On the surface, investors would appear to have only themselves to blame for this whipsaw, given the sharp contrast between their romancing, yet again, the idea of a Federal Reserve “pivot” and what, for once, has been consistent messaging from central bank officials that no such policy change is in the offing. Below the surface, however, the situation gets more complicated.
The hope early last week for a Fed pivot was born of three developments. First, Australia’s central bank increased rates less than the consensus forecast; second, the Institute for Supply Management’s measure of US manufacturing activity came in weaker than expected; and third, investors extrapolated from the Bank of England’s emergency market intervention to avoid a potential “meltdown” — to use the word from the deputy governor’s explanatory letter to Parliament — to conclude that financial stability concerns would add to recession worries in getting the Fed off what, at least for now, is the most front-loaded rate-increase cycle in recent history.
By the end of the week, all these hopes had been dashed, mainly both by consistent statements from several Fed officials and by a monthly unemployment report that was widely interpreted as consistent with yet another big rate increase at the next FOMC meeting in early November (a record for successive 75-basis-point increases). It also did not help that the OPEC+ decision to cut output by 2 million barrels a day pushed oil prices back above $90 a barrel.
Once again, investors and traders experienced that awful trifecta of disappointing returns, unsettling volatility and the positive correlation between risk-free and riskier assets that robs investment portfolios of their ability to mitigate risk by diversifying between stocks and bonds.
In the past, such a “pivot whipsaw” would normally have been due to some off-the-cuff dovish comment by Fed Chair Jerome Powell that suggested a replay of his big U-turn in the middle of the market volatility of the fourth quarter of 2018 — that is, the notion that the long-standing Fed “put” was back in the money.
Not this time. All Fed speakers, and there were many, reinforced Powell’s latest narrative that the policy battle against inflation is “unconditional” and that the Fed “would keep at it.” There was no hint of any backtracking.
This time around, the explanation goes beyond inconsistent Fed communication. The following is worth considering.
Perhaps investors do not need the hint of a Fed signal to front-run what they think is a coming pivot. It is enough to search for developments that would force such a pivot, even if they come from overseas. After all, it is a strategy that reinforced the BTD/TINA/FOMO conditioning that was previously incredibly powerful in pushing asset prices ever higher (that is the Buy the Dip as There Is No Alternative, especially given the Fear of Missing Out on another price rally).
Maybe some investors have not yet sufficiently internalized that high and persistent inflation prevents a credibility-damaged Fed that is also heavily data-dependent from a preemptive pivot; and that this inflation is associated with longer-lasting structural changes. Instead, the world’s most powerful central bank would need strong evidence that core inflation is coming down and that the broadening of its drivers is reversed.
The alternative — a pivot caused by a sudden economic or market accident (or both) — is not conducive to buying assets ahead of a policy change. It would be a similar situation if inflation were to come down because the Fed tipped the US economy into a damaging recession.
Last week is not the first time some market participants have suddenly foreseen an early change in Fed tightening policy. It is, however, notable that they did so with no hint whatsoever from central bank officials.
I suspect that it was years of prior Fed conditioning, together with insufficient appreciation of the underlying structural changes, that made keen and inherently optimistic investors jump back into what turned out to be yet another ill-fated — and, this time, very brief — pivot romance. It is a reminder that conviction without sufficient foundation can often prove problematic as an investment approach.