The infamous Jackson Hole this past Friday has officially sealed the end of summer holidays and lack of trading liquidity, thanks to Fed Chair Powell reassuring the market just what it needed. The words "still a significant amount of work needs to be done to reach our goals" was all the market needed to see it trade back higher, unwinding the weakness going into the meeting.
Starting this year the market and each sell side house had been pushing the reflation/reopening trade, as seen by their multiple upgrades following the Q4 rally. However, over the past quarter, this reflation trade has almost unwound as we saw iron ore fall 40%, copper down 15%, and oil down 10%, to name a few. The big debate going into Jackson Hole was whether the Fed would announce a tapering decision sooner or later.
One of the Fed's main objectives is to reach full employment pre-COVID levels and will keep their foot on the pedal till they achieve that goal. Even though they have taken their inflation assessment higher, they maintain that it is transient and will soon moderate over the course of the year. They have to say that as they honestly do not know, they only wish.
The problem is that the Fed has made this liquidity bubble so big now post the Global Financial Crisis, that it has become too big to fail. Given the amount of global dollar denominated debt, they cannot let rates rise too much lest they and other governments default on their loans. The only other problem in this modern monetary theory is that rates are now close to 0 and even negative, and they have no room to cut if something were to go wrong now. Every time they try to raise rates or ease back QE, the markets throw a tantrum and financial assets collapse, which is linked to the overall net asset value and wealth of all Americans and consumer spending.
The U.S. central bank's balance sheet is above $8 trillion, and over the past few months we've seen signs of U.S. growth plateauing after the rushed reopening trade of 1H. All that money thrown at the system and now it is still showing signs of slowing down, and one can only wonder how much the Fed will print at the next problem. That can keeps getting kicked further down the road.
The market has unwound most of the long reflation trade as commodity prices, especially those exposed to China, have taken a big hit post the Chinese deleveraging, despite their fundamentally tight inventory balances. That is why macro is so important for commodities as well as micro. When China sneezes, the whole world catches a cold. This could not be closer to the truth, literally and figuratively.
Going into the Jackson Hole meeting, the market was more deflationary than inflationary. One needs to remember the Fed's role is a reactionary one, they only react to emergencies, they do not pre-empt. Chairpersons like Volcker are a rare breed of the past. Since Greenspan, every Fed official has followed the "Greenspan put" model, as they have not been paid to do so otherwise. It has not failed, so why change it.
Inflation is a lot stickier than the Fed expects, but the fact that producer prices have stalled a bit here buys them room to keep their QE going given the Delta variant and potentially more closures, and job payroll growth still lagging. And that is what they did on Friday, tilting in a slightly dovish tone set the markets on fire pushing up the price of copper, oil, and all inflation related assets. It's Sod's law and this is happening at a time when houses like UBS (UBS) are now downgrading cyclicals and upgrading healthcare, after a 20%+ unwind - such value add analysis.
Now we wait for the Friday job payroll numbers. Once full employment is reached, then it will be a much more difficult question to ask, and the Fed might need to tackle that by Q4. Will it be another rehash of December 2018? Time will tell. Given the change in global supply chains and massive money printing, inflation is not about to ease any time soon. There has been a distinct change in global supply chains, witnessed in container shipping rates and the price of food and consumer goods across the board. Inflation is not a myth it is very much live and real.
For now, Powell has given no firm time table, just saying it would be open to tapering later this year. To put things in perspective, tapering may just mean scaling back a few billion in MBS or Treasury assets, not reducing the balance sheet as such. For now, it remains a guessing game. So until then, enjoy the free ride.