As we approach the end of 2022, a year that asset managers would like to forget and remove from the ledger altogether, the market is trying to break above the key 200-day moving average that has been a huge headwind all year long. The market has rallied since the S&P 500 touched its October lows of 3,600 and has held on to the gains that it racked up after a softer-than-expected Consumer Price Index figure for October.
This was a key point in time for the markets as inflation had been coming in stronger than expected for most months this year, which suggested an even higher rate trajectory for the Fed. But now that the rate of increase in CPI is lower, the market is taking solace in the view that the Fed may be done tightening as the phrase "Fed pivot" is heard across trading floors.
It is important to put the recent data into context. The market eagerly was awaiting Tuesday's November CPI release, which came lower than expected. Headline CPI reported at 7.1% year over year versus the 7.3% consensus expectation and core CPI was up 6% year over year versus the. 6.3% expected. The previous month rates were around 7.7% and 6.3%, respectively, so the trend is moving in the right direction.
That improvement was enough to get the algos to push the market above the 4,050 level and get the shorts running for cover as the market tried to head to 4,150, which would be uncharted territory for the markets this year. The data also caused the dollar to collapse, causing bonds, gold and equities to rally.
Given that this year has been abysmal for most strategies, the market is desperate for any hint of good news. Machines can be blamed for reacting to stops going off as they are programmed to do so. However, as human beings we are flawed in the sense that we only read and listen to the narrative we wish for.
The reality is, the Fed is nowhere close to pivoting, if a Fed pivot means a U-turn from tightening to cutting rates.
Historically that has never happened, as even in 2001, when the Fed cut rates, the markets fell another 10%-plus. It is ironic that the market is cheering when inflation is still averaging around 7%. We are past peak inflation as we have seen an outright collapse in global supply tightness in freight and demand, and inflation may be slowing, but to do a victory lap calling an end to inflation altogether is a bit presumptuous.
Here on Wednesday we have on tap the Federal Open Market Committee's (FOMC) latest rate hike announcement. The market pretty much has priced in a rate hike of 50 basis points. Anything outside of this would be seen as either terribly bullish or bearish.
However, if anyone was to go back to Fed Chairman Jerome Powell's statements over the past few weeks, the Fed has indicated that its work is not done despite consumer inflation cooling as the labor market remains robust and inflation is nowhere close to the 2% target the Fed has cited all along.
Given the market's rally since October and the easing of financial conditions, this represents about 225 basis points of tightening unwind, which will not be appreciated by the Fed. There were definitely improvements underneath the hood as energy costs and used cars were the biggest drivers of the cooling in the CPI print, but shelter inflation was still quite high. This takes time to feed through as the economy cools, but it will still be higher for a lot longer.
The Fed raised rates aggressively this year in increments of 75 basis points, and surely it cannot go on raising rate at this rate, so the rate of hikes will slow eventually. Nonetheless, the Fed is still tightening even if in smaller increments.
Another factor that compelled the Fed to raise rates so fast is that rates were at 0% and if a financial crisis ensued due to economic stagflation trends post-Covid, it would need some ammunition to be able to cut rates later on if necessary. With rates closer to 4% to 5%, this gives the Fed a lot more room to ease in the future if the economy really gets out of hand.
Over the past decade or so, investors have gotten used to the Fed either injecting the market with liquidity like it was on steroids or deflating it by embarking on aggressive quantitative tightening. It has moved from one extreme to another as the system has gotten more and more levered.
Most market participants are not used to investing in a market that sees rates higher for longer as it takes time for inflation to cool. The Fed has suggested that the terminal rates would be a lot higher going forward, and this is something to which the market and investors need to get accustomed.
The past decade of 0% rates caused intrinsic values and multiples to go to levels not imaginable. Such is the effect when liquidity is free flowing and interest rates are at 0% or even negative, as excessive risk is taken. When the rug is eventually pulled, the skeletons come out of the closet as we saw with FTX and other levered ventures. Every Fed-induced quantitative easing (QE) cycle causes a recession and a bust of some sort. In 2008 it was Lehman Brothers, and in 2022 it was FTX, but will that be the end of it? Only time shall tell.
The market would be better suited to listen to what the Fed is saying rather than what it hopes the Fed would do. We know the Fed is not able to predict or forecast, but it only regurgitates what the data say as it plays a reactionary function, there to react to emergencies, but never able to prevent one. It looks at the data in the rear-view mirror, which means the Fed always tends to over-tighten and over-ease, causing these massive extremes in the market.
It is time for investors to get used to the new world order, one where inflation is a lot higher for a lot longer and monetary policy will remain restrictive for longer. The only problem is that the new generation of investors are not used to any other strategy besides "buying the dip," as for them, the markets can only ever go up.
