The Fed seems to be caught between a rock and a hard spot.
Friday's higher-than-expected CPI is going to force their hand on the inflation fighting front. Not only is inflation continuing, even if they are able to contain inflation, the prices for food and energy are already high and hurting the economy.
Consumer Confidence, a number I rarely pay attention to, was so bad, that I find it difficult to ignore. But the Fed will likely have to ignore that, while also ignoring any other signal that points to a potentially slowing economy.
The narrative on jobs is changing before our eyes. I cannot remember the last time some major company CEO said they can't find employees, while everywhere I look I'm seeing layoffs or discussions of overstaffing.
Evidence that inventories are building is mounting. I am also hearing shipments are declining too, not just due to supply constraints but slowing demand.
On the one hand, signs that the economy is slowing, which should relieve inflation pressure are everywhere, but the Fed cannot afford to seem to let up the fight right now.
Financial Conditions
Markets are doing a lot of the Fed's work for them.
The red line is zero, or neutral, for the Chicago Fed's financial conditions. Technically, they are still "loose" as they are negative, but they have risen to levels that are as tight as the Fed typically lets it get, outside of one-time shocks. Based on financial conditions, the Fed should be cautious about hiking (and let's not forget quantitative tightening), but they don't seem to have that luxury.
When talking to market participants, especially bond market participants, liquidity is abysmal. That is one thing the Fed attempted to address in the past. Even last summer, the Fed stated, repeatedly, that quantitative easing was still being provided to assist liquidity. I can tell you without a doubt, liquidity is worse now than back then, yet they cannot be seen to respond to that.
Dovish or Hawkish Hike?
The Fed will certainly hike at least 50 basis points Wednesday. The only question is whether they will hike 75 or more.
There are pros and cons from the Fed perspective on doing 50 or more than 50:
-- The Fed has telegraphed 50 bps for weeks, if not months. They like to telegraph decisions so as not to surprise markets. That will weigh on their decision and push them towards 50.
-- On the other hand:
- Markets have priced in a high probability of 75 bps, so the Fed might not want to disappoint markets, causing them to lean towards 75 or more.
- They may want to send a clear message that they are serious and focused, both to markets and politicians. The University of Michigan Consumer Confidence report had longer-dated inflation expectations rising to 3.3%, the highest it has been this cycle. The Fed may want to tamp down expectations.
I'm leaning towards 50 bps, but 75 would not surprise me, while 100 would absolutely shock me.
The question, that I'm grappling with, is how does the market respond to whatever hike they give us?
I think 50 bps and anything less than super hawkish statements would be viewed as a "dovish" hike. Probably, like other times, stocks would react positively to a dovish hike, but I do not think that reaction would last long.
A hawkish hike, 75 with strong language, might, after some initial sloppiness, be rewarded by investors. We might see a bounce on the hopes that the Fed is finally getting ahead of the curve. Sadly, I cannot get comfortable that reaction would last long.
So I'm left in the precarious situation that I don't think the market will respond well to anything the Fed does. That seems counterintuitive -- and it is -- as one decision should be better than the market has priced in and one should be worse. But I think once the market has had time to digest the Fed's actions, little good will come of it.
Quantitative Tightening
I continue to believe the QE helps asset prices and QT hurts all asset prices.
The impact of QE is bigger than the impact of QT as the Fed is currently handling QT. That is because during QE, the Fed bought long-dated bonds, "goosing" the impact, by taking duration out of the market.
During QT, the bulk of the balance sheet reduction will be done by letting bonds mature, which is less disruptive than selling bonds. So QT won't be as big as QE in magnitude, but it will act as a pressure point.
It might be one reason we are seeing more days where bonds, stocks and commodities all drop together.
Bottom Line
I'm not optimistic about the Fed navigating Wednesday well for markets, and while I don't address it specifically here, I am increasingly concerned we could see a very abrupt rise in Treasury yields (positioning and the aforementioned lack of liquidity playing a big role).
