Pivot? Think Again. The Fed's Pulling Teeth.

November 4, 2022

We’re at the dentist.  A 12 bed operation just for kids, TV screens literally built into the ceiling so kids can watch movies as they lie flat. It’s quite the production here, catering to the little ones, and someone (I’m guessing the dentists) are pulling in some big money while pulling out some tiny teeth.  

It’s just a check-up for my son, but since it’s T+3 days post-Halloween, there’s an over/under on the number of cavities, and I’m taking the over.  He likes them sour patch kids, and it’s been a gummy massacre at our house as he’s doing his best impression of a Kaiju.

Gums getting cleaned, cavities getting filled, and teeth getting pulled.  It’s all around me. Not many tears yet from the kids as they’re all trying to figure out what in the world is going on, or completely tuned out with the TV on.

So basically, the real-world equivalent of . . . a Fed meeting.

After years of lax fiscal and monetary policies, and a decade plus of a liquidity sugar rush, we’re finally getting the results of our dental check-up, and the dentist (i.e., Chair Jerome Powell) IS. NOT. HAPPY.   

I mean sure, like any good doctor he’s giving constructive feedback couched with the good and bad. He acknowledges that removing the sugary rush too abruptly could cause distress, so they’re monitoring the data and not blindly charging ahead. Just compare yesterday’s statement to the one issued at the prior meeting, and you can see the changes.

Yet, real feedback has to be given, and lest you think he’s going easy on you, think again. In the press conference following the meeting, some real hard truths were shared.

2% is still our target . . . so we’re still going to crank-up rates lest cavities and high inflation become . . . entrenched. The procedure has just begun.

“What abouthh tha pivoth??” some kid blurths out through the cotton balls stuffed in their mouth.

Are you kidding? That’s premature kid . . .

We’re doing all of this because it’s good for you . . . and for the world.

So sit back, because we have a ways to go . . .

Though the visit started pleasantly enough, by the end, we knew 1. this is gonna hurt a bit and 2. this is gonna cost us. As we further tighten financial conditions, we’re going to need to pay attention to the 3 things enumerated by Chairman Powell:

1. The speed of the tightening;

2. How high to raise the policy rate; and

3. How long will that rate be maintained.

First off, we’re transitioning between the 1st and 2nd point and though the Fed is cognizant of the financial turmoil that the shift is causing, the path forward is clear. Inflation and all its evils must be rooted out. Like root canals or tooth extractions, it’s a painful, but necessary to maintain the overall health of the ecosystem.

Second, at the next Fed meeting (and likely before) the discussion about how high to raise rates will be clearer. We believe it’ll end somewhere around 5.0%, but frankly, if we’re being “data dependent” going forward, much of that depends on what inflation data points and job figures reveal in November and December . . .

. . . or does it?

We write that skeptically because think about it. The Fed met on Wednesday, two days before today’s job’s report that continues to show a really strong labor market.

Wages are still increasing along with hours worked, and given the high number of jobs available, the tight labor market will persist for awhile. It’s near certainty that the Fed had this data in hand before their FOMC meeting earlier this week. In fact, they likely also have the preliminary CPI figures that’s due out in a few days. We anticipate that to be strong as well (8.0%?), and showing only small signs of easing. It would explain why the language and tone in the press conference was so hawkish because without it, the market would’ve rallied as it embraced the idea of a pivot, when the inflation and job figures don’t justify the move.

So we’re really left with one more CPI report and one more jobs report in December before the next FOMC meeting (Dec 14-15). If those numbers come in strong again, then watch-out because remember #2? The top-end of rates? Well the Fed may have to guide higher.

In the palace of truth, we’re already teetering in that direction because the Fed doesn’t just look at one month’s figures, but instead a 2-3 month average. Since jobs and CPI data in November are (and are likely) to be strong, you’d need December data to come in decidedly weaker to offset the near-term strength. We’re not sold that’ll be the case.

If the expectations for terminal rates and their persistency (i.e., #2 & #3 of Powell’s framework) rises, the market’s almost certainly going to go lower as higher rates further sap energy from the markets. Couple that with declining earnings because of the macroeconomic slowdown, and we have the ingredients for a bearish market. The question still remains, however, does this lead to a financial blow-up? Does some esoteric part of the shadow banking system (i.e., pension, insurance, hedge funds, non-bank lending institutions, etc.) experience a melt-down because of the rising rates? It’s too soon to tell.

Overall, while some analysts are framing this as a beginning of a pivot, we don’t think so. That will eventually come, but this isn’t it. At best it’s a tacit recognition that the unrelenting pace of rate raises are starting to create market stress, but as the economic data trickles out, it’s apparent there are little alternatives. The labor market and inflation prints are still too strong.

This process will continue to hurt. There will be more financial pain to come given the severity and speed of the financial tightening, but this is the process being prescribed by our economic dentists. Financial decay, from a decade of overindulgence and recent monetary/fiscal sugar-binge, has set-in.

So get the gas ready and relax.

It’s teeth pulling time.

If you’ve not had a chance, please review our Q3 Letter that we published recently. Hit the “like” button and subscribe below if you enjoyed reading the article, thank you.