Powell Check-Raises The Market With ‘Hawkish’ Pause (SP500)

Last February, I had postulated that Jay Powell had “caught the bond market’s bluff” and that the Fed has a better handle on financial stability than the market seemed to give it credit for.

I believe the subsequent events around the bank failures proved this assertion correct. Now, after this last meeting, I think Powell’s previous shoe is now on the other foot. The Chairman’s actions are similar to check-raise in poker. A hawkish pause is a contradiction, just like checking and betting in the same round of betting. You check raise for two reasons:

• You are confident in your hand, and you are trying to maximize your gains.
• You are trying to bluff your opponent and promote the desired behavior of him folding, instantly giving you the gain of what’s in the pot.

Powell’s behavior is definitely the latter, but perhaps a little of both. Listen, the Poker metaphors are fun but also not perfect. Usually, I’ve used the heads-up Poker metaphor to describe Powell versus the Bond Market. In this case, he’s bluffing the American public and commercial entities because he wants them to behave as though more hikes are coming, not in a disparaging context but a metaphorical one.

I am stating right now that I predict either one hike or no more hikes are coming despite the dot plot suggesting two in the pipe and one FOMC member even suggesting as many as four. Bluff! This is bullish for the S&P 500. The reasoning behind this assertion is that I believe inflation data will continue coming down fast enough not to justify further hikes. Talk is cheaper than hikes, to paraphrase bond market expert Jeffrey Gundlach.

The reason for the hawkish rhetoric is to bluff the market into not bringing inflation back to levels that will not require more hikes. Powell stated in his press conference that there’s no consensus on how long monetary effects take to make themselves known. This is particularly important given the recent bullish action in the stock market because a runaway rally could reignite inflationary forces, maybe before the tightening has taken full effect.

The Check-Raise is one of the most aggressive moves you can make in the game of Poker. Some poker rooms even ban it for the consternation and frustration it can cause. Many poker players consider it an unfriendly move, but when trying to quell inflation for our collective economic well-being, it can be excused.

The dots have been consistently coming in higher than the bond market suggests, and the bond market may finally be correct. There’s a lot of reason for cautious optimism. I think Powell, despite a genuine commitment to vanquishing inflation at all costs, thinks that there’s a decent chance the FOMC is done. I could be wrong, but that’s the sense I get from his presser.

Jeffrey Gundlach stressed, in his customary post-Fed meeting interview, that all the indicators suggest imminent recession. He thinks the Fed is hiking needlessly into a recession, as do many others, given the damage already done to the economy and the downward path of inflation.

• The Fed, if you take them at face value of their rhetoric, seems to be making the opposite mistake as at the beginning of this cycle.
• Instead of waiting too long to hike, they are waiting too long to stop hiking.
• Only they didn’t hike. And Crucially, if they also do no more subsequent hikes, the bond market and the Fed will pretty much agree-hand over, and Fed wins, and hopefully, we avert a bad recession. Flush draw!
• CNBC’s Steve Liesman said it seemed like the Fed is paying too much attention to backward data, but maybe they’re more worried about controlling the crowd than giving their true outlook.

The Fed got pretty cute this time. It did a dovish action dressed in hawkish rhetoric. And while reasonable minds may disagree on why Powell would do this, I do think it is because he gives himself more flexibility to “see the cards.” Indeed, he said as much when he asked why he didn’t hike. His response was:

1. He’d have more information before the next decision on hiking.
2. He’d like the economy to have more time to adapt to high rates.
3. He’d like more time to assess the banking turmoil.

The Fed also has other methods that are currently working to tighten the economy right now, like shrinking the massive balance sheet. I also think Powell gave himself away in the press conference:

We don’t go out of our way to surprise markets or the public. At the same time, our main focus has to be on getting the policy right. And that’s what we’re doing here, and that’s what we’ll do for the upcoming meetings.

Chairman Powell

One thing to remember is that the Fed has lots of non-public information, and it’s certainly not only OK but encouraged for them to use it in achieving their mandate.

If they see a rosy picture privately and a real path to a soft landing, which Powell admits they do on the latter point, then this is really quite a rational action. I think the market reaction also betrays that after such a historically fast hiking cycle, 50 bps wouldn’t likely make the difference between recession or not anyways.

Indeed, Mr. Powell and Mr. Gundlach might actually be in greater agreement than meets the eye. The bond market reaction would suggest so. Powell maintains that there is still a path to a soft landing and that the labor market is showing “extraordinary resilience.” However, both for the market’s sake and for the sake of his own hawkish committee members, the hawkish rhetoric was likely still required.

I believe it will ultimately be proven a bluff for the sake of ensuring market ebullience doesn’t resurrect the vitality of increasingly weak inflationary pressures. I think there will be fewer hikes than the SEP currently suggests or none. For instance, when used cars likely reverse next month, the numbers will look even more favorable to support that the Fed should be done.

Does the Fed Have the Best Hand? Wait for the River!

There will be a lot of headlines saying, “Market drops because of hawkish Fed,” but there was a relatively low drop in response to the announcement. Ten minutes before Powell’s press conference, markets looked like this; you’ll notice that the VIX was also down, albeit slightly.

Although, the Fed has kept you guessing on purpose because, yet again, Powell has pretty masterfully given himself some leeway to feel around in the intense “London Fog” caused by COVID. The pandemic caused so many stalwart correlations to break down. Remember to think from Powell’s point of view, he bought himself some time here, and again he bought himself some leeway. You can see after the press conference much of the prior losses were reversed, and the VIX cratered by 5%.

There’s no doubt this was a somewhat confusing Fed meeting, and I think this is largely by design. Powell is playing heads-up Poker, and so far, he’s played it pretty well. This cycle has been defined by the Fed postulating more aggressive rate hikes than the market is pricing in. The market seemed to think financial stability issues would force the Fed’s hand, but they did not.

I suspect this may be the last instance of this dynamic and, potentially, the last hike. The hike language, at least for now, is almost necessarily designed for the psychological impact. It seems this was a hard-negotiated unanimous decision, and we’ll know more about the dynamic that led to this decision when the minutes are released.

Risks and Where I Could Be Wrong

There are plenty of risks that could cause the Fed to follow through on its stated course outlined in the dot plot. The Fed could hike two or more times for a variety of reasons. I do think that Powell is being genuine when he states that he thinks the risk is to the upside for inflation, but it may not favor the upside by much. The War in Ukraine and continued geopolitical deterioration with China could unleash extreme inflationary pressures at any point.

Thus, the Fed is wise to have the market prepared for the possibility of more hikes. However, I think the labor market fundamentally changed during COVID and that there are a lot of misunderstood positive effects from so many workers being given time and breathing room to consider how to allocate their productive capacity best. Time is very valuable, and workers have a lot of it.

Nonetheless, anytime there’s a hybrid Fed move that purports to be both hawkish and dovish, it usually means the risk of misunderstanding is elevated. My former colleagues at Fundstrat put this graphic together, which always gives me a laugh but also should alert you to the high level of risk around Fed transitions.

There are still financial stability concerns, and Commercial Real Estate woes could lead to a vicious re-emergence of the fears we all felt when some of the largest bank failures in recent history occurred. Still, there’s mounting evidence that a new bull market is afoot, and climbing a wall of worry is definitely something the market could pull off.

Conclusion

The Fed has come out with one of its most anticipated rate decisions in history. This is also an incredibly important juncture for markets as it could potentially mark the end of the second most aggressive Fed hiking cycle in history. And I’ve covered this Fed hiking cycle several times using the metaphor of Poker. This metaphor is particularly poignant in the wake of COVID since both the Fed and the bond market could well be described as “flying blind.”

Sophisticated market participants use orienting themselves in the economic cycle as one of their main advantages over less sophisticated participants. Still, given the anomalous and ubiquitous effects of the recent pandemic, this art has been compromised whether you’re a Fed economist or Fixed Income Manager.

The Fed’s hawkish rhetoric masks what seems like a latent optimism. Powell now has an opportunity not to hike if the data supports it, and the expectation is that he will if the data shows inflation’s resurgence or persistence. The GDP projections have actually increased since the last meeting, but so did expected inflation. There was definitely a wide diversity in rate projections, with one member even predicting four more hikes.

So while the decision to keep rates unchanged was unanimous, the dot plot showed a recently unprecedented divergence in expectations for hikes. What this means is that the Fed is very much data-dependent. If the data continues positive trends, there could be quite a lot of upside that many don’t expect after such a powerful recent rally.