having had expectations so inflated during the protracted Bubble period, now the depressing downside.
The great Chinese surveillance apparatus and communist party iron fist could very well keep protestors off the streets for now.
But I believe something important sprung to life last weekend.
The Chinese people were willing to tolerate their heavy-handed government as incomes grew and living standards improved.
With the future so bright, they would look away from increasingly oppressive government overreach.
The future has darkened.
A bursting Bubble has revealed the fallibilities of the great Beijing meritocracy.
A coercive autocratic central government is now viewed more as the problem than the solution.
The Chinese people deserve much better – and they know it. Beijing wants them off the streets – and can force its will.
Beijing wants them instead in stores, in showrooms and buying apartments.
I’m skeptical that an oppressive Beijing is compatible with the type of consumer confidence necessary for economic recovery.
For years, I’ve pondered how the Chinese people, devoid of the ballot box, would respond to a collapsing Bubble.
China’s Bubble inflated longer and much greater than I ever imagined.
The pandemic and “zero Covid” were not part of the analysis.
Nor was the invasion of Ukraine by China’s “partner without limits.”
Trust has been broken.
I think Beijing is going to have its hands full.
We can only hope they don’t resort to using the Taiwan issue as a nationalism rallying cry.
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