The longed-for Fed pivot may come quicker than expected — especially after this week’s very soft inflation data — but equities still face more downside if hopes for easier monetary conditions clash with the rising risk of a recession.
The Fed’s battle with inflation this year has pitched the stock market into one its most bearish cycles in decades. The expectation — or hope — is that once the Fed takes its foot off the brake, stocks will cast off their shackles and new a bull market will take flight.
“Then the kingdom of heaven shall be likened to ten virgins who took their lamps and went out to meet the bridegroom. Now five of them were wise, and five were foolish.” Mat. 25:1-2
Central-bank rhetoric has begun to soften, the midterms are now behind us, and market expectations of where the Fed rate will peak now consistently exceed the high-point implied by its so-called “dot plot” projections. With the market now helping, not hindering, the Fed in its monetary objectives, the central bank shouldn’t have to keep sharpening its talons for much longer.
On top of that, the Fed pivot could come much sooner than most expect. The median length of time between the peak in inflation and the first rate cut is 22 weeks, according to US hiking cycles going back to 1972. June’s CPI print likely marks this cycle’s peak in headline inflation which, historically speaking, would put the first cut in as little as four to eight weeks.
This is not a prediction. But it does highlight how a Fed reversal could happen more quickly than the market expects. Either way, equity investors should treat it as the false dawn it is.
Firstly, financial conditions continue tightening for about five quarters after the first Fed hike. In the current cycle this would take us until the second half of 2023. Secondly, there’s a still greater squeeze in liquidity to come. The Global Real Policy Rate is still extremely negative and close to the all-time lows of -6% it reached in 1974, before it rose all the way to +3% by the early 1980s. Today it is at -4.4%, barely above its -5.6% nadir.
Overall, global financial conditions, as measured by the Global Financial Tightness Indicator, remain very restrictive, with no respite on the horizon. This will remain a poor environment for equities and other risk assets.
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