'Act Accordingly'

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by: The Heisenberg
Summary

Both rates and equities are foaming at the mouth for Fed cuts.

The assumed deleterious effects of the trade war have prompted multiple banks to reassess the growth outlook and call for easing.

Here's a look under the hood, a review of some recent big calls from Wall Street and a trip down memory lane to a 1995 quote from Janet Yellen.

Jerome Powell didn't pull a Jim Bullard on Tuesday.

That is, Powell didn't explicitly say a rate cut "may be warranted soon," as Bullard did on Monday.

But Jay didn't push back against market expectations for cuts (top pane in the visual) either. Rather, he went with "We will act as appropriate to sustain the expansion," during remarks in Chicago.

(Heisenberg)

That lack of pushback was all the "confirmation" anyone needed to send US equities (SPY) off to the races for their best day since early January, when Powell ushered in the dovish pivot during remarks in Atlanta alongside his predecessors.

To be clear, it wasn't all Powell on Tuesday. The surge was in part the product of a squeeze (the most-crowded shorts ripped nearly 4% higher) and, as Nomura's Charlie McElligott detailed on Wednesday morning, the steepening in the curve on Tuesday (and bear steepening at that) played a role.

"As I have previously highlighted when discussing the impact of the yield curve on equities' factor behavior, there too was a major macro catalyst for a Value rip higher and a Momentum blast lower via yesterday’s powerful bear steepening," McElligott wrote in a note.

(Nomura)

Of course, that came hot on the heels of Monday's tech wipeout, which was largely responsible for the iShares S&P 500 Growth ETF (IVW) underperforming its value counterpart (IVE) by one of the widest daily margins since the crisis. That's shown in the bottom pane of the visual below. In the top pane is relative performance for the iShares Edge MSCI USA Value Factor ETF (VLUE) versus the Momentum product (MTUM). The shaded circles denote Monday.

(Heisenberg)

As a quick aside, please do keep in mind that it's not always easy to illustrate certain market dynamics in a straightforward way that's amenable to quick presentation on this platform. Those charts are merely a simplistic effort at visualization using ETFs and should be interpreted as such. The excerpted passage below from McElligott takes you into the granular details of things:

"A massive “grossing-up” of Short books and/or “dynamic hedges” via futures since the start of April from the buy-side in an effort to reduce net exposure levels to nearly two-year lows, all due to the tariff-related “growth scare into recession”—but which then created the “fodder” for said squeeze (Crowded Shorts +3.9% Tuesday and +4.7% week-to-date, 1Y Momentum Shorts +3.8% Tuesday and +5.2% week-to-date). Just how 'pressed' were these Shorts? A US Equities 'Crowded Shorts' single-name basket of most-popular shorts was -16.4% between April 10th and May 31st vs. S&P just -4.7% over the same period, as Short hedges 'did their job' and worked to help offset the performance bleed in Longs. Particularly, the vast majority of said 'pressed Shorts' happen to be in the 'Value' / 'Cyclical' universe."

When you throw in sizable negative dealer gamma positioning headed into Tuesday, you end up with what we got - a "squeezy grab higher," to quote Charlie one more time.

Anyone interested in more detail on that can find it here, but the point is to give you a bit more visibility into what's going on "under the hood," so to speak, just to flesh out the generic narrative about Powell leaving the door open to rate cuts.

As far as the rate cut story goes, another bank threw in the towel on Tuesday, as BofA joined Barclays, Credit Suisse and JPMorgan in calling for cuts. The bank sees 25 bp cuts in September and December and an additional cut in 2020. BofA also slashed their growth forecasts across the board citing - you guessed it - the tariff escalations.

"We think it's going to get worse," the bank's economics team lamented, on the way to suggesting a sharp equity correction of up to 20% from the peaks might be necessary to force the Trump administration back to the table.

Worse though it may well get, the nearly universal expectation of rate cuts has seemingly served to put a bottom under things at a time when the news flow suggests risk assets should be, for lack of a better way to put it, bleeding to death.

As I've been over time and again both here and exhaustively on my site, it is impossible to overstate how perilous it would be were the Trump administration to slap 25% tariffs on all imports from both China and Mexico (that would be the worst-case scenario). If the US were to take things a step further still and go ahead with Section 232 auto tariffs, the combined total value of tariffs would rise to some $275 billion.

(Goldman)

No bank that I'm aware of has 25% tariffs on all Mexican and Chinese imports as their base case scenario. Additionally, analysts are reluctant to accept that auto tariffs will ultimately go into effect. But, even if you assume just a 10% tariff on everything Mexico and China ship to the US, the outlook darkens considerably. That is now Goldman's base case and, ultimately, it prompted the bank to trim their outlook for the US economy this week.

"Reflecting the drag from tighter financial conditions, heightened uncertainty, and eroded consumer purchasing power (with tariffs expected to boost inflation by +0.5pp in 2H), we are lowering our Q3 and Q4 GDP forecasts by 0.5pp and 0.4pp respectively to +1.9% and +2.0% (qoq ar)," Goldman said Monday. The new forecasts reflect the following negative effects from the assumed further escalations in the trade war:

"Three consecutive quarterly declines in equipment investment (Q1-Q3), reflecting FCI tightening, weaker business surveys, heightened uncertainty [as well as] softer consumption growth in the second half of the year (2.0% annualized), reflecting higher inflation and a possible temporary uptick in personal saving rates."

There are some offsetting factors, but the point is, none of that is good. BofA, in the note mentioned above, now sees second-half growth averaging just 1.2% (their previous forecast, prior to the latest trade escalations, was 1.8%). Thanks to a strong Q1, BofA's annual growth forecast for 2019 is still 2.4%, but whatever numbers you want to go by, you should make sure and contrast them with the Trump administration's latest budget, which assumes annual growth of 3.2% in 2019, 3.1% in 2020 and 3% through 2024.

The irony, of course, is that the worse the outlook gets, the more convinced the market will become that the Fed will be forced to cut rates. That, in turn, is bullish, as long as you believe monetary policy can offset the drag from trade frictions.

Importantly, the incessant trade escalations are giving Powell all the plausible deniability he needs when it comes to asserting that despite the strong Q1 GDP numbers and despite unemployment sitting at a five-decade nadir, there is, in fact, a good case to be made that a so-called "insurance cut" is warranted.

I use the term "plausible deniability" not just in the context of explaining away rate cuts at a time when the economy is still expanding at a 3% clip (or at least it was as of last quarter) and the labor market is still in fine fettle, but also in the context of Powell being able to say that the Fed isn't bowing to political pressure. That's a key concern in light of the dozens upon dozens of times the president, the vice president, their advisors (e.g., Larry Kudlow) and associates (e.g., Stephen Moore) have implored the Fed to cut rates. Note that I linked to objective articles from major national news outlets documenting rate cut calls from all of the parties mentioned. The point: Even if you want to argue that Powell doesn't feel any pressure from the administration, critics of the White House have read those same linked articles (or articles like them), and Democrats would doubtlessly cite those reports were the Fed to embark on a series of rate cuts without a plausible economic justification.

Analyst after analyst has alluded to that in suggesting that the Fed might wait too long to ease out of concern for bad optics. Here's what Gluskin Sheff's David Rosenberg said this week, for instance:

"The bitterest of ironies is that if [the White House] hadn't publicly badgered the Fed, Powell would be in a position to limit all the damage by cutting rates. But the president basically boxed Jay in. Now for sure the Fed will show up too late."

Or maybe not. Because now, the trade situation is so potentially dour, that Powell has the justification he needs. If the question is "Does the Fed have a solid case to make for a cut?", the answer, I would argue, is "Yes". I would have said "No" less than two months ago, and so would many other commentators. But things have changed since May 5.

Finally, when it comes to whether Powell will brave disappointing the market, I would refer you to an excerpt from the transcript of the July 1995 meeting. The quote is from someone called "Janet Yellen" - perhaps you've heard of her:

"As I already emphasized, I am concerned about downside risks and the possibility of destabilizing feedbacks that could weaken the economy more than the Greenbook envisions... All our forecasts, with or without a cut in the funds rate of the size we are envisioning here, show a decline in inflationary pressures as we go forward. To me, one of the major rationales for such a cut, as Governor Blinder and others have emphasized, is that we need to cement in place the existing financial conditions that are already working to provide the critical cushion against the downside risks.

[...]

I certainly am not arguing that we should be setting monetary policy by following the fed funds futures, but I think we should recognize situations when the market has gotten things right and act accordingly."

You've got to love that last bit: "Act accordingly."

To the extent you believe the Tuesday-Wednesday rally is largely attributable to Fed cut hopes, you could say investors have "acted accordingly", as well.

(Heisenberg)

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.