Powell’s Plan Has A Blind Spot And It Means Market Violence

Authored by Oliver Renick via LinkedIn,

There is a logical blind spot in the Fed’s framework that will create forced selling of bonds even without changes to the Fed’s balance sheet or stated hiking plans. It stems from the notion that without a defined counteracting force to inflation, the risk/reward of holding bonds when growth is trending as it is now is so skewed towards selling that it’s likely to create severe spikes in yields until some equilibrium is reached, likely through yield-curve control.

Here’s what I see.

The central bank has told us they’re not going to fight inflation until it runs at their target for some undefined period of time. So policymakers have unprecedented free reign to throw everything they can at the economy to get it going. That means that if there is some theoretical way to generate upward price pressure greater than the deflationary forces of demographics and technology, we are going to find it. You don’t have to have some strong view on the economy to see this. It’s a Murphy’s Law-type principle that over a long enough time horizon, if it’s possible, it will happen. As Ian Malcolm says in Jurassic Park, life will find a way. So will inflation. Whether it’s this year, next, in 5 or 100, the Fed has promised it won’t get in the way until we find it. So we can be absolutely certain we will find it.

And there’s the glitch. Markets are not supposed to have absolute certainty.

By telegraphing its plan to let inflation run past the 2% target, the Fed has given investors exploitable asymmetric knowledge by reducing the number of actions it can possibly take by eliminating the possibility of a hike until sustained inflation. By turning a defined barrier into a flexible one, the economy and the market will naturally discover the limit of that flexibility.

An analogy: if a kid knows his parent will ground him if he curses more than five times a day, he’ll stop cursing at four. But if they say they’ll ground him after a certain number of curse words between five and ten, and the kid likes to curse, he’s naturally going to figure out where the grounding threshold is, i.e., he’ll go until he gets slapped. Bonds will not stop selling until they find out where they make daddy Powell uncomfortable.

Perhaps more attuned to markets, think about it through poker. If I know the most important player at the table doesn’t play a certain hand, I’m going to make above my expected value because I have information I’m not supposed to. It changes the game in a way that I can manipulate. The most important player in the bond market is the Fed, and because investors know Powell’s hands are tied, they can exploit this knowledge by selling their bonds in advance of the inflation that we can assume to be inevitable. Why buy a bond now if I know it’s going to be cheaper later on? Maybe if I like the income, but, 1.5% ain’t too hot. So we’re unlikely to reach a natural equilibrium anytime soon.

The mistake I see investors making right now is connecting the long bond with the Fed’s commitment to low rates. The most common thing I hear from guests is “yields won’t rise too much because Powell isn’t hiking.” Yet long-term yields literally bottomed this summer as Powell unveiled his plan! And now they’re spiking without any hot inflation prints — just expectations and improving economic data. It’s quite clear that the market will determine rates outside of the Fed’s overnight purview.

I joked today that the only thing that may calm the stock market’s response to rates is if Jay Powell talks about hiking. It’s actually not even that crazy. The ascent in yields will be relentless under average inflation targeting because it removes the counteracting force (hikes) that would otherwise slow the economy. So when the time comes and the Fed talks hikes, yields will finally slow their ascent as investors process the notion of hikes slowing down the economy.

If it sounds backwards, it’s because it is. It’s been that way since the Fed caved to investors and reversed course in December 2018, not because of any issues with the economy (loosest financial conditions for rate cuts ever in 2019), but because markets and the President pressured Powell to do so. That skewed the risk/reward too far in favor of buying bonds for investors not to do so. If the economy is bad, the Fed cuts; if economy is good, Fed cuts anyway. We then had a year-long period of falling ten-year yields despite rising inflation, and it’s been upside down ever since. There’s no reason not to expect the same speed to the downside as we got on the upside.

I’m not saying the Fed is doing a poor job today; it’s clear we needed to boost our economy and not fretting over inflation seems like an OK approach in this snapshot of time. But the price investors pay will be unprecedented bond volatility, and that’ll likely hurt the stock market by transition. There is no magic wand of words Jay Powell can use to stop bonds from trading with inflationary prospects, in fact it seems like the more dovish he gets, the harder bonds drop (which makes total sense according to my thesis). If he wants to stop yields from spiking in a way that disrupts the market, it’s going to take another wall of money and he’s going to have to buy the bonds himself. Maybe Powell knows this and it’s not a blind spot. Maybe he plans on yield-curve control after all.

Bottom line: policymakers are playing with matches and Thursday is an example of what happens when investors smell smoke. Yes, growth and recovery are driving the direction of yields, but the severity of the moves will in part be due to inefficient market dynamics fostered by the Fed since 2018.