Lest Bubbles They Stoke

There is a fine fellow named Jay
Who not too much later today
Will take to the stage
And help us to gauge
How quickly Fed funds will decay

This week several Fed members spoke
And all of them sought to invoke
That growth is still fine
Thus they’ve drawn the line
On more cuts, lest bubbles they stoke

It is quite remarkable that despite ongoing unrest in Hong Kong, with the temperature there rising each week, as well as the countdown to Brexit getting shorter and shorter, the only thing that matters right now is Jay Powell’s speech this morning from Jackson Hole. It is the defining theme of today’s market activity.

Let me set the stage to begin: interest rate markets are pricing in a rate cut in September, another in October and then a chance of one in December with “certainty” of that third cut by March 2020. Given that GDP growth in the US is running at 2.1% annually, Retail Sales have consistently beaten expectations and are up more than 4% in the past year and the Unemployment Rate, at 3.7%, is a tick away from its post-WWII lows, three cuts seem like a lot of monetary stimulus. After all, despite the fact that the Fed watches the PCE Deflator as their inflation gauge of choice, we all know that inflation is running higher than its current reading of 1.4%. The government’s own evidence is from CPI readings which most recently showed prices rising at a 1.8% level, with the core reading there at 2.1%. And ask yourself if even that conveys the feel of inflation. My guess is: Not. Even. Close.

At any rate, that’s what the market is pricing. As NY walks in this morning, equity markets around the world have shown modest gains (US futures included), bonds are falling with 10-year Treasury yields back up to 1.64% and the dollar is stronger almost across the board. Arguably, expectations are for Powell to confirm that July was not a ‘one and done’ rate cut but rather the beginning of several insurance cuts. The fly in that ointment comes from the comments we heard yesterday from a series of regional Fed Presidents, all of whom said that they saw little reason to cut rates further at this time. Effectively their argument was that growth is solid, unemployment low and inflation pretty close to target. While all paid heed to the fact that the Fed funds rate was above the 10-year yield, they were unwilling to buy into the idea that the curve inversion was presaging a recession at this time. There is just not enough evidence to them.

With the Fed’s hawks in full flight, it will certainly be tricky for Powell to describe anything about the FOMC as coordinated. Remember, the Minutes showed us members who didn’t want to cut at all as well as members wanting to cut by 50bps. That’s a pretty wide dispersion of thought. All told, he has a pretty tough job today if he doesn’t want to spook the markets.

As I have no idea what he will say, let’s game out two different views; first he manages to surprise dovishly and second, more likely in my opinion, he disappoints and sounds more hawkish than the market (and President) wants.

Dovish Surprise – If he confirms the markets current pricing and, for example, doubles down saying QE is an effective tool and they will use it again, look for a sharp equity rally to begin with, as well as a bond rally and dollar weakness. Certainly that would be the initial price action. However, it is not clear how long that would last. After all, if the current claim is growth is solid, what is the reason for all the ‘insurance’? At some point, market participants will ask that very question, as well as, what does the Fed know that we don’t? The result would be a reversal of equity gains, although bonds would likely still rally. And the dollar? I think a rebound would be in order as well as strength in the yen and Swiss franc. However, even if he does manage to sound dovish, I don’t see the dollar falling more than 2%-3% before finding a floor. At this point, I cannot paint a scenario where the dollar enters a longer term downtrend. Overall, my unscientific odds on this outcome are less than 25%.

Hawkish Disappointment – This seems far more likely to be the outcome, if only because to my eyes, the market has really gotten ahead of itself with regard to rate cuts. Essentially, if Powell doesn’t confirm that July’s cut was the beginning of a new rate-cutting cycle, the market is going to be disappointed. If he pushes back at all, sounding more like Esther George or Eric Rosengren, the two dissenters, than James Bullard or Neel Kashkari, the 50bp advocates, the market will be REALLY disappointed.

In the first case, I expect we will see equity markets fall a percent or a bit more today, with Europe giving up its early gains and the US quite weak. Bonds are a tougher call here, although I expect that the initial price action would be for further weakness. Remember, despite the fact that yields are 15bps from the low point seen two weeks ago, they are still down 37bps this month. There is plenty of room to fall. As to the dollar, that will rally further against everything, the yen included. I would expect the euro to finally test, and break, 1.10, and we could easily see 1% weakness and more throughout the emerging markets.

If he pushes back, well today may be remembered in market history as PB (Powell’s black) Friday. Equity markets would see significant losses as all the bets on further easy policy would be shed immediately. Bonds, too, would fall sharply as the idea that the Fed would no longer need to cut rates would change the entire sentiment there. And finally, the dollar would explode higher. Any ideas that the Fed has further room to cut rates than virtually all its counterparties, a key dollar bearish thesis, would be swept away and the dollar would really appreciate sharply. Think about EUR at 1.08; GBP at 1.20 (and that’s without the Brexit story); and the yen back to 108.00. However, given the risk of this type of market disruption, I do not believe this is at all likely either. In the end, a mild disappointment seems the most likely outcome, so look for stocks to close the week on a low note and the dollar on a high note.

Before he speaks at 10:00 this morning, we do see New Home Sales (exp 647K), but quite frankly, nobody cares about that today. It is all Powell, all the time.

Good luck and good weekend