What Financial Markets Are Telling Us: Pain Now Due To Harsh Words From The Fed, But Pleasure Later As The Fed Restrains Itself

Interest rates led equities lower yesterday but I regard this painful moment as part of the bottoming process. The volatility risk premium points to a higher market over the next few days, but my technical reading of key stocks in the S&P 500 is neutral. Yesterday's cross-asset action brought one positive factor for US stocks. Inflation expectations are stabilizing based on measures of Treasuries and TIPS. But there were also several negative factors across global asset classes. Oil is pointing to stagflationary conditions. The action in currencies signifies $US strength. The US yield curve is rising and in the current context that is bearish. Expect the S&P 500 to be range-bound over the next few days.

The spike in short-term yields as Powell was speaking and the relatively modest move up in long-term yields caused the yield curve to flatten significantly and points to investor concerns the Fed could be making a mistake in being so hawkish. This mistake would largely stem from political pressures rather than data-dependency, as the GOP has an incentive to berate the Fed into raising rates while Biden is helpless to stop this given his acknowledgement of inflation pain. I believe Powell maintained credibility with the hawks while securing a future argument against hawkishness by catalyzing such a disruptive move in financial markets. With inflation expectations subdued (per the 5-year 5-year forward and 10-year breakeven rates) it’s unlikely the Fed makes a mistake, particularly after Trump’s attempt to interfere with Fed independence during this tenure. Thus we’re likely to see short rates top out soon and long rates catch up, resulting in nothing more than zero real interest rates based on inflation expectations. This is a positive backdrop for equities.

My current market positions include a moderate cash position, Amgen (AMGN), American Express (AXP), Goldman Sachs (GS), Johnson & Johnson (JNJ), 3M (MMM), Pfizer (PFE), Starbucks (SBUX), Titan Machinery (TITN) and the levered ETF UPRO.