Will The Fed Pivot By Early November When 'Something Breaks'?

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Vivian Lou Chen of MarketWatch reports the Fed may need to pivot by early November, when ‘something breaks,’ says Guggenheim’s Scott Minerd:

With multiple cracks emerging in global financial markets, the Federal Reserve may be forced to end its aggressive rate hikes “when something breaks” and to pivot by the end of the World Series this fall, said Guggenheim Partners Global Chief Investment Officer Scott Minerd.

In an outlook posted on Guggenheim’s website, Minerd pointed to the past two weeks of interventions by the Bank of Japan to support the yen and by the Bank of England to help the U.K. bond market as a few of the troubling signs. Cracks are also showing up in credit markets, where deals are being abandoned; in an increase of mutual-fund outflows; and in a rising dollar that’s acting like a wrecking ball worldwide, he said. Mortgage-backed securities are under pressure, while implied volatility has risen in bond, stock, currency markets — all of which are exposing the fragilities caused by rapid aggressive rate hikes in the U.S. and around the world.

Data released on Friday only reinforced the likelihood that the Federal Reserve will continue to rapidly raise interests rates to contain the hottest inflation stretch of the past four decades. The U.S. added 263,000 jobs in September, the smallest gain in 17 months, though just enough to keep policy makers on track. Meanwhile, traders are bracing for the consumer-price index report next Thursday to show another 8%-plus annual headline inflation rate for last month.

“My biggest concern is that further tightening will test the fragilities of market plumbing,” Minerd wrote on Thursday.

“We will soon witness how the players perform as market stresses increase as central banks around the world simultaneously remove liquidity at a record pace,” he said. “Events of the last week demonstrate that shadow market participants, many of which are already highly levered, are facing their own margin calls resulting in them unwinding positions just at the moment when they should be providing liquidity and bidding for securities.”

Minerd is best known for outlooks that contain a mostly downbeat tone. A month ago, he said that he expected the S&P 500 SPX to drop 20% by mid-October, given a bear market that remains intact. On Thursday, he wrote that “the end of Fed tightening will come when something breaks and the Fed will have no choice but to reliquefy the system, an event which I would expect before year-end, and most likely before the end of the World Series.” Game 7 of the fall classic is scheduled for Nov. 5.

The likelihood is growing of more black-swan events like the tumult in the U.K. bond market, which “had the potential to spiral into a global financial crisis if not for the quick action of the BoE.” A black swan is defined as an unpredictable development with extreme consequences, and Minerd has pointed to the risks of one emerging since at least 2020.

Investors reacted to Friday’s job report by sending all three major U.S. stock indexes lower, with Dow industrials falling around 400 points in morning trading.

Meanwhile, investors sold off Treasurys, which sent yields higher across the board. The 10-year yield rose 7 basis points to 3.89%. And traders boosted the likelihood of a 75 basis point rate hike by the Fed in November, to almost 82% on Friday from 75% on Thursday — which would take the fed-funds rate target to between 3.75% and 4%, according to the CME FedWatch Tool. They also raised the likelihood of another 75-basis-point hike in December, to 24% — up from 7.4% on Thursday.

In what would be a paradoxical kernel of good news, Minerd said that, in the short run, “a Fed pivot will be good for bonds and risk assets, which are cheap at today’s prices.”

“No one is going to ring a bell when the Fed is forced to pivot. Investors should focus more on value opportunities which abound and stop licking their wounds and trying to pick the bottom,” he said.

Joy Wiltermuth of MarketWatch also reports bond markets facing historic losses grow anxious of Fed that ‘isn’t blinking yet’:

The Federal Reserve has been showing no signs of letting up on aggressive rate hikes, even as its policies fuel carnage for the ages across the roughly $53 trillion U.S. bond market.

The selloff has yields on everything from highly rated corporate debt to riskier mortgage bonds nearing crisis-era levels, while the Fed’s fight against high inflation slams the brakes on the U.S. economy.

As a result, borrowers from the U.S. government to major corporations and home buyers have been paying the most for access to credit in more a decade. The payoff — eventually — should be lower inflation.

But for many bond investors, keeping credit spigots open over the past nine months has meant enduring the sharpest whiplash from rates volatility in their careers, even though the pain still might not be over.

“We are buying some Treasurys, because we are drinking the Kool-Aid in the messaging from the Fed,” said Jack McIntyre, portfolio manager for global fixed-income at Brandywine Global Investment Management, by phone.

The message from central bankers has been a vow to bring the roughly 8% U.S. inflation rate down to the Fed’s 2% annual target, through higher interest rates and a smaller balance sheet, even if it means pain for families and businesses.

“But the timing of that is tough, and how much tightening is required to break inflation,” McIntyre said. “The Fed isn’t blinking. That’s why more pain could be right around the corner.”

Worst selloff in 40 years

The dramatic repricing in bonds this year could give investors a badly needed break after a painful nine months.

Much of the hit to bond prices can be tied to gyrations in rates, including the benchmark 10-year Treasury yield, hich briefly touched 4% in September, its highest since 2010, before swinging lower and rebounding to roughly 3.9% on Friday.

For a fuller picture of the wreckage, the selloff in Treasurys from 2020 through July 2022 was pegged as the worst in 40 years by researchers at the Federal Reserve Bank of New York, but also the third-largest since 1971.

“I don’t think the bond market really knows which direction to go,” said Arvind Narayanan, a senior portfolio manager and co-head of investment-grade credit at Vanguard, by phone. “You are seeing that in daily volatility. The U.S. bond market is not supposed to trade by 20 basis points in a day.”

Volatility in financial markets might feel far removed from everyday life, given the roaring jobs market that the Fed wants to tamp down. Even so, haven sectors like Treasurys have tumbled 12% this year (see chart), while lower-risk segments like corporate bonds were at minus-17% as of Oct. 4, on a total return basis.

To be sure, stocks have tumbled even more, with the S&P 500 index down about 23% on the year through Friday, the Dow Jones Industrial off nearly 19% and the Nasdaq Composite 31% lower, according to FactSet.

Bond yields and prices move in opposite directions. Higher interest rates make bonds issued at low rates less attractive to investors, while rate cuts boost the appeal of bonds offering higher returns.

“If you continue to see stress in the market, and we go into a recession, bonds are most likely set to appreciate and outperform from here,” Narayanan said of investment-grade corporate yields now near 5.6%, or their highest since 2009, but also that “liquidity will remain at a premium.”

Cracks appear

Major corporations and American households appear to be weathering the rate storm that’s washed over financial markets, with both groups borrowing or refinancing during the pandemic at historically low rates.

But an area that looks cloudier, despite a recent uptick in workers reporting to jobs in-person, has been the office component of commercial real estate.

“You just have too much space and the world has changed,” said David Petrosinelli, managing director, sales and trading at InspereX, a broker-dealer.

While trading securitized products, from mortgage bonds to asset backed debt, has been his specialty, Petrosinelli said debt deals across credit markets recently have struggled to cross the line or have been postponed, as issuance conditions have gotten worse.

“I think it’s a tough row to hoe,” he said, specifically of commercial mortgage bonds with heavy exposure to office space, or leverage loans from companies with less tolerance for rate hikes.

“We’ve seen nothing like a deep recession priced into those areas.”

While the Fed isn't blinking yet, Ye Xie of Bloomberg reports that Bill Gross is siding with PIMCO bond bulls in seeing yields peaking:

Bill Gross and his former colleagues at Pacific Investment Management Co. can agree on at least one thing: bonds are attractive now.

Why? Because the market is now pricing in the Federal Reserve’s key borrowing costs will peak at 4.5%. That’s too high, according to Gross, the co-founder of Pimco who was ousted from the bond powerhouse in 2014.

Fed Chair Jerome Powell can’t afford to keep raising rates to slay inflation in the way his predecessor Paul Volcker did in the 1980s, because the US economy is much more leveraged now and global growth is slowing, Gross wrote in his latest outlook. That means the two-year Treasury yield, currently at 4.2%, is too high and rates across the curve have reached a “temporary” peak, he said.

His view is in line with a growing number of investors, including those at Pimco, who are finding value in bonds after the global fixed-income market suffered an unprecedented 19% loss this year.


Earlier this week, Andrew Balls, Pimco’s chief investment officer for global fixed income, and economist Tiffany Wilding said the return potential in the bond market is “compelling” after yields hit multiyear highs. Jeffrey Gundlach, chief investment officer at Doubleline Capital, said late last month that he had been snapping up Treasuries.

While “inflation is the Fed’s seemingly solitary focus at the moment, economic growth and financial stability may soon gain equal measure,” Gross, the 78-year-old former bond king wrote. “Ever-increasing leverage is the culprit. The US and other economies cannot stand many more rate increases.”

Gross co-founded Newport Beach, California-based Pimco in 1971 and rose to the pinnacle of the financial world after building it into a fixed-income behemoth. In 2014, he shocked the financial world by abruptly leaving the firm following clashes with other executives. Five years later, he retired from the asset management business.

He remains active in expressing market views, mainly through the investment outlook published on his website.

On Thursday, Gross said his personal portfolio is “increasingly leaning toward a small percentage of medium-term bonds.”

An inverted yield curve -- when short-term rates rise above longer-term yields -- increases the risk of a downturn because banks will be reluctant to lend, choking off the credit flow, according to Gross. The potential damage from the current inversion, or negative carry, could be bigger than previous recessions because of the higher debt load.

“The longer and wider the negative carry, the deeper the recession,” he wrote.

For investors who are gun-shy after the brutal bond losses this year, Gross advised: buy the iShares TIPS exchange traded fund (TIP), which invests in inflation-linked bonds.

Yields on five-year Treasury Inflation-Protected Securities, or TIPS, reached 2% on Sept. 30, a level last seen in 2008. TIPS not only offer protection against inflation, they also provide the potential for capital appreciation should rates fall, said Gross.

It's Friday, the stronger than expected US jobs report sent rates up and stocks tumbling as traders anticipate the Fed will continue to raise rates aggressively.

The question of a Fed pivot is back in the media and while a black swan event is possible as the Fed raises rates, not everyone is in agreement that a pivot is inevitable.

Earlier this week, Francois Trahan of Trahan Macro Research posted this on LinkedIn:

Can we please stop with the "Fed Pivot 2.0" stories already? The Fed just turned truly hawkish a little over a month ago. This, at a time when the institution's credibility is being questioned. It would be an insane move for them to start changing their tune AGAIN anytime soon. The more likely scenario is that they dig their heels in, like they did with the "inflation is transitory" call but this time in reverse, and stay the course on tightening. At this point, I think it is far more likely that the Fed overtightens policy than pivots early. What do I know?!?

There is a really good article on Bloomberg this morning entitled "Fed Has A Poor Record Forecasting Joblessness Around Downturns". Those of you with access should read it. Makes it pretty clear that overtightening is par for the course for this institution. I suppose the real conclusion if you read between the lines is that forecasting the economy is not the Fed's strong suit!

I dug up this chart from a 2017 paper written by Reifschneider that looked at how accurate economic forecasts were. The author concludes that the economics community overall is not that good at forecasting and neither is the FOMC. Ouch.

There are plenty of reasons why equity prices might move higher at this point but hoping for a Fed Pivot is not it. Bear market rallies are typically fueled by better data ... something very likely in the coming months that could spark a Q4 rally.

We shall see.

FT


Now, I agree with Francois, it would be insane for the Fed to pivot with inflation still running hot, risking its credibility. I also agree with him that the real risk is the Fed will overreact on raising rates as it did with lowering them during the pandemic and keeping them too low for far too long as inflation ramped up. This time around, it might keep them high for far too long.

Having said this, it's going to take a lot more Fed tightening to bring inflation back down to 2% and there are a lot of structural reasons why inflation is so high that have nothing to do with demand (supply chain and other problems).

And that's where Scott Minerd and Bill Gross raise a good point, as rates rise and financial conditions tighten, cracks are appearing and there could be a financial crisis which forces the Fed to pivot.

Nobody knows for sure, all I know is some really smart people at OTPP and HOOPP are buying some long bonds here to hedge their liabilities. 

OTPP's CEO Jo Taylor told Bloomberg this week bonds are getting more appealing:

“What do we think about bonds? Getting more attractive,” Taylor said in an interview from the fund’s Singapore office. “We’ll probably increase our allocation to fixed income a little bit, but we are still lightly allocated compared to what we might have been given the type of plan that we are.”

Bonds are getting appealing for all sorts of reasons, hedging liabilities and hedging exogenous risks.

As far as inflation, on Thursday we will get the September US CPI report and while some people think inflation is going to fall as quickly as it came up and you should buy stocks at peak inflation, we still don't know the longer-term outlook for inflation if a wage spiral develops, something Francois Trahan explained to me after reading that article:

Sure but most of those episodes were commodity related. The only one about core inflation is Volcker in 1979 who felt a wage/inflation spiral was taking hold. Inflation peaked and stocks still sank as the effects of higher rates led to a double-dip recession.

Longer-term consequences of inflation remain to be seen but if the report on Thursday shows some good news on US inflation, traders will bid bonds and risk assets hard. Even if it shows bad news, I think they might buy risk assets like they did on June 14 the day after the US CPI was released and the Nasdaq hit a fresh low of 10,733 (it recently hit a new low on September 30th of 10,572 and closed at 10,652 on Friday):

Will we see another Nasdaq bear market rally back to its 200-day moving average over the next three months? 

That very well could be the next pain trade or something can crack in markets forcing the Fed to pivot and that will be followed by a major rally (not right away).

Either way, next week is shaping out to be an interesting one and while cracks are forming in many markets, don't be surprised if risk assets rally in the final quarter of the year. 

This doesn't mean the bear market is over, far from it, it just means with sentiment being so depressed and investors fleeing to cash like it's 2020, it could be that markets rally in Q4.

We shall see but this week was another volatile one and people are understandably nervous about what is going on in the stock and bond markets.

Speaking of volatility, the VIX index hit 31.4 today, rising but it didn't make a 52-week high like it did on January 24th (39) and is below the level it hit on June 13th (35), which is sort of good news (fear index might be peaking):


Anyway, wish all Canadians a nice long Thanksgiving weekend, take some time to rest this weekend. 

Below, Scott Minerd, Guggenheim Partners global chief investment officer, joins 'Closing Bell: Overtime' to discuss the Fed, inflation and markets.

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