The Fed's Trichet Moment?

Yesterday may have been the Fed’s Trichet Moment. Signaling a higher for longer outlook as the economy has begun to roll over means we are assured of a harder landing. Enter the narrative “The Fed is Behind The Curve.” Bad setup for small cap equities.

The Trichet Moment refers to the ECB, on the eve of the financial crisis, raising interest rates in July of 2008 in order to help slay inflation which was continuing to spiral out of control on back of higher food and energy costs despite the fact there were ample signs that economic momentum was already rolling over. It seems like the Fed may have just committed that mistake again yesterday.

I believe we are finally at the point where the long and variable impacts of monetary policy tightening are hurting a large enough portion of the economy to overwhelm the benefits that we have seen so far from higher rates that have been afforded to the wealthy asset holders, homeowners with locked in low rate mortgages and corporates that were able to borrow cheaply during Covid.

However, this transition to a growth slowdown has just begun and since inflation is still well above target, while the unemployment rate is still quite low by any historical understanding of maximum employment, the Fed will to be slower to react to the growth slowdown, which actually will increase the likelihood that the slowdown will become worse than expected as we move into next year.

The Fed needs to wait longer before acting in order to be sure that inflation has been slayed. However, their asymmetric policy stance, where the bar to cut is lower than the bar to hike, has created extraordinarily loose financial conditions which continues to bid up asset prices, and thru the wealth channel, makes achievement of 2% inflation that much more difficult. The market has already front run the Fed’s reaction function and this complicates the Fed’s ability to deliver on easing.

Since the Fed has basically neutered QT as a tool to help with asset prices by starting their tapering of QT, the only real tool they have left is the Dot plot. They need to show the market that their reaction function is slower and will be less accommodative than folks believe. The only way to do this is to remove cuts from their outlook, both for this year, and importantly for 2025 . They did this yesterday by moving in a hawkish direction despite lower than expected May inflation data. They took up their forecast for core PCE for 2024 as well. They also moved the LT neutral rate higher. So the Fed is shifting in a hawkish direction as the data is shifting the wrong way. This will wind up being a mistake.

With nominal GDP growth momentum finally decelerating, it will be hard to generate earnings growth momentum to support stock prices. With the Fed slow to deliver accommodation until unexpected weakness in the labor market shows up, it will be hard to get further multiple expansion from on an already overvalued stock market.

The strike price on the Fed’s “put” to act is lower than here. My favored portfolio expression in short small cap equities and long gold on the above thesis.

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