Powell's nuance confirms the Fed is done

Markets

As Powell's nuance confirms the Fed is done, stocks are trading higher, and the dollar shifts lower, triggering yet another gold rush.

There's a nuanced shift in Powell's characterization of current policy settings. While he previously described rates as "not too tight" in October, he now states that rates are "well into restrictive territory." While these descriptions may not be inherently inconsistent, traders, if astute, might discern the unspoken message.

"The full effects of our tightening have likely not yet been felt," Powell added. Powell added that the Committee is moving "carefully" at this point, given a better balance between the risk of not doing enough and over-tightening.

Obviously, Powell had to retain the pretense of two-way policy risk. "We are prepared to tighten policy further if it becomes appropriate to do so," he said Friday. But as our Asia close report stated, the market would unlikely buy it. 

Whatever additional Fed soundbites emerge over the next few weeks, the message is (or at least should be) clear: The Fed's done. They're not hiking again, barring a significant turn for the worse in the incoming inflation data.

It is time to cut rates to avoid the consequence of real rate lagged effects; the question now should be how much deeper of a cut is needed beyond the insurance cuts to avoid passively tightening real rates as inflation falls.

At one point during the Q&A at Spelman, Powell said a good inflation report is "as fun as it gets

It might not be too early in the current economic cycle to consider awarding "Central Bank of the Year" participation awards to the current crop of central bankers. Jay Powell, in particular, has managed to guide inflation down by 5-to-6 percentage points (or possibly more) from last year's peaks without triggering a full-fledged recession. This accomplishment is increasingly gaining recognition in financial markets,

Federal Reserve Governor Waller added fuel to the market's speculation this week by openly stating that rate cuts could be on the table if inflation decreases over several months. Waller's remarks, especially given his previous hawkish stance, significantly captured the market's attention, increasing speculation about potential rate cuts. Although other Fed officials attempted to temper expectations by suggesting that rate hikes are possible if inflation disappoints, investors appeared to disregard such comments. 

Even Federal Reserve Chair Powell's message to cool down on rate cut speculation in Friday's remarks seemed to have limited impact. The market's exuberance, reflected in Bitcoin approaching $40,000, Gold eying $3000 and even meme stocks getting into the act, may not align with the Fed's goal of restoring price stability and suppressing inflation expectations,

Of course, the problem is that no matter how rational expectations for rate cuts in 2024 might be (or at least might sound), those expectations can feed irrational overshoots in asset prices, which is where the financial conditions reflexivity comes in.

In just five weeks

The past five weeks have witnessed a remarkable transformation in market dynamics. The sequence of events, including a conciliatory approach to the term premium in the Treasury refunding, softer macroeconomic data in the U.S. (such as the jobs report and CPI), and Chris Waller's pivotal remarks confirming the Fed's willingness to consider insurance cuts in the first half of 2024 if inflation continues to recede, collectively triggered a notable shift across various asset classes. The aftermath, often called the "everything rally, 2023 edition," has been characterized by a uniformly favourable turn of events, making it one of the most positively memorable periods in recent market history.

This period has seen a capitulation out of the established macro trend trades associated with the Old Wall St guard, attributing to narrative-shift catalysts aligning dovish, contributing to sea changes in market dynamics.

Notably, systematic trading strategies have influenced a significant portion of the recent market activity.

Market participants must recognize the impact of systematic trading flows. Ignoring these dynamics can be a mistake, especially for top-down fundamental equity strategists who might consider it outside their purview. Understanding and incorporating systematic influences is essential to analyze market movements comprehensively. It's the new guard with one of the most significant market footprints.

In the past month, estimated notional flows out of the CTA trend/managed futures space reflected a one-way buy-to-cover mission. The estimated buy flow exceeded $100 billion in bonds and nearly $40 billion in short-term interest rate swaps (STIRS). This highlights the significant impact of systematic trading strategies on market dynamics.

The recent surge in equity markets, often called the "November squeeze," significantly impacted systematic trading strategies, particularly CTAs (Commodity Trading Advisors). In the past month, CTAs flipped from a bearish stance to being "outright long," with estimated buying totalling nearly $56 billion. This shift in positioning underscores the role of systematic strategies in driving market dynamics, especially in the context of changing macro narratives.

At the same time, the relentless grind lower for realized vol triggered some $46 billion in mechanical equity buying from vol-control cohorts over just the past two weeks,.

Estimating systematic flows indeed comes with some uncertainty, and there are challenges in precisely quantifying the impact of such flows on markets. However, for several reasons, dismissing the importance of understanding these flows in favour of a purely fundamental narrative could be problematic.

The challenges with relying solely on a traditional fundamental narrative are twofold. First, some equity strategists may have a narrow view of what constitutes the "big-picture fundamental narrative," potentially overlooking crucial factors beyond earnings and macroeconomic predictions.

There's more to it than plugging in an estimate for index-level aggregate EPS and filling in all the other blanks with the economics team's year-ahead macro predictions (which will all be wrong) and a 10-year yield forecast (which will be wrong, too).

Second, the risk of getting caught woefully offside seems to grow as time passes. Late last month, for example, a couple of big-name bears on the research side cited a humdrum list of familiar talking points in suggesting a Santa rally was unlikely.

Gold markets

Gold is taking another flyer driven by the prospect of Fed interest rate cuts in 2024, driving the US dollar weaker. Also, uncertainties persist amid geopolitical risks such as Russia/ Ukraine tensions, Middle East dynamics, the upcoming US Presidential election, and the negative economic effects of prolonged higher interest rates. So, markets remain bullish into 2024 as EM central banks are expected to continue diversifying into gold as a hedge against a possible weaker US dollar and possible de-dollarization trends gaining traction next year.

Oil markets

Oil markets are getting crushed as speculators anticipate wider cracks to appear in OPEC compliance and doubt the voluntary cuts will be enough to stem concerns about oversupply.