Fear the Bear
The Credit Strategist - April 6, 2022
Fear The Bear
It appears that the bear market rally is ending as signs abound that stocks may retest their recent lows. Rates are heading higher after Fed Governor (soon to be Vice Chair) Lael Brainerd, normally dovish, said that QT could start as soon as May and that she is open to 50 basis point hikes, a position gaining support among her colleagues. The Fed’s March minutes released this afternoon confirmed that the Fed would have hiked 50 basis points in March but for the Russian invasion and is almost certain to do so in May and keep going unless inflation falls sharply (which is unlikely). Ms. Brainerd also reinforced statements by Fed Chair Powell and Fed Governor Esther George that the Fed needs to move “expeditiously,” which is more than obvious to anyone other than a CNBC contributor or a sell-side strategist. Brainerd also said she expects QT to proceed “considerably more rapidly than in the previous recovery,” which was confirmed this afternoon when the Fed said it planned to shrink its balance sheet monthly by $60 billion of Treasury securities and $35 billion of agency MBS (higher than the $80 billion combined expected by the consensus. With the U.S. yield curve over two years trading above 2.5% and the 2/10 curve flat-to-inverted, bonds are signaling an economic slowdown despite efforts by the usual suspects to dismiss this traditional recession signal. Until further notice, we should not dismiss what the curve is telling us especially when it conforms with other data such as oil and other commodity prices.
Other voices are joining the chorus urging the Fed to move more aggressively. Former Fed Vice Chair William Dudley wrote: “To be effective, [the Fed will] have to inflict more losses on stock and bond investors than it has so far. Investors should pay closer attention to what Powell has said: Financial conditions need to tighten. If this doesn’t happen on its own (which seems unlikely), the Fed will have to shock markets to achieve the desired result. This would mean hiking the federal funds rate considerably higher than currently anticipated.”
This morning the S&P 500, Dow Jones Industrial Average and Russell 2000 dropped below their 200-day moving averages. Much of the recent rally (one of the strongest rallies in recent history) was driven by short covering and flow-driven trading (including the return of meme idiocy and the like) which is characterized by weak conviction and short-term thinking. The longer-term prospects for stocks (as opposed to long-term prospects, i.e. multi-year outlook) remains challenging with tightening monetary conditions, over-hyped earnings expectations, commodity shortages and price spikes, and geopolitical instability posing serious obstacles to higher prices. The bond outlook is even worse but whether the lack of a fixed income alternative is enough to keep investors chasing stocks (which are still overvalued in my view) remains to be seen (it largely depends on their time horizon and what percentage of holders are renters instead of owners). For the moment, investors are fighting a Fed that is talking tougher than it has in years while still needing to demonstrate that it has the wherewithal to do the job it was ostensibly established to do more than a century ago.
Pessimists argue that the Fed actually has been doing that job which is why we are in the terrible dilemma we face today – an economy characterized by too much debt, speculation and obscene wealth inequality. Optimists hope the denizens of the Eccles Building will move the needle in the other direction to more productive and equitable monetary policy. They face a herculean task rendered more difficult by their past errors, but they now have a historic chance to change course. But doing so will be painful for them and for the citizens they serve. History favors the pessimists but faith tells us to give the optimists the benefit of the doubt and let Jay Powell and his colleagues earn our trust and confidence. They have yet to do so but we can always hope they will surprise us.
Michael E. Lewitt
 Peter Boockvar notes that achieving the MBS drawdown may be more easily said than done because the MBS portfolio holds $2.72 trillion of securities with little natural run-off. This means the Fed will have to start selling MBS outright in order to meet its goals which could trigger losses. The Treasury cap would not appear to be a problem.