Hey There Income Hunter,

 

The hawkish Fed message has been delivered by everyone but Jerome Powell.

 

Will J-Pow now step up to the podium and attempt to convince the markets he is the true mini-me to Paul Volker?

 

The most recent message was communicated by Kansas City Fed president Esther George, who said this earlier in the week …

 

“It’s very important that we are clear in our communication about the destination we are headed. We have to get interest rates higher to slow down demand and bring inflation back to our target.“

 

George even went as far as to say …

 

“We want financial conditions to tighten along with the direction we are moving around policy.”

 

However, the market continues to call the Fed’s bluff.

 

The Fed presidents continue to bang the drum on tightening financial conditions but the stock market rally has eased conditions considerably… 

 

 In fact, since the start of July, despite all the hawkish FedSpeak, financial conditions have eased dramatically as traders priced in the “Fed Pivot.”

 

Today, we will look at the data showing easing conditions and what expectations the markets have currently priced in for Powell’s Jackson Hole speech.

 

The Bloomberg Financial Conditions Index (BFCI)

 

The Factors behind the BFCI  include:

 

1. US Ted spread measures the difference between the London interbank borrowing rate (Libor) and US T-bill rate. This is a signpost for bank financial conditions versus the “risk-free” government guaranteed rate of interest. If the economy is under real stress, money will be parked in US T-Bills and a widening of this spread will indicate that. 

 

 2. Libor/OIS spread measures the cost of lending/borrowing with an exchange of money, while the swap rate (OIS) is simply an exchange of risk via derivatives, without any exchange of money. When Libor rates widen to OIS, that is a warning that the cash lend/borrow markets are freezing up and there is extreme financial stress in the system.

 

​3. Commercial paper/T-bills spread (difference in credit spreads between corporate and government borrowing and lending from one to 12 months. When conditions reach extreme levels of stress, few investors are interested in corporate credit risk, even short term maturities.

 

4. US High Yield/10Y Treasury spread measures the long-term credit spread between US Treasuries bonds and US high-yield credit.

 

5. US Muni/10Y Treasury spread measuring the long term credit premium between US municipal bonds and US treasuries

 

6. Real Volatility on nterest rate swap options gauges fear or calm in rates markets. 

 

7. S&P 500 (SPX) stock market level reveals investor confidence in financial markets via equity market pricing.  

 

8. VIX real option volatility on SPX gauges investor sentiment that ranges from fear to greed and has recently moved from extreme fear to market neutral position. 

 

The BFCI is an excellent measure of stress in the system and the graph below illustrates that financial conditions (BFCI) are back to levels of ease prior to Fed hiking rates (right scale inverted).

 

 

This confirms that the markets, anticipating a pause in the Fed tightening trend …

 

It is now Powell’s move and if he doesn’t convince the market otherwise, the Fed may lose the progress they have made on inflation and we could see another rise in the months ahead. 

 

Bring It Home

 

Will Powell successfully deliver a speech that is hawkish enough to convince the market he will “do what it takes” to break the back of the stock market?

 

This is a scenario where inflation stress could be prolonged indefinitely if Powell does not accentuate a tightening policy. 

 

Powell must focus on inflation and etch his commitment to follow through until we see a much lower inflation rate in the core CPI in the months ahead. 

 

What he needs to do is increase the target for the terminal Fed funds rate expectations …

 

If he does that, he can avoid an even further easing of financial conditions and remove the risks of a renewed breakout of inflation. … I believe he can do that and still have wiggle room to maneuver if needed because:

 

• He still has next month’s CPI & jobs data to review
• He will likely acknowledge that there may be rising recession risk, while still talking about the need to stay the course on inflation.
• He may already have weak core PCI inflation data and personal spending and income data in-hand, which could continue to support the “past peak inflation” bullish input for stocks. 

If he fails to instill extreme hawkishness, look for stock prices and long-term interest rates to rise. If he is convincing and equity sellers emerge, we could see SPX trend lower towards 4100 and possibly 4000 is the weeks ahead. 

 

Stay tuned for an alert on the important points from his speech and opportunities I see in the markets over the next couple of weeks.   

 

Live and Trade With Passion My Friend,

Griff