Chief Investment Officer
Summary: Equity and bond markets both sold off yesterday after Powell failed to provide any hint of any incoming Fed put. Rest assured, the Fed will eventually have to act, but will likely do so only once financial conditions have deteriorated sufficiently to force its hand. Today we look at the market developments that will indicate the Fed is finally set to send in the cavalry once again.
What: Powell and FED is being pushed by market – this is analysis of WHEN has financial condition tighten too much?
Answer: another 1 standard deviation decline in financial conditions
Action: Await Fed signal (and begin to position once the Answer is triggered)
Trends: EURUSD had broken lower, another layer of Gold support broken, US yields testing YTD highs
Yesterday, I wrote that it is far too early for the Fed to act on yield curve control, a message the market was clearly not prepared to hear, as equities and treasuries sold off heavily when Fed Chair Powell essentially shrugged off the recent rise in treasury yields as only something that “caught his attention”. It should not have been such a surprise, as Powell is following the script that the Fed has to follow – that it will only act due to financial market considerations on a material decline in financial conditions, one sufficiently large to threaten the fulfilment of their dual inflation/employment mandate.
The most interesting set of comments yesterday from Chairman Powell on WSJ webinar were these:
“I would be concerned by disorderly conditions in markets or a persistent tightening in financial conditions that threatens the achievement of our goals,” Mr. Powell said Thursday. He added that the Fed is looking at “a broad range of financial conditions,” rather than a single measure.
This makes clear that Fed policy will be driven by Financial Conditions – and Bloomberg has a useful measure of US financial conditions, shown below. As the graphic shows, conditions are still positive and would have to decline about 1 standard deviation to about -0.50 from the current 0.40 to get to their worst levels since recovering from the pandemic reaction last spring. That level was just before the US election, by the way.
To anticipate potential moves in this index – you can align the factors in the list by volatility – of course the stock market has the “fastest speed (volatility)) – meaning a very large move in the stock market could force the financial conditions index into territory where the Fed will intervene.
Below I have made a basic chart of Bloomberg Financial Conditions with panel including Z-score (21 days – or about one month) and the Nasdaq 100 measured by the same one-month rate-of-change (ROC)… in order to gauge the speed of the move up or down.
I may be “stretching” the argument and correlation here, but clearly – a cross-over move can be defined in this chart, meaning we are within a standard deviation of seeing the next action from the Fed – whether from a sufficiently large further correction in equity market and especially if credit spreads (still showing no strain) becomes unanchored.
What will the next Fed action be? Most likely an addressing the turmoil in repo and funding markets caused by the US Treasury drawing down the majority of the $1.6 trillion in its General Account at the Fed. But remember: this is merely short-term noise bigger story: We have had a major paradigm shift from a focus on financial stability to a focus on social stability, a move which changes everything, including potentially the velocity of money, inflation outlook and growth. The next level in the 10-year US treasury yield is 1.65%, and then there is some mortgage convexity hedging between 1.7-1.8%, which could lead to 1.90/1.95%, which is way above my earlier trend channel (see below).
My medium term channel was established mid-January..
Safe travels and nice week end
Steen Jakobsen
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