After June's Federal Open Market Committee conference took investors by surprise, the July FOMC meeting gave an air of caution as the Fed was intent on not getting it wrong again.
The June FOMC came at a time when inflationary shocks were rampant in the market, as prices of used cars, goods, services, and energy all contributed to one of the highest year-over-year Consumer Price Index readings at 5.4%, with core printing 4.8%.
The Fed has continuously said it would keep the liquidity taps open until inflation would be above 2% sustainably or employment goals reached. But it kept moving goal posts every time, so the market assumed the Fed was far away from even considering tapering. Its slight hawkish tilt in June immediately raised alarm bells and saw the vicious unwind of the consensual long cyclicals and short dollar trade. Most hedge funds had been positioned long the reflation trade at the expense of technology and other defensives, ignoring China's slowing down. Now, the dollar spec shorts have all but covered their positions as the Commodity Futures Trading Commission speculative positioning shows a small long even.
This was the set up going into the July FOMC presentation.
Taper talk had been picking up in recent weeks leading up the July meeting. This was all assuming the Fed is a rational institution and would actually pre-empt a situation instead of waiting for it to happen. But as we have learned over the past decade, the Fed is incapable of taking a view other than state what has already happened. It only knows how to put out fires -- it plays a reactionary role, not one that leads.
The Fed has constantly claimed that inflation is transitory and that year-over-year base effects will be short-lived. Months later, the Fed now admits that it feels inflation will remain elevated for some time, but feels over the next year it may moderate. The Fed honestly does not know, it is more like wishful thinking or hoping, rather. They know that they cannot stop their asset purchases or taper, because if they do, this market will collapse like a house of cards. Similarly, the Fed knows that if inflation runs away faster than the U.S. gross domestic product, then it will be check-mated. Since inflation never appeared over the past decade, what harm does another $5 trillion make?
Powell started his press conference by stating that substantial progress had been made toward taper talks. The market took this as slightly hawkish at first. But then Powell was asked to define what exactly that meant. In the abstruse nature with which Fed officials are told to master their deliberations, the response left the market more perplexed than it was even before the meeting. He then flip-flopped between growth being robust and the COVID delta variant remaining a risk to the economy.
One sentence gave it away: Powell reiterated that the Fed is still behind in employment goals. The Fed is ignoring inflation and will continue to do so until the economy gets back to pre-COVID employment. That is its main agenda. Keep the foot on the pedal until inflation gets significantly above, or the economy grows more, whichever comes first. Even though most commentators picked up the FOMC meeting as hawkish, it was in fact quite dovish, as now it seems to have bought some time before having to make that decision.
If only Powell were more like Greenspan, who took the brave decision to raise rates before things actually got worse. It seems Powell will just wait till he has no choice. In the meantime, he is hoping that financial markets keep chugging along, even though he acknowledged that wealth inequality and job losses were biased without addressing how quantitative easing solved that dilemma.
The performance of the market has all been about extreme positioning. Into June, traders were short the dollar and long cyclicals, thinking the Fed would never taper. We know how that played out. Into July, they were all prepared for a taper sooner than later, and now the dollar has been falling since Wednesday, which is giving cyclical assets a boost. Sod's law. It is all one big macro-trade, as some cyclicals are just up a bit more given their tighter demand/supply balances.
The multimillion dollar question still remains in the market, is this inflation transitory or secular in nature? And if the latter, will it outpace U.S. economic growth. For if it does, no matter how much liquidity the Fed pumps, the market will be forced into a downward spiral of stagflation. For now, the jury is out, so enjoy the ride.
