Dual Sided Risk For Fed's Next Move Is Necessary

I have been saying for several weeks now that I believe risk assets will stop rising when the odds of the Fed’s next move comes more into balance between cutting and hiking. There simply needs to be two sided risk in the rates market to put a damper on volatility selling strategies non-stop behavior which then allows for animal spirits to remain engaged, inflation expectations to become unanchored and for actual inflation to not return to 2%. The Fed allowing financial conditions to continue loosening is self-defeating.

The Fed continues to show the asymmetrical nature of its bias, as they repeatedly tell the market that they will be very slow to raise rates further to deal with sticky core and potentially re-accelerating inflation however will be quick to cut rates should the labor market deteriorate.

They continue to say the bar to raise rates further is much higher than the bar to cut, even after we continue to get higher than expected inflation readings including the CPI last week. The reactions from Fed speak so far has been that even though inflation data has come in worse than expected to start the year, and that they probably don’t need to be cutting rates any time soon, they are still broadly not thinking about hiking rates. Powell at the May press conference tried to shut the door on the rate hikes as being necessary. I believe this is a mistake.

Despite all the uncertainty the Fed has about why growth, labor and inflation have been stronger than expected in this “tightening” cycle than in previous cycles, they remain convinced that the easing cycle is still likely to commence this year. It is just a question of when. But don’t worry, they say they are humble and have humility. I say it’s institutional arrogance and political bias.

The pathway to a risk asset top is through “stagflationary” data which pushes the odds of the Fed’s next move being a hike or cut into better balance. Strong wage, core inflation and inflation expectation momentum is the pathway toward a more humbled Fed (I know, don’t laugh) that will need to remove the cuts, introduce hiking potential and truly work on tightening financial conditions again in order to bring inflation back down to 2% in their time horizon.

Important Fed speak during this week can help push us in that direction while the odds that they do are virtually zero. Waller speaks today and is often someone that can push market pricing in a specific direction should he want to. Then on Wednesday we get the Fed minutes which are likely to be more hawkish than Powell’s press conference as they will discuss the fact that rate hikes were probably discussed at the May meeting. The Fed can start to set up the market to expect that the June SEP will show significantly less cutting in the forecast horizon. I anticipate that the median dot for 2024 will move down to 1 cut and several members will be at no cuts for 2024. I also suspect we could see cuts come out of 2025 and a tick higher in the neutral rate. All of this would help dampen animal spirits.

I continue to run the long Gold/BTC vs. short IWM playbook while I wait for the Fed to decide whether or not they are going to get more serious about bringing inflation back down to target or not. 

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