The Week Behind

Markets traded evenly heading into Friday’s much-anticipated presser at Jacksonhole. When Powell took the stage, the markets must have identified some sharp, hawkish talons as the indices scrambled for cover, losing ~4% on the week in the process.

Highlights

• The FED utilized Jacksonhole to project a unified stance against future rate cuts.  
• While DG had a better quarter and outlook than DLTR, both traded down after reporting. The content and market response to these reports refute the idea of imminent real recession in the U.S. for the next 6-8 months.
• Financial conditions incrementally tightened: the US2YR is back ~3.4%, the year’s high; the US10YR closed back above 3%. 

While Jacksonhole did not produce any new or material information for markets, Powell’s hawkish tone catalyzed a hefty sell-off featuring 90-10 declining issues on the NYSE with above-average overall volume. In a short and direct presser, Powell explicitly stated the FED will not stop tightening until inflation is defeated, even in the face of economic “pain”. In other words, the FED will not pivot to save the economy if it means jeopardizing their fight with inflation. While it is not prudent to make too much out of one day, all of a sudden, a market that felt like it was beginning to give the benefit of the doubt to the bulls and place the burden of proof on the bears feels more neutral.

Equities Caught Offsides: Insights from Friday’s Sell-off

The only message to come out of Jacksonhole was short, concise, and direct: the FED Pivot is dead. No room for creative interpretations. Soon after that hit the wire, indices tumbled 3%, unable to find support anywhere along the way into the close. There are a number of bullish strategists, many of whom I agree with regarding the underlying dynamics of the economy, who will tell you on a day like Friday that their bull case is not dependent on the FED Pivot. However, Friday’s session suggests that “the market’s” bull case is predicated on that pivot. 

Interestingly enough, while the equity market had a volatile Friday, the fixed income (bond) market had a relatively calm day. Leading into Jacksonhole, financial conditions had been gradually tightening as the US2YR revisited June’s highs and the US10YR approached 3%. Powell’s tone appears to have alerted the equity market that the fixed income market was more accurately priced, resulting in equities falling to better reflect the higher risk-free return available in treasury yields. 

Even though the fixed income market is priced similarly to June, I do not think it means the equity market needs to adjust back to June’s levels. The lows in June were catalyzed by ~$120 oil, historic low consumer sentiment, high uncertainty regarding recession, forced long-side margin liquidation (the opposite of a short-squeeze, people who bought on margin being forced to sell), high short-interest, as well as a higher interest rate environment reflected in the fixed income market. The fixed income market was one of many contributing factors, not the sole contributing factor. In fact, going into next week, because we know that the fixed income market is more appropriately priced for FED policy, we can expect a little less yield volatility, which is good for equities. To close, I think a new negative catalyst will be required to revisit the lows because the equity market should not be as vulnerable to the set of concerns that brought us to June’s levels and the fixed income market is moving at a comfortable pace in a comfortable range. 

The Week Ahead

To begin the week, the major indices and a number of individual stocks are heading back toward support – 50d or 100d SMA – after retreating from resistance – 200d SMA. Assuming Friday’s volume is indicative of market participants returning from summer vacation, the next 5-10 sessions will be crucial as equities trade around critical levels of support and resistance.

Aside from Crowdstrike (CRWD, cybersecurity) and Broadcom (AVGO, semiconductor) reporting Tuesday and Thursday, it’s a pretty underwhelming week of earnings. Instead, the market will likely be focused on job data culminating on Friday with August’s nonfarm payrolls. While Powell said he will remain “resolute” and endure “pain” in his fight against inflation, it is easy to send that message when very little “pain” has yet to come. In other words, it is easy to talk hawkish and hike rates 50-75 bps a meeting with an economy at full-employment. I suspect his tone and the FED’s approach will evolve appropriately if unemployment ticks up to 4-4.5%. 

Consequently, now that Powell has temporarily corrected market expectations, I think we return to the “bad news is good news” trade. In my opinion, to avoid another wide-breadth sell-off to end the week, Friday’s nonfarm payrolls need to come in weaker-than-expected. A weak number shows FED tightening is slowing the economy, giving reason to pause at year end. If we get a hot number, it permits the FED to continue hiking without reservation, which is bearish for stocks. 

The Terminal Fed Funds Rate

To close last week, the Terminal Fed Funds Rate, as shown via the Fed Funds Futures, is between 3.5% and 3.75%. While it is not the most user-friendly, here is a link to CME Group’s Fed Funds Dashboard. If you go to the dot plot, the consensus is highlighted in blue. In 2023, it projects a peak at ~3.65%. In 2024, it decreases to ~3.38%. This is the FED pivot, an interest rate cut. Powell’s speech took that off the table so long as inflation is problematic and unemployment is low. 

Earlier, I mentioned that a new low will require a new catalyst. I’m not sure this would be it, but the equity market is not currently priced in for an interest rate environment with FED Funds at or above 4%. If the terminal rate gets priced there, then stocks would slip as money flows from the “riskier” equity market to the short-duration, “risk-free” treasury market with a guaranteed return that is fairly attractive given the uncertain macroenvironment. A hot jobs number could be the first step in raising terminal rate expectations.