The Fed isn't the world's central bank anymore
A Halcyon Half-Hour
Jerome Powell gave stock and bond bulls approximately 30 minutes to party on Wednesday, stoked by dovish-sounding phrases in the policy statement such as "cumulative tightening" and "lags" and how both those things will be taken into account as policymakers chart the future course of interest rates.
Then, Powell took the stage and unleashed this painful reality check:
With that, the market's collective attention turned to the terminal rate, dragging the S&P 500 to its worst Fed-day performance since January 2021. The thinking goes that a higher ceiling for the Federal Reserve's tightening campaign is going to crush any animal spirits that might be stoked should the central bank dial back the pace of rate hikes.
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"We're going to focus on, where is the destination?" said Jim Bianco, president of Bianco Research LLC. "The risk markets desperately, desperately want them to stop and what they basically said is they're not going to stop."
Clipping Coupons
There's maybe a silver lining here. As discussed ad nauseam by this newsletter, cash is super hot right now: it yields a lot and there's virtually zero credit or duration risk. If the Fed lifts rates to a higher endpoint and then hangs out for a while, that should boost cash's appeal even further.
Citigroup strategists see the logic.
"Rolling recessions are likely coming and cash is becoming an increasingly attractive place to wait for opportunity," quantitative strategists Alex Saunders, Dirk Willer and Hannah Sheetz wrote in a Tuesday note. "Cash looks like it is an alternative to investments in risky assets, with yields rising after every central bank meeting."
Still, money has been draining from ultra-short duration exchange-traded funds as of late. While cash-like funds are still on track for a record annual haul, nearly $2.5 billion exited from the $21 billion iShares Short Treasury Bond ETF (ticker SHV) on Tuesday alone — the biggest one-day exodus since the fund launched in 2007.
That follows a wave of withdrawals from other ultra-short ETFs in recent days, perhaps another byproduct of the latest run at the pivot trade — a pipe-dream that sent the S&P 500 more than 8% higher in the weeks leading up to Wednesday's Fed-induced hosing.
The other interpretation is that investors are ditching cash to venture back into longer-duration debt, fueled by the idea the Fed will hike the US into a recession.
The fun thing about tracking cash is that it could go either way.
"Some of those people might be saying, 'We're about to go into a recession, let's go long Treasuries,'" said Tim Murray, capital markets strategist with T. Rowe Price's multi-asset division. "There might be others that say, 'The market's bottomed, the Fed's about to pivot, let's get into equities.'"
Let Me Be Clear
One exchange in particular during the Fed chief's Q&A caught my attention.
Howard Schneider with Reuters, referred to Powell's comment that policy makers would likely discuss downshifting hikes at the next meeting:
If I could follow up on that, to what degree was there an importance or weight given to a need to signal this possibility now, given all the concerns, really around the globe, about Fed policy sort of driving ahead and everybody else, you know, dealing with their own stress as a result?
Powell's answer:
Well, I think — I'm pleased that we have moved as fast as we have. I don't think we've overtightened. I think it's very difficult to make a case that our current level is too tight given that inflation still runs well above the federal-funds rate.
Avid listeners of BMO Capital Markets' Macro Horizons podcast will know Ian Lyngen has made the point many times that the Fed has been stepping away from its role as the world's de facto central bank. By not even paying lip service to the pain other economies may be dealing with at the hands of a historically aggressive Fed, Powell pretty much confirmed that idea.
In fact, that answer concluded with one of Powell's more hawkish lines of the presser: "We still think there's a need for ongoing rate increases, and we have some ground left to cover here — and cover it, we will."
The second reason I found this exchange interesting was because I went ahead and mapped inflation against the effective federal funds rate. It's a crude chart: I used year-over-year CPI, not PCE, and as Bespoke Investment Group's George Pearkes pointed out to me, comparing instantaneous rates with backward-looking inflation doesn't necessarily hold much such.
But Powell said it, so I charted it. The spread between the two measures hit the highest since at least 1970 in March, and is still above any level seen prior to 2022.
There's two ways this gap will narrow: either CPI will ease or the Fed will have to keep hiking. Of course, it's going to be a combination of those two — we just don't yet know which will be the more dominant force. We'll get another clue with next week's US inflation print.
Tweeting Through It
Sadly, Elon Musk's completed purchase of Twitter means the company has left the public equity markets. Luckily for our purposes, there's still plenty of bond-market drama to keep this newsletter busy.
Case-in-point: keeping tabs on the banks left with the perhaps-herculean task of offloading about $13 billion worth of Twitter's buyout debt to tech-weary investors.
As Bloomberg News laid out this week, there's two big hurdles here.
The first is saturation: money managers who would package the loans into collateralized loan obligations have already dedicated roughly 11% of their holdings to software company debt, S&P Global Ratings data show. That's the biggest weighting, with healthcare providers and services a distant second at 6.6%.
"With stretched valuations and higher interest rates, we are seeing some stress in the tech sector," said Scott Snell, portfolio manager at Tetragon Credit Partners. "Some of these companies are very levered, which could lead to negative rating actions and ultimately lower loan prices."
The second deterrent is that tech is the biggest portion of CLOs' B- rated debt, according to S&P data. Portfolio managers might theoretically be reluctant to add more given that B- rated debt is one tier above CCC — the riskiest rung. Many portfolios face guidelines limiting them from owning too much CCC rated debt.
That's another unfortunate wrinkle for the Morgan Stanley-led contingent, given that S&P downgraded Twitter to B- just this week.
