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(Note: The following was written before Chair Powell’s address to the Economic Club of New York. The initial reading of Powell’s comments goes with the points made below.Whew.)

A common theme that pervades the ongoing market conversation involves the concept of “higher for longer.” The phrase implies the Federal Reserve’s intention to keep rates elevated until their 2% inflation target is achieved. But it’s not evident that the Fed has the stomach to raise rates much further – if at all. Thus, the correct way to think about the path of future rates is more likely to be “high for longer,” not “higher for longer.”

Remember the Fed’s dual mandate: price stability and maximum sustainable employment. Considering that we have an unemployment rate of 3.8% and that this morning’s report on Initial Jobless Claims showed 198,000 – well below the 210k consensus and below the lowest survey estimate of 200k – it is fair to say that they have largely achieved the latter portion of their mandate. The former part, inflation, remains a concern. 

To be clear, inflation is far less problematic than it was last year. Disinflation means that inflation rates are slowing. In other words, prices are rising, but not as quickly as before.[i]September CPI showed a 3.7% year-over-year increase, while the core reading was +4.1%. Many economists prefer to annualize the last three months of data, which indicate a 4.8% rise in the headline number and a 3.2% rise in the core. The Fed’s preferred inflation measure, the PCE Core Deflator, showed a rise of 3.7% in September on a year-over-year basis, though it reads 2.1% on a three-month annualized basis. 

It is clear that we are approaching the Fed’s goal of 2% inflation – and in fact, by one measure, we’ve achieved it – and expectations for future rate hikes reflect that. Fed Funds futures imply only an 8% chance for a 25 basis point hike at the upcoming November 1^st FOMC meeting. Going forward, futures imply a 39% chance of a hike by December and a 51% chance by January 2024. After that, the probabilities decline. In other words, we have coin-flip odds that the Fed might hike just once more within the next three months. We’ve either reached peak short-term rates or will be there by January.

Yet we have been saying since March that “peak and pause do not mean pivot”. Just because the Fed stops raising rates does not mean that cuts are imminent. And it finally appears that the markets have gotten that message. Futures don’t imply more than a 50% chance of a cut until July (it’s 89% right now). Chair Powell and his colleagues are students of history. They know about the difficulty in corralling inflation during the 1970’s, and that a good deal of the blame goes to the Fed for reducing rates too quickly for inflationary expectations to be quashed. That explains why even though the various Federal Reserve talking heads are split about raising rates in the short term, their rhetoric about leaning toward restrictive policies is essentially unanimous.

The FOMC has recently acted like a bunch of financial firefighters.[ii]When firefighters declare that a fire is under control, it doesn’t mean that their work is done. They continue fighting the fire until it is out. In the case of inflation, we can say that it is largely contained, if not yet under control. But the FOMC will not declare that the fire is out until they can be reasonably sure. The last thing they want is for stray embers of inflation to reignite, as they did in the ‘70s.

So, what does this mean for markets? The long end of the bond market should have fewer concerns about ongoing inflation, but those have been replaced by worries about future deficits amidst pullbacks in buying from China and Japan. That said, I spoke to some veteran bond investors last night, and they begrudgingly admitted that a 5% long rate may at least be approaching fair value. That was hardly an endorsement, but it was less glum than prior conversations we’ve had. 

But “high for longer” invalidates a key premise that has driven equity investors for years. We all heard about TINA: “There Is No Alternative.”I wrote about it as early as May 2016. The problem is that there IS an alternative. Short-term, risk-free rates, such as Treasury bills and FDIC insured CDs, are yielding 5% or more. Money market accounts are just below that level.[iii] Equity investors often focus on potential returns, but they really should be considering the balance of risk and return. Everyone’s calculus is different, but there is an argument to be made for shifting assets to products that offer a positive real rate of return with little to no volatility from investments with more uncertain outcomes. There is no need to move money into high-yielding cash equivalents if one doesn’t want to, investors have that choice. And if equity returns appear uncertain, it is reasonable to think that more investors will consider cash and cash equivalents to be more appealing.

Quickly circling back to yesterday’s piece about expectations for Tesla (TSLA) earnings, we noted at the time that the options market seemed to be underpricing the potential post-earnings move for TSLA. We wrote:

It is important to note that the stock fell nearly -10% after each of the last two earnings reports in April and July, though it rose by more than 10% in January. It would not be at all surprising if substantial volatility would be once again priced into the market.

Yet it’s not. At-money TSLA options expiring on Friday sport an implied volatility of about 100%, which translates into implied daily moves of about 5%.That seems quite sanguine in light of a sequence of three ~10% moves…

Traders should consider if there is an opportunity present in the relatively low implied volatilities, either by purchasing relatively inexpensive protection or speculation, or using strategies like straddles, strangles, butterflies, or condors if they believe that near-term options offer a value. 

As I type this, TSLA is currently -9.45% lower. The options market indeed underpriced the potential for today’s move. And there was no way that NFLX’s 15% jump was in the cards…

[i] We can think of disinflation as a second derivative of prices. Inflation is the first derivative – the rate of change in prices. If the rate of upward change in prices is slowing – aka disinflation – that’s the second derivative.

[ii] Some might assert that their prior behavior had a role in starting the inflationary fire, and/or stoked it in recent years, but the firefighter analogy holds at present.

[iii] Interactive Brokers is currently offering up to 4.83% on cash balances

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