Contradictions & Catch-22s

A sleepy month of August this is not. On the week, the raging rally in major market equity indexes continued. The flagship S&P 500 gained an impressive 3.26%, commodities joined the party, and precious metals participated in the positive price action as well. 

Elsewhere in markets, the dollar sagged and bonds were little changed. Meanwhile, the 2s10s yield curve inversion reached its most negative reading since 1981, and continues to scream warnings of pending trouble to anyone who will listen. 

Last week, HAI suggested that we had reached “the end of the beginning” of the aggressive bear market rally that’s unfolded in equity markets since late June. The ongoing equity rally is getting overextended technically, and is on extremely thin ice fundamentally. After another spirited jump higher in major indexes this week, the equity rally runaway-train is now likely speeding towards its next stop—the beginning of the end.

For major market indexes, there’s an awful lot of relief in this “relief rally,” and such rallies are so named for a reason. Extreme bearish sentiment, extreme bearish positioning, deeply oversold technicals, and negative news flow saturation provided the kindling for this rally. The spark that lit the fire came in late June. With credit and equity markets teetering on the verge of a self-perpetuating de-risking/deleveraging liquidity crisis, the imminent Fed policy pivot narrative grabbed the reins of equity market prices. Risk equities bounced off the ropes and headed higher. Short covering dynamics triggered a violent squeeze, and more and more cohorts of the investment community from retail to hedge funds chased prices higher for fear of being left behind. 

Comments interpreted as dovish from Fed chair Powell at July’s FOMC added credibility to the narrative that the pivot fix was in, and stoked the rally further. Meanwhile, though Q2 earnings season in July was not good, it was better than feared. Next up, July’s non-farm payroll establishment survey dramatically outperformed expectations, suggesting the economy might be stronger than feared. This week, both the Consumer Price Index (CPI) and Producer Price Index (PPI) inflation gauges came in softer than expected, adding further fuel to the equity rally fire.

In the first positive sign on consumer prices since the Fed began raising interest rates, the Bureau of Labor Statistics reported that year over year (Y/Y) CPI for July registered 8.5%, down from 9.1% in June and less than the 8.7% expected. Month over month (M/M) consumer price inflation was unchanged at 0.0% vs. the expected 0.2% increase. The easing in the CPI was primarily due to a 4.6% decline in energy costs. Shelter and food costs continued to rise, however. Core CPI (ex food and energy) advanced 5.9% Y/Y and 0.3% M/M, but both were less than expected. 

A day later, PPI producer prices registered a 0.5% decline in July, also primarily due to a decrease in energy prices. This is the first time wholesale prices have declined in two years. Annually, PPI rose 9.8%, marking the lowest Y/Y increase since October of last year. Core PPI advanced 0.2% in July and 5.8% Y/Y. Energy costs for producers fell 9% and comprised 80% of the total decline of goods prices. The reports were good news on the inflation front that’s been a long time in coming. All in all, significant relief indeed from the darkest days of late June.

Reacting to the report on a Bloomberg interview Friday, former Treasury Secretary Larry Summers said the report was better than most people expected. He noted, however, that the improvement was heavily driven by volatile sectors and that “we’ve sort of seen this movie before. We had a terrific core number in March, but it was from those volatile core sectors and then it bounced back up in April, May, and June.” While acknowledging the report was better than it could have been, Summers added that “it’s nothing like we’re out of the woods, it’s nothing like a fundamental change in the orientation, it’s nothing that means that we can pivot away from the overwhelming paradigm being a need for restrictive policy to contain inflation.” He went on to caution, “If the Fed regards this as a major game changer, they will be making another major mistake… They certainly shouldn’t make that kind of mistake.”

While it remains to be seen whether the Fed will make the sort of mistake Mr. Summers cautioned against, the financial market reaction to the data and the entire sequence of events after the June lows is troubling. Financial markets are now pricing in a soft economic landing outcome, minimal further interest rate hikes, sufficient growth to keep earnings supported into 2023, and dissipating inflation. In other words, the “relief” in the rally is now priced in and premised on an extremely rosy set of assumptions.

Essentially, for now, markets are embracing the idea that the U.S. economy can pull off some form of soft landing where inflation is convincingly headed down towards the 2% target with economic growth still intact. At that point, the Fed would be able to pivot its focus from tight inflation fighting policy back to full employment and growth-supportive policy easing. In a global backdrop where serious recession risks and potential crisis dynamics appear virtually everywhere, optimism over relative U.S. strength and better odds of a soft-landing also present U.S. equities as the cleanest dirty shirt in the laundry basket. So, the idea goes, equities rally on soft-landing and pivot hopes, and U.S. markets benefit with a disproportionate boost from relatively outsized global inflows. Onward and upward! 

It is possible that this rally could still shock to the upside. Even if a hard-to-fathom run to new all-time highs in U.S. equities unfolded, it would almost certainly be a short-lived trap. Nevertheless, such a development has slim potential, and the scenario would gain traction only if the S&P 500 regained the falling 50-week moving average (now around 4,350) and turned it back higher. More likely, the rally meets its end at the 50-week moving average.

The whole rally premise sounds good, but the logic may be quite flawed. The thesis carries an embedded Catch-22 that may already be starting to play out. Generally speaking, loose financial conditions accompany risk-on activities in the financial markets and economy, and are stimulative of economic demand (growth). Conversely, tight financial conditions accompany risk-off in the financial markets and economy, and are demand destructive (contractive). The 225 basis points of Fed rate hikes since March are intended to tighten financial conditions and curb economic demand in order to fight consumer price inflation. The Fed rate hikes are assisting an economic slowdown already in progress. The slowing economy, with additional growth headwinds from Fed policy tightening, has been responsible for increased recession fears. Those fears caused recessionary demand destruction to be priced into commodity markets earlier in the summer. 

As the CPI and PPI data show, the drop in commodity prices, energy prices, and specifically gas prices, is the primary driver for the easing in this week’s inflation data. That said, however, the soft-landing/Fed pivot rally of the last month has caused market-based financial conditions to loosen dramatically. According to the Bloomberg Financial Conditions Index, market-based financial conditions have loosened to the point where markets have essentially undone the impact of 150 basis points worth of the recent Fed rate hikes. Accordingly, credit spreads have backed off, credit markets have snapped back to life, and receding fears of a U.S. recession have started to push commodity prices back higher again as more demand is priced back into an already tight supply dynamic. 

This is dangerous. Despite a positive first step in CPI and PPI data, if the current market reaction persists and market-based financial conditions remain loose, commodity prices will likely rebound along with other inflationary inputs. We have a potential Catch-22 here. Risk-on and loose financial conditions are taking hold because markets now think that Fed policy will reduce inflation enough to declare victory and pivot back to economically stimulative policy. The market’s risk-on loosening of financial conditions, however, likely won’t let the economy slow enough to actually lower inflation. The market’s thesis for this risk-on rally contradicts and negates its own premise. The result will only force the Fed to keep raising interest rates higher for longer. With the full negative economic impact of Fed rate hikes running at a minimum six-month lag, higher rates for longer increases the risk of an even bigger problem for the economy and markets in the future.

This week, Goldman Sachs echoed the Catch-22 observation and warned clients that, “Macro markets are pricing an unsustainable contradiction — it is difficult to square a softening [financial conditions index], a more accommodative Fed pivot, falling inflation expectations, and drawing commodity inventories.” The bank stressed that, “Investors counting on a softer global economy to pull commodity prices lower may instead be faced with scarce supplies and inflation, as the market is awash in contradictions.” 

Goldman’s head of commodities research Jeff Currie nailed the developing plot narrative on Thursday. He suggested that the lower commodity prices since June, positively impacting CPI and PPI, were the result of selling pressure due to anticipation that an economic downturn would destroy demand, resulting in extra supply, and thereby further reduce future commodity prices. With the market now loosening financial conditions, anticipating a soft-landing and a policy pivot, he cautioned that, “if excess supply does not materialize as we expect, the restocking scramble would exacerbate scarcity, pushing prices substantially higher this autumn, potentially forcing central banks to generate a more protracted contraction to balance commodity markets.” 

That’s our market moment in a nutshell. Markets misbehaving, loosening financial conditions in an attempt to front-run a misguided, Catch-22, soft-landing-then-pivot narrative that defeats itself. The consequence: more inflation, more Fed, more trouble to come.

Fed speakers this week seemed to grasp the need for markets to get in line and heed Fed guidance. Minneapolis Fed head Neel Kashkari on Wednesday said that he continues to believe that the U.S. central bank will need to raise its policy rate to 3.9% by year-end and to 4.4% by the end of 2023 to fight inflation. Kashkari’s rate targets are more hawkish than financial market expectations, which are pricing a top fed funds rate of 3.75% to be reached mid-2023, with rate cuts to follow. Kashkari said that the Fed is “far, far away from declaring victory” and needs to raise rates much higher than its current 2.25%-2.5% range. He also said, crucially, that markets are “not realistic” in expecting rate cuts early next year, and that the Fed won’t cut rates “until we get convinced that inflation is well on its way” to the Fed’s 2% target.

Chicago Fed President Charles Evans, who also has a preferred terminal rate hike target above market expectations, said this week, “I feel like we’re in a good place and we can pivot to be more restrictive if inflation gets out of hand more than what I’m thinking about, but also, if things get better more quickly, we can not raise rates quite as much.” Again, consequentially, the current market reaction to events leaves the Fed little choice but to be on that “more restrictive” side of the policy pendulum until the market adjusts or the accruing negative impact of tight Fed policy finally bites far more materially.

Interestingly, Treasury and futures markets appear to be picking up on the Catch-22 contradictions inherent within the market’s rally premise and the consequential implications. Futures markets indicate that the recent rally and easing of financial conditions has alleviated concerns for an imminent recession or crisis event happening immediately, but at the same time, futures markets have increased expectations for both the overall risk and magnitude of a pending market “event.” Futures markets have merely pushed out the timetable of trouble by a few months. The signal in the futures markets that tells the tale is “when” Fed-pivot rate cuts are priced into futures curves and at what scale are the cuts. The smaller the cuts, the smaller the implied recession or “event.’ 

On the other hand, if the Fed rate cuts that the market prices into futures curves are sudden, large scale, impulse cuts, the implication is of a larger crisis-level “event” motivating an emergency policy response. As for the timing of “event” response rate cut signatures in futures curves, they have moved from early 2023 deeper into the year. As far as the magnitude, let’s turn to Nomura’s highly respected cross-asset strategist Charlie McElligott to describe the shift in futures markets expectation for the scale of pending trouble. This week he said, “what the market is telling you is to expect a much bigger impulse easing on the way out of this thing.” In other words, the picture being painted is no soft-landing. It’s a hard landing getting harder.

Weekly performance: The S&P 500 gained 3.26%. Gold was up 1.36%, silver was up 4.33%, platinum was higher by 3.75%, and palladium gained 4.26%. The HUI gold miners index was higher by 4.63%. The IFRA iShares US Infrastructure ETF was up 5.16%. Energy commodities were up. WTI crude oil bounced by 3.46%, while natural gas gained 8.73%. The CRB Commodity Index was up 4.43%, while copper added back 3.32% of recent losses. The Dow Jones US Specialty Real Estate Investment Trust Index was up 3.29% on the week, while the Vanguard Utilities ETF (VPU) was up 3.59%. The dollar slid by 0.92% to close the week at 105.51. The yield on the 10-yr Treasury gained 1 bp to end the week at 2.84%

Best Regards,

Morgan Lewis
Equity Analyst & Investment Strategist
MWM LLC