Federal Reserve Chair Jerome Powell speaking at Jackson Hole on Friday sought to put a scare in markets, which had been trying to teleport to a moment some months from now when interest rates would peak without serious damage done to stocks or the economy. In placing investors and the public on notice that the fight against inflation remains single-minded, would involve “pain,” and not end until price trends fall toward the Fed’s 2% target, Powell essentially sought to keep the wall of worry standing high and straight. With its 3% tumble on Friday, the S & P 500 quickly cooperated, with traders’ reflex response conveying a sense of concern that, to Powell, a recession might be the prescribed medicine for inflation and not merely an unfortunate side effect. Crude tools This, at least, is the simplest account of the interplay between a blunt Fed chair brandishing the central bank’s crude policy tools, a market already in pullback mode after a roaring rally, a late-summer Friday session and a still-skittish investment community. Still, it helps to fill in the context of the market’s field position, already-subdued investor sentiment, the message from other markets and some helpful trends in inflation indicators apparently underway. A 3% index drop immediately following a purposeful effort by the Fed to tighten up financial conditions that had recently slackened is not to be dismissed as a mere technical, low-volume August air pocket. The drop sliced through the prior August low in the S & P 500 near 4080, also a 20-day low, often used by traders as a level that should hold if a short-term rally is to be trusted. And Bespoke Investment Group notes that over the past 70 years when a 3% S & P 500 loss has occurred on a Friday, the following trading day has seen an average of a 1.5% decline. Yet from a birds eye view, the market could merely be undergoing a typical setback to consolidate the near-19% two-month rally from the intraday June 16 low to the mid-August high. The S & P 500 has slid 6% from that recent peak, retaining more than half the ground picked up in the rally, though with little more than a 1% cushion above its 50-day average level. The retreat hasn’t undone what some observers view as important and relatively rare momentum signals that were triggered in the broad, forceful run higher through July, which in the past have foretold positive returns for the indexes in ensuing months. Veteran technical strategist Jeff deGraaf of Renaissance Macro Research has been placing a lot of weight on these momentum indicators, despite the lack of a more persuasive fundamental case for significant upside. Writing the day before Friday’s selloff, he noted such a muddled outlook isn’t unusual at such moments: “Evidence of one of the most hated rallies in recollection is apparent in [heavily net short] S & P futures positioning, and frankly we don’t blame them. Bull markets start with an incredulity, and as price moves higher, a narrative germinates, and as trends establish themselves the narrative grows roots and becomes the dominant theme.” Whether such a story takes hold soon, before the June low (down 10% from here) is tested is unknown, though it suggests that low would not give way too easily without a serious further macro shock. The tape or the Fed The impressive technical action since June leaves Canaccord Genuity strategist Tony Dwyer caught between the two revered Wall Street maxims attributed to celebrated investor Marty Zweig: “Don’t fight the tape” and “Don’t fight the Fed.” The tape, as noted, has sent a positive message. The Fed, though, is decidedly hostile, vowing to lift rates into the “restrictive” zone and keep them there a good long while, into an economy that’s slowing, or stalling, or possibly shrinking in real terms – never mind the fractured housing market or inverted Treasury yield curves. To Dwyer, it’s a formula for a market capped not far from the recent highs even if it would become pretty attractive again near the mid-June depths. On the notion that it was a “hated” rally, it’s clear, at least, that investors never set aside their anxieties. The American Association of Individual Investors poll has, for 21 straight weeks, turned up more folks saying they’re bearish on stocks for the next six months than are bullish. Another such week and it will become the second-longest streak of its kind since 1987. The National Association of Active Investment Managers has its own weekly survey of professional tactical investors’ equity exposure, which ticked lower from neutral levels days before Friday’s swoon. In a down-trending market such as this one, with monetary-policy headwinds, sour sentiment is not itself a reason to buck the crowd and binge on risky assets. But this also shows it probably wouldn’t take much more market weakness or Fed growling to get pessimism to contrarian extremes again. Perhaps it’s notable that the bond market Friday hardly moved at all, traders seeing no need to reprice rates in response to Powell, having already pushed yields higher over the prior two weeks to add back the expected rate hikes that Powell essentially promised in his Friday speech. This could mean stocks are once again acting like the tag-along asset class, more prone to overshooting and perhaps in the sway of systematic, trend-following funds that Goldman Sachs warned would become net sellers in response to certain index levels, volatility readings and ahead of likely month-end rebalancing out of equities by asset allocation strategies. Bonds also might have been incorporating the barely noticed drop in core PCE inflation in Friday’s official consumption data and the further decline in University of Michigan survey inflation expectations. The reality is, Powell almost has to talk tough about “higher rates for longer” whether that’s the likely future path or not, so that markets don’t get too giddy and work against his tightening efforts. And the bond market reflects the range of outcomes after a bit more hiking of rates in coming months. Fed earning back credibility Blackrock chief investment officer Rick Rieder reacted to Powell’s remarks by noting that the Fed has clearly already earned back its credibility, as evidenced by market-based inflation expectations retreating toward long-term “normal” levels below 3%. This should enable the Fed to “Hurry up and wait,” he says, with another sizable hike, perhaps one or two more smaller ones, bringing the policy rate into the restrictive zone, after which “the Fed will have a chance to relax at a historically higher Fed Funds rate for a longer period of time.” It might be hard to buy into the idea that a chance to relax could soon follow days like Friday, but eventually tension releases and pain subsides.
