It feels like a lot has changed since the December FOMC meeting. The headline being that since the end of the stock market’s December highs, the S&P 500 is off 10% and the Nasdaq is down around 15%. – i.e., since the Federal Reserve met last month. 10-year real yields have risen 50 basis points 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.
The question is, has a lot changed since the December FOMC? Three things to note:
In terms of rhetoric, the Fed has actually not moved that more incrementally hawkish since the December meeting.
The Fed “pivot,” or what I have called the “Jason Furman pivot,” is complete. Going to three hikes in the 2022 dots along with an accelerated taper finalized the Furman pivot. 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 isn’t to say inflation expectations are not a risk, but now the bet on the Fed to “outhawk” these 2022 dots is effectively a bet on inflation being out of control from Q2 on. Again, very possible, but not as a compelling in Fed implieds (what is being priced) terms relative to this new base case. The hawkish trade was great because the Fed had to narrow the gap between itself and Furman and then there was the question, “What if right tail inflation realizes?” Now the gap has been closed and the only “what if” left is right tail inflation. Which is of course still relevant but doesn’t carry the same asymmetry anymore. This is all to say the Fed is now on-sides if its inflation forecast gets hit. No guarantee that happens, but ex ante the Fed is in a very different place than it was in Q3 and Q4.
QT has been a huge shift.
Chair Jay Powell will likely spend a lot of time at the news conference talking about the balance sheet. The reason is, the Fed has shifted a lot on the balance sheet, even since the December meeting. One thing that has been peculiar, other than the fact that the U.S. central bank is still buying bonds at the same time it is talking about quantitative tightening, is that this was a brief moment of the December press conference but was the theme of the December meeting minutes. And that is really why thematically, QT has been so “scary.” The rate of change has mattered a lot more than the end game. In other words, the path to QT has been very disruptive. Think about where we have come from. At the November FOMC meeting the Fed outlined a benign tapering of QE. Two months later, we are not only talking about a faster taper, but actually unwinding the balance sheet. AND not only unwinding the balance sheet this year as opposed to well after the first hike (like last cycle), but at a faster speed than last time. In terms of rate of change, the market is right to take notice of that in terms of a policy posture. However, going into tomorrow’s meeting, it will be hard to see how Powell surprises the market on QT in either timing or speed.
The market took seriously non-SEP meeting hikes (faster than quarterly). The front-end math changed.
The market has now assumed that the inflation drop is 50-50 ex ante Q2 CPI data. And by inflation drop I mean chances that year-end core PCE, or personal consumption expenditures excluding volatile food and energy prices, is above or below 3%.
What seems like a month ago, but is really only a week ago, we had a 30bp move lower in EDZ2 since start of the year. And the market was pricing a bit more than four hikes.
If inflation being in line with the Fed Summary of Economic Projections is 50-50, this is the math.
Five hikes are less likely than three in a modal case. The bar for Fed to break quarterly is high, and likely higher than the bar for the bankers skipping a meeting to announce QT if inflation is on track to be in line 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. I.e., seven is more likely than one. And this is important. Let’s say the market decides that five is right -- and that is critical because it would suggest a pace faster than quarterly -- then the market has to take seriously the tail of seven hikes, i.e. every meeting. In the reciprocal, of three hikes, the market does not have to take seriously the tail of one because the Fed has a much stronger floor at three given the dots and the fact that we know it will hike in March.
The question now is, in light of this backdrop, will we get a hawkish reprieve?