Fight the Fed

Stocks sold off big again today. Slowly, we are inching ourselves toward a bear market here. And I think the mantra has to be ‘Fight the Fed’.

In this morning’s market piece, I explained why this could be the Fed’s last rate increase. And the gist was that the Fed’s forward guidance for next year already is down to two rate hikes for 2019. If financial conditions tighten enough, March will be off the table. And at that point, any material slowing would put the Fed off permanently. So, it pays for the market to sell off and fight the Fed to get it to climb down.

On the Fed’s causing inversion

In the meantime, I am focused on bonds, not stocks. we should consider the possibility that the Fed essentially hiked into a yield curve inversion. It’s not that the Fed would have continued to hike rates after the curve was already fully inverted. Instead, the Fed would have ’caused’ the inversion by over-tightening, with the market taking us into the actual inversion. We will find out early next year if this actually happens. And it would be the December rate hike that got us there. If the curve fully inverts next year, the Fed would have to look back at December as a policy error.

Yields appear to be stabilizing though. If you look at the price action from today, the curve had some bull steepening out of a deeply overbought condition. And that saw yields pop across the curve, particularly on ten-year paper. Where the day began with the 2-10 spread under 11 basis points, we are now closer to 14 basis points. In addition, the full inversion in the middle of the curve has gone away, with the 5-year yield rallying above the 3-year yield. That’s where we saw the biggest price movement in Treasuries. All of this is good – and to be expected given how overbought Treasuries had become, especially at the long end.

My read on equities

I am thinking about equity markets now as more of a realignment of portfolio risk weighting into the year-end, with investors realizing they had become to leveraged to high beta names and were underweight government bonds. Since government bonds sold off today, that re-weighting may be near played out.

This leaves the equity market price action as largely a case of a reduction both in forward-looking earnings and earnings multiples. Though we could get a bear market here, I don’t think it will last. Major bear markets are the result of not just a growth slowdown but of a severe recession. And not only do not expect a severe recession in the near-term, I don’t even expect a mild one. Instead I anticipate slowing in 2019. And that should put a floor under shares.

Mantra: Fight the Fed

The other way to look at this risk-off episode is as the market warming to a ‘Fight the Fed’ slogan. Up until recently, the Powell Fed has been more hawkish than the Yellen Fed was. Moreover, the forward guidance of the Fed in its dot plot shows short-term rates going beyond neutral. That’s hawkish. It definitely shows a Fed that risks over-tightening. And now that we have seen the Fed back away from its guidance, the market is pushing for more. If financial conditions deteriorate enough, the Fed will back down. Ergo, ‘Fight the Fed’.

Will this work though? I see Q4 shaping up well outside of new residential investment. In 2019, I expect capital investment in the energy sector to add to this drag on growth from capex. But I think Q4 consumption numbers should be good. And consumption growth in 2019 should remain relatively buoyant as well. When the Fed sees these data, it will difficult for it to entirely back away from its guidance.

Most likely, we will simply see a pause. And if the GDP growth data remain decently robust – in the 2.5%+ range – then we should expect the Fed to eventually pull the trigger on the first hike by June. So, rather than the market fighting the Fed and beating it into submission, we would see the data leading the Fed and the market.

We are at a very iffy point in the business cycle. Markets have begun to revolt due to the rate hike regime now in place. And the Fed has been forced to dial back its pace as a result. But the Fed’s guidance is still, at core, hawkish. So, the danger of over-tightening remains alive. Given that mix, it’s not clear how the market will react as the data come in. I tend to lean toward the “good data equals bad news” thinking, at least over the near-term, because – at a minimum – it keeps the Fed in tightening mode.

Watch the dollar, because that will be the release valve for the real economy.