For traders it has become something of a game to forecast how quickly Mr. Market can make the newly “data-dependent” Fed change its tone. In the fourth quarter as the Fed Chair became somewhat hawkish, the market sold off and discovered that the pain point and the strike of the Fed “Put” was right at 20% drawdown from the peak. On cue, the Fed took two tightenings for 2019 off the table and actually started to talk easing. Trial balloons were floated that effectively convinced the market before the February presser that financial conditions were going to now be easy and that the market could party back on, which it did. As soon as the market made new highs, the new game was betting how long it would take the Fed to start talking hawkish again. It took but a matter of weeks before the “re-pivot” happened, and the Fed Chair replaced the easing bias with “transitory” in their outlook for why inflation was so low. This sounded to the market like the return of a hawkish tone.
Since the last press conference, trade war fears have resurfaced, and the equity markets have begun their fall from record highs. The new game now is betting on how long it will take for the Fed to start talking about economic weakness, trade war spillovers etc. to justify easing policy. We believe this talk is right around the corner, and could be accompanied with a 10% to 20% correction from the peak of the S&P 500, if we get there. Put that somewhere around 2500 to 2600 on the S&P 500.
None of this should be surprising. The Fed’s new mantra – “data dependence” means they will be more tactical in their approach. Since the market is probably THE key variable in determining consumer behavior and economic outcomes in the short run, the Fed is hitching its wagon to the market. If one believes that in this cycle easy monetary policy has resulted in inflation in asset prices rather than in the consumption basket, then it is not hard to see that any deflation in asset prices can result in a rapid deterioration of the economy via a loss of confidence. In other words, the only game in town for the Fed is to keep asset prices high, since it is now well established by the Japanese and European experiences that the transmission mechanism from monetary policy to the real economy is broken. The ECB keeps doing more of what is not working, and negative rates have simply resulted in money flowing into yieldy dollar assets or being hoarded by banks. In Japan easy policy and repeated quantitative easing has done nothing more than to create a bloated balance sheet with a circular flow of money between government entities, and of course also some leakage into the US asset market. No developed Central Bank is close to hitting its inflation targets, because the market is wise and knows that current, high debt, leverage-enhancing policy is deflationary in the long run.
The equity markets have three salient characteristics that any data dependent authority should pay attention to. First, it is a market of confidence, i.e. if confidence is shattered it is very hard to get it back. If the market loses confidence that the Fed will have its back, watch out below! Second, the equity market is a discounting mechanism for future investment dreams, and these dreams can turn into nightmares in a flash. This requires the Central Banks to commit to “no-pivot from easy policy” for the “foreseeable future”, i.e. walk itself away from data dependence to a more strategic approach. And finally, the market will always take the shortest path to the point of maximal pain for the largest number of participants, and this includes a tactical, data-dependent Fed. In the game of tactical trading, market participants have way more experience than the Fed, and it will be tested.
For now, watch for the market to push the point of pain and for the Fed and other Central Banks to start walking back the neutral policy stance to an accommodating one. Given the long age of this bull market, tight spreads and increased geopolitical risk, this is probably the only way to keep the game on. Focusing on short-term Treasuries and taking advantage of low implied volatility may be a prudent ways to preserve capital until the market is done testing the Central Banks.