Jay Powell’s Identity Crisis

???????????????????“Fool me once, shame on--shame on you. Fool me—I won’t get fooled again”

??????????????????????????????????????????????????????--Jay Powell as George W. Bush

Keeping your sails up during a maelstrom to show conviction may not be an ideal move.

Key takeaways:

o??A problem facing the economy and markets is a Fed slow to react to inflation’s rise may be slow to react to easing supply chain pressures.

o??Powell stressed that the costs of easing too fast far outweigh the costs of raising rates. Fed Fund forecasts in the Summary of Economic Projections (SEP) are not really dots in a dot plot to him, but helium balloons that rise continuously every month.

o??Hong Kong markets were up 10% this week on easing lockdowns and stimulus hopes. Markets do not move up that much without a reasonable expectation of an inflection point.

o??US long/short net exposure remains at a 1st percentile low and volatility funds carry a 7th percentile exposure rank. That could add more demand to $10 billion in daily corporate buybacks.

o??Despite the potential demand and improved supply outlook, the failure of the S&P 500 to break above 3900 keeps the market vulnerable to a very sharp downdraft this month.

“At my signal unleash Hell” Dept : last week’s quotation was a little bit too on point, as Chairman Powell not only did his best Paul Volker impression, but the financial testosterone-filled press conference would have had a more fitting ending with Powell saying “I am Iron Man” a la Tony Stark. The Fed’s plan actually played out as Nick Timeros’ original Wall Street Journal article had outlined, meaning the FOMC will reduce the size of future rate hikes, but the terminal rate in 2023 will be higher. The reaction was ferocious on the downside for two reasons:

·????????The FOMC statement added a few seemingly dovish lines (quite a significant change when altering ?one single word can move markets) that gave the market hope for a pivot. After the statement but before the press conference, Ian Shepherdson of Pantheon Economics wrote that he was not ruling out a 25bp hike in December. Then, the FOMC Chair completely reversed the tone during the press conference.

·????????There was a concentration of one-day option contracts bought for the FOMC day, which left the dealer community exposed to sell into a down market.

This brings up an important point regarding market structure. With the introduction of one-day option contracts, there has been an explosion of interest, not just for retail, but institutional investors. 40% of Q3 2022 option volume is comprised of daily options, up 50% from Q1. I fear this is 2022’s version of 1987 portfolio insurance. This type of one-day gamma exposure can increase volatility in both directions, but the real problem lies in that it could drive a multiple day sharp drop. This is not a momentary fad as it appears to have gained institutional sponsorship.

The time may be right for a Fed intervention—not a Treasury intervention in the currency markets—but a questioning of the Chairman and the FOMC as a body. This is a group that clearly missed the opportunity to tighten earlier given their firm belief that inflation would blow over. Now, they are acting as though they have learned from their mistake of not being tough enough on inflation. Their real problem was succumbing to policy inertia—they maintained the wrong outlook for too long. Doubling down on their newfound resolve reveals they may be repeating the same mistake. They may need to do a deep self-analysis and reset before the markets reset things in a flash.

ISM Prices Paid dropped over 5 points to 46.6, the lowest since May 2020. I do not believe this is the time for the Chairman to mention that if they produced a Fed Funds forecast for November, it would have been higher than September’s. He added the markets should note the Fed’s rate forecasts have been rising all year and his expectation is that it will continue to do so in the future.

It is true that the SEP has been rising all year, with September’s median Funds rate forecast at 4.6% for 2023. The market reacted to Powell’s remarks, now pricing in an additional 50 bp of tightening at 5.0-5.25%. If we travel back eons to the September 2021 SEP, it listed the 2023 median projection at 30 basis points with forecasts ranging from 10-60 basis points. It was back then that an obstinate man revealed the Committee was not even “thinking about thinking about raising rates”.

We do not know the path inflation will take, and I have not forgotten last week’s chart showing persistent inflation trends when global CPI moves above 8%. However, there is anecdotal evidence of improving inflation conditions globally: for example, Brazilian CPI has fallen from 12% to 8% in 2022, reminiscent of early 2016 when it fell from 11% to 2.5% over 18 months.

The Fed’s gameplan is to push demand down to match low supply, despite data that supply has been rising. New car inventories have risen 65% y/y and inventory days at Chevrolet and Ford are back to 2019 ?levels. Used car prices are actually dropping daily and the compression of auto dealers’ margins is occurring. This is crucial, since auto margins have an outsized impact on the PPI trade services index, which over time will depress core CPI. ?

So yes, Fed interest rate forecasts have been rising constantly, because the year ago forecast was embarrassingly low. Does it make sense to forecast continually higher rates out in 2023 and not even mention the improvement in supply chains?

Secondly, China’s Covid lockdown policy has impacted supply chains, but the Hang Seng index rose 10% for its best week since 2015. For Hong Kong equities to have been bid up 10% from Sunday through Thursday night while the S&P 500 fell 5% is impossible to ignore. There were other encouraging signs with favorable news regarding trade ties between China and Germany that could reverse fears of anti-globalization. German Chancellor Scholz said that “Germany has no intention of decoupling from China”

The Chinese need to press for expansion and stimulus. South Korean October export data showed a 16% drop in exports to China, a fast deterioration from an already poor 6.5% September decline. In the face of such economic weakness, Xi is inclined to show immediate improvements following the Party Congress meeting. Most likely, the Hang Seng is reflecting that reality.

So where does that leave us??We have a Fed Chairman who:

1.??????Wants to follow in Paul Volker’s footsteps;

2.??????Holds a press conference as machismo as Tony Stark’s; and

3.??????Is adopting George W. Bush’s perspective that fine, he was fooled once, but that won’t happen this time.

By my count, he is dealing with three other personalities. Perhaps he should channel his inner Keynes: “when the facts change I change my mind” going forward…until that happens, investors must tread lightly in risk markets. Brittle is bad: he needs to heed the FOMC statement’s own words: “The Committee will take into account…the lags with which monetary policy affects economic activity”.

__________________

Regarding the markets: Inflexibility is particularly dangerous at this market juncture, because the potential for an absolute unwind exists. We could be setting up for a very sharp move down if we see a break below 3700 in the S&P cash Index (tested multiple times on Thursday and Friday) and then a post-election rebound that fails to move above 3900. I am very concerned due to all the one-day options that will be traded for the day after elections and more importantly, Thursday’s CPI release.

On the positive side, CPI could surprise to the upside, and there are four supporting factors:

·????????Favorable seasonality;

·????????Volatility Funds and Hedge Fund low net exposure;

·????????Corporate buyback demand;

·????????Positive Chinese news flow.

So this is going to be a week that has to be taken on a day-to-day basis, and trade a long term view against the 3900 SPX level—until we can move above, the chance for much lower prices exists.

Peter Corey

PavePro Team

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