By: Steve Sosnick Chief Strategist at Interactive Brokers

I think it’s time for me to retire my oft-repeated (ad nauseum?) portrayal of Federal Reserve Chair Jerome Powell as “Goldilocks in a Suit”.The rationale for that moniker came from investors’ remarkable ability to seize upon any of the Chair’s comments that might be interpreted in a dovish manner even if the general tone of his commentary was hawkish. 

Exhibit A was the reaction after the last FOMC meeting on July 27^th. The S&P 500 Index (SPX) rose nearly 5% in the days following his press conference comments that implied monetary policy was in the range of neutral, ignoring his subsequent comments – coming just a few sentences later – about trying to move to a restrictive policy. Traders also ignored the pushback from other senior Fed officials in the immediate aftermath of the meeting. The talk switched away from incipient rate hikes and an increased pace of balance sheet reduction (QT) to when the Fed might pivot back to adding liquidity to the system. 

It became painfully apparent that Mr. Powell no longer wanted to be accused of any ambiguity. In a terse eight-minute speech, he made it abundantly clear that fighting inflation was the Fed’s number one consideration, maybe its only consideration. The written version made that message obvious, and the televised version conveyed a level of seriousness, if not anger, that implied “mark my words – I mean this.”If the Fed’s activities bring about a decline in output, then so be it. Rates will be going higher, the question is by how much and how fast. While there was no explicit mention of QT, there is no reason for anyone listening to doubt the Fed’s commitment to reducing the size of its balance sheet. 

Stock and bond traders clearly took notice. After a brief head fake, stocks sold off broadly and sharply throughout the rest of the day. Tighter monetary conditions and reduced output are not equity-friendly. Treasury bonds sold off at first, but then closed generally unchanged.  Remember that inflation eats away the long-term appeal of a fixed stream of interest payments, so a commitment to fight inflation is good news for bondholders.

But there is one remaining segment of the market that may not have gotten the message. Fed Funds futures are still implying that rates will decline as soon as next spring, as shown by the graph below:

(Click on image to enlarge)

Source: Bloomberg

These futures currently imply about a 75% chance of a ¾% hike at the September 21^st FOMC meeting, and that rates will peak at about 3.75% in March. Subsequent to that, we see rate implications declining, with a full ¼% drop priced in for next June or July. That seems a bit quick since the Fed tends to leave interest rates at a plateau after a period of hikes rather than immediately reverse course. Perhaps Fed Funds futures traders are actually far more pessimistic than others since the best explanation for their pricing regime is that a recession will come so quickly and decisively that the Fed will need to switch back to rate cuts sooner than other traders anticipate.

Yes, Fed Funds futures are pricing in a Fed pivot. But the remaining equity traders who still hope for a Fed pivot should be very careful what they wish for. A policy change that results from a swift, sharp recession is one to be avoided, not applauded. When your choices are inflation or recession, that is hardly an optimal climate for risk assets.

We all know that the story of Goldilocks ends with her being eaten by the three bears. On Friday, Goldilocks in a Suit ended the story by offering the bears a hearty portion of red meat instead.

More By This Author:

Goldilocks: “Stop Doubting My Resolve to Cool the Porridge”
Can “Goldilocks in a Suit” Keep The Bears Away?
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