FRI 7 JAN 2022
The irony about the market’s reaction to the hawkish FOMC minutes this week on the discussion of balance sheet run-off is that it should not have come as a surprise given how late the Fed has been so far in this cycle. I am reminded of the classic line by John McLane in my favourite Christmas Movie; “welcome to the party pal” as Sergeant Al Pal finally realises that terrorists have taken over Nakatomi Plaza.
Of course, as Cam Crise noted overnight it is a very long time since the Fed exhibited a “strong commitment to contain inflation pressures” (most investors have never actually experienced a hawkish Fed). Indeed, for years the FOMC has exhibited the opposite bias and has arguably contributed to negative behavioural asymmetry in risk assets; where tightening cycles are gradual, but policy is easing is aggressive on the downside. That has likely underwritten the self-reinforcing cycle of ever rising leverage, asset prices and volatility compression. However, inflation is now so far above the Fed’s target (chart 1) that they probably have no choice but to withdraw liquidity and increase policy rates. Investors might be forced to learn that “don’t fight the Fed might work both ways.”
As we noted yesterday, the recent shift in the consensus belief on rates (and QE) was likely reinforced by positive re-opening expectations and the partial labour market data earlier this week. The other side of the Fed’s dual mandate is also important for the policy reaction function. Spare capacity in the labour market (the shortfall in total employment) was the key justification for remaining cautious through 2021. However, that argument no longer holds water with total employment much closer to pre-pandemic levels (adjusted for those who have left the labour force) and strength in total household income. Hence why the employment data is so important in the US tonight.
To be fair, when push comes to shove, the Fed might not end up being as hawkish as feared. Stated differently, they might “bottle it” if there is a major correction in risk assets. That appears to be the prevailing bias in the equity market. Ironically, some of the leading indicators of inflation pressure suggest that headline consumer prices might have already peaked (around the time that the Fed capitulated on their “transitory” thesis). That said, underlying inflation pressure is typically driven by a wage-price inflation spiral and shelter costs (as a large component of the basket). Both of those factors could still lead to higher-than-expected or persistent inflation pressure this year, even if the headline CPI starts to ease.
In conclusion, a large upside surprise, combined with a low unemployment rate and/or improved participation might reinforce the recent hawkish shift in the prevailing bias on rates and liquidity withdrawal. While our sense is that headline inflation pressure is likely to moderate from here, the current rate is so far above the Fed’s target that they probably have no choice but to normalise policy more rapidly than existing consensus beliefs.
For markets, while there has been a non-trivial (greater than 50% decline) in some long-duration growth equity, the price-to-sales ratio on the US Technology sector appears disturbingly similar to the first technology bubble. Of course, policy rates were 6.5% in June 2000 and the 1999 rate hike cycle did not prevent the last phase of the bubble, but the starting point and rate of change matters. Moreover, in the current episode, liquidity beneficiaries also have to deal with the reversal of QE or potential Quantitative Tightening. Their demise could resemble the fall of Hans Gruber from the Nakatomi Tower.