The Fed Preview: 'Wait-And-See' Is Like Playing With Fire

The data-dependent hold

The Fed's recent interest rate hiking campaign is now finished, at least based on the consensus market expectations embedded in the Federal Funds futures.

The Fed is widely expected to hold the Federal Funds rate at the 5.25-5.50% target range when they meet next week (November 1st) - with a 99% probability. There is around 75% probability that the Fed holds when they meet in December, and around 70% probability they continue holding when they meet in January.

The Fed also held interest rates at the September meeting, and indicated in the post-meeting statement that it was a data-dependent hold:

The Committee will continue to assess additional information and its implications for monetary policy. In determining the extent of additional policy firming that may be appropriate to return inflation to 2 percent over time, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.

However, the Fed's dotplot in September's Summary of Economic Projections suggested that the majority of FOMC members expected one additional hike in 2023.

It's really a wait-and-see approach

The only problem with the "data-dependent" approach is that the data does not support the hold. The Fed is apparently going to end the interest rate hiking campaign with:

• The GDP growth rate for Q3 QoQ at 4.9% (advance measure).
• The unemployment rate at 3.8% - that's full employment.
• The weekly initial jobless claims at around 200K, which also suggests an extremely tight labor market.
• Widespread labor strikes, which is inflationary.
• The core CPI inflation rate at 4.1%, which is double the Fed's 2% inflation target.
• More importantly, the recent monthly core CPI readings at around 0.3%, which needs to be between 0.1% and 0.2% to get to the annual 2% target.
• Crude oil trading in the mid-80s, facing the most serious geopolitical situation since the 1970s.
• Trade war with China, with trade barriers and onshoring.
• Home prices and stock prices still not too far from the all-time highs, supporting a strong wealth effect.

The data does not support the hold. Even the Taylor Rule Utility by Atlanta Fed suggests that the Federal Funds rate should be somewhere between 5.75% and 6.25%. The current environment is inflationary, and requires a tighter policy rate.

So, this is not a data-dependent approach, this is really a "wait-and-see" approach or even better a "wait-and-hope" approach.

The Fed has inverted the yield curve to bring inflation down to 2%. Historically the inverted yield curve is known to cause a recession, which ensures that inflation returns to the 2% target.

However, there are lags at which the inverted yield curve affects the economy, and generally, it takes around 12 months from the initial inversion until a recession. The 10Y-3m yield curve has been inverted since October 2022 - exactly 12 months.

Thus, the Fed is aware that a recession should be coming soon, and it's willing to wait for it. The data says the economy is running too hot and the policy rate should be even tighter. But the Fed is ignoring the data - waiting for the lagged effects.

Dangers of "wait-and-see"

The Fed has two options:

1. Continue increasing the Federal Funds rate until the stock market collapses, which would cause a negative wealth effect and accelerate the economic downturn and thus accelerate the disinflationary process.
2. Leave the policy rate slightly under the required level for a longer time to give the economy time to adjust and gradually bring inflation to the 2% target.

The Fed has chosen Option 2 - they defined it as the "higher-for-longer" approach, which is really a "wait-and-see" or a "wait-and-hope" approach. The Fed is unwilling to disturb the financial markets.

In fact, the recent inflation shock is due to the fact that the Fed was way too slow to react to the post-pandemic inflation, not to disturb the markets. I don't believe that the Fed really saw inflation as transitory - this was also a "wait-and-hope" approach.

So, what is the danger of "wait-and-see"?

The market could start questioning the Fed's commitment to the 2% inflation rates, which could result in a spike in long-term interest rates (TLT) as the breakeven inflation expectations de-anchor.

Note, the FOMC members and the Fed Chair Powell have all strongly indicated that the Fed is committed to the 2% target - they understand the danger. But many economists simply don't believe that it would be possible to reach the 2% target without a deep recession - caused by Option 1 from above.

The 10Y yield can be decomposed as the sum of 1) real rate, and 2) breakeven inflation expectations. The recent rise in 10Y yields has been caused by the rise in real rates (blue line), while the inflation expectations (red line) stayed in a narrow range of 2.2-2.5%.

So, what to look for at the next Fed meeting?

It's all about the red line - the inflation expectations. If inflation expectations start rising above 2.5%, towards the 3% level, that would suggest that the market is questioning the Fed's 2% inflation target, which could push the 10Y yields towards 5.5% and probably much higher.

Obviously, this would also be a shock to the economy and the markets, as it would require the Fed to resume the hiking campaign to catch up with the rising long-term yields, and to re-anchor inflation expectations.

Some are calling to formally increase the inflation target to 3%. This would have a similar effect - the inflation expectations would de-anchor. If you allow 3% inflation, why not 4% inflation, and so on.

In other words, the Fed is playing with fire. They have been ultra-dovish, and possibly scared to act, falling for the "soft-landing" objective, which they know is elusive.

Implications

The S&P 500 (SP500) is now sitting right at the key long-term support - the red line. This was the initial resistance that was broken on June 1st, and caused the summer rally, which many called a new "bull market". I argued all along that this was a 'fake breakout", and here we are, back at the red line.

What happens next?

The S&P 500 is waiting for the Fed at the key level. Two things could happen.

1. The major breakdown towards the next support (black line) as the Fed pause causes the increase in 10Y yields above 5%, due to the increase in inflation expectations above 2.5%.
2. The bounce from the red line and the year-end rally. Why? The Fed paused, the economy is fine, and especially if the data starts coming a little softer in Q4, which would start looking like a soft landing. This of course assumes that 10Y yields stay below 5%.

The first scenario seems more likely. However, given the geopolitical situation, and some flight to safety to Treasuries, it is actually possible that 10Y yields don't overreact to the upside, despite the Fed hold, especially if the government shutdown on November 17th is avoided. Thus, the Fed-pause fueled year-end rally is possible.

So, at this point, as a tactical trade, I am neutral, waiting to see the reaction - with a short bias. I'm also going in the wait-and-see mode.

Beyond the short term, I am bearish on the stock market (SPY) - the recession is coming. Strategically, TBills at 5.5% yields is the place to be for now.