THU 27 JAN 2022
It is always important how price responds to news. While the initial reaction to the January FOMC statement was relatively calm, the price action following Jay Powell’s press conference has been rather bearish. Equities faded badly and trade during the Asian session (including the US futures) has been rapid and emotional. There has also been a reflexive relationship between the impulsive rise in Treasury yields and the correction in equities. Although we were not surprised about the hawkish message from Chairman Powell, clearly the price action suggests it was clearly not fully discounted. As we noted yesterday, inflation has probably lowered the strike price on the Fed put.
While the January FOMC Statement was probably consistent with the prevailing bias of economists and market participants, it was notable that it did not contain the usual gradualist language of previous cycles. Perhaps even more important was the communication during the press conference. The summary of the Chairman’s response in question time suggested that the pace and magnitude of the rate hikes might be greater than prior consensus beliefs. For example, he did not rule out a 50 basis point rate hike in March or a hike at every meeting this year.
From our perch, that should not come as a shock to investors. Afterall, headline inflation is 7% with current policy settings still at emergency levels. However, for markets, speed or convexity has contributed to the withdrawal of liquidity and reduction in leverage. What has been notable is the sharp (vertical) rise in real 10 year yields (nominal minus breakeven). The move appears disturbingly similar to the taper episode in 2013 (chart 1). Of course, the magnitude is still much less, so far and could contribute to further reflexive or self-reinforced selling of rate sensitive assets.
As we have noted recently, the rationale for this correction is genuine; the withdrawal of super-abundant liquidity. Moreover, the capacity of the Fed to dovish pivot has clearly been constrained by inflation, lowering the strike price of the Fed put. On the positive side, our tactical indicators have already reached extremes in sentiment. The recent price action has also clearly been impulsive, rapid, emotional and correlated or consistent with capitulation.
As we have warned for months, the most expensive, levered and profitless sectors have been eviscerated, but the correlated selling in profitable and value sectors of the market is now likely an emotional overreaction. It is also an opportunity to take on. Of course, given the nature of the episode, inflation and the starting point it is plausible that the correction from peak in the global risk proxy (the S&P500) could plausibly be -20% (or another 8% or so) and comparable to Q4 2018. Another tactical indicator to watch for a potential turning point in risk is the dollar index to identify when Fed expectations (and de-leveraging) are largely priced.
On the positive side, would push back on the growing consensus that the correction in equity will lead to an imminent “growth scare.” Rather, this episode is probably something akin to 1994. Also in our humble opinion, the policy error in this episode was leaving normalisation too late. For value investors (with liquidity) this is an opportunity to scale into profitable companies. Moreover, the best trades are made when you are deeply uncomfortable.