The market is trying to figure out two things:
1. Is the recession risk real?
2. Does recession risk, which lowers yields, help or hurt stocks?
We seem to be flip flopping, on an almost daily basis, about the state of the economy. Last Friday's PMI data lends credence to the idea that the economy (both here and in Europe) is contracting faster that expected. Housing data has also been consistently weak.
Other data hasn't shown much weakness (yet). I'm worried about the state of the economy and a rapid deterioration, and the White House publishing a blog on how economists determine if we are in recession, quite frankly, doesn't give me comfort (which I think was the intention of the paper).
For part of last week, stocks rallied with higher yields (which I view as healthy). Then they rallied with lower yields (a reaction I don't think makes much sense now). Finally, on Friday, stocks sold off as yields rallied (which I think is logical).
The main reason I think for the knee-jerk reaction of buying stocks on lower yields right now is that yields are going lower because of growth fears, rather than Fed policy. When yields were going lower due to Fed policy (dovish talk and QE) it was easy to argue that stocks of all shapes and sizes should benefit, because we could use a lower discount rate, while keeping future earnings expectations constant. Right now, I think we need to adjust earnings down, along with yields, mitigating the benefit we've experienced for much of the past two years.
Here are my expectations for Wednesday's meeting:
-- 75 basis points (consensus and priced in).
-- No tamping down on QT (negative for markets, but mostly priced in).
-- Data dependency and no set path for rate hikes (positive for markets, but mostly priced in).
Why a 75 bps Hike?
- Canada going 100 bps gave the Fed a chance to indicate they would go 100, before their quiet period started, but they steered towards 75 bps.
- Europe going with 50 opened the door for the Fed to do more, but I've seen nothing reported that indicates that behind the scenes the Fed is pushing the market towards more than 75.
- Commodity prices have generally rolled over and there has been some weak economic data (like the PMIs), but with the high CPI print too fresh in everyone's mind, it is difficult to see the Fed hiking only 50.
The QT on QT
Will they do anything about "quantitative tightening"? There has been some chatter that the Fed may signal that they will be cautious on balance sheet reduction.
On the one hand, even last summer, the Fed mentioned market liquidity as a reason to continue with QE and market liquidity is far worse now than it was then (I still can't believe even T-bills are experiencing a lack of liquidity).
On the other hand, It would be an admission that QE and QT do not work in practice the way many thought they do in theory. QT was supposed to "steepen" yield curves, it hasn't. It supposedly didn't impact asset prices, which I just cannot believe.
I think the Fed sticks with QT because they have to and cannot be seen to be backing down on this.
Recent signs of economic activity slowing down and the fact that many commodity prices have dropped, etc., give the Fed every reason to drive home the fact that they remain data dependent. That will lower rate-hike expectations, especially if we get any more doozies like the PMI data last Friday.
Messaging Will Be Key
The messaging on the path of future rate hikes will be key.
The more the Fed plays up that inflation is ebbing and/or that they are data dependent and watching the economy, the better it will be for markets.
I do think, especially with Janet Yellen also being quoted last weekend as saying she is not seeing recession risks, that the Fed will remain too focused on inflation and too hawkish for markets.
I'm cautious still on risk, precisely because I think the Fed is still fighting inflation and should have moved on to ensuring the strength of the economy, and that is what the market needs to hear on Wednesday to rally significantly from here!