Powell May Not Know It Yet, But The Fed Is Now Trapped

In other words, traders - who hold the market hostage (as Powell first discovered back in 2013) - force the Fed’s hand, a conclusion supported by the surprisingly short lag time of the Fed reaction function. Indeed, as shown in the chart below, it usually takes 1 month on average - and no longer than three months - between the first 20% drop and an appropriate Fed reaction. Then, once the Fed gives in and cuts, it takes at most 4 months for equities to find a bottom, as the economic backdrop and Fed are supportive. This story seems to fit fairly well with the current environment: i.e. the Fed hiked in December, and then the equity market fell 20%. Meanwhile, current economic conditions remain relatively robust, and in line with previous slowdowns (and stronger than prior recessions), so the logical next step is that the Fed flinches – they have always in the past after all.

(Click on image to enlarge)

The obvious problem is that the Fed is cutting because the economy is indeed entering a recession, even as market have already rebounded by over 10% from the recent "bear market" low, effectively cutting the drop in half expecting the Fed to react precisely to this drop, while ignoring the potential underlying economic reality (the one noted above by the bizarrely low neutral rate, suggesting that the US economy is far weaker than most expect).

Ultimately, what this all boils down to is whether the economy is entering a recession, and - some reflexively - whether the suddenly dovish Fed, trapped by the market, has started a chain of events that inevitably ends with a recession. The historical record is ambivalent: as Bloomberg notes, similar to 1998 and 1987, the S&P fell into a bear market last month (from which it immediately rebounded) following a Fed rate hike. The difference is that in the previous two periods, the Fed cut rates in response to market crises - the collapse of Long-Term Capital Management in 1998 and the Black Monday stock crash in 1987 - without the economy slipping into a recession. In comparison, the meltdown in December occurred without a similar market event.

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