Just Do-Over

Later today we will hear from our hapless monetary leader, Jerome Powell who was caught napping last week. Going into the Fed rate announcement, the market had begun to construct a narrative of immaculate deflation, one premised on a soft landing. The second derivative of inflation, having gone negative recently, has been extrapolated by the bulls into a painless slaying of the inflation dragon. The 'Mission Accomplished' attitude is evident in a market now sporting a 19X pe on a falling earnings profile. Powell has completely lost control of the narrative and he knows it. In his press conference, he was cornered by the dovish questions and promptly blinked - implying that a soft landing was actually possible.

The awakening of a long-slumbering adversary - inflation - is throwing the recently adopted playbooks of money management out the window. The usual 'Fed put' that investors have grown used to expecting is likely now gone as the recency-biased Fed gropes blindly to regain a degree of credibility over the run-away risk markets. While last Friday's blow-out jobs numbers are a stern rebuke for the perma-bears, it presents a major problem for the growing cohort of bulls. What if instead of 'landing' the economy does a 'touch-and-go' and begins to briefly expand into the second half of the year? Shouldn't there be a 'Fed call' too?

The complexities of the modern economy are creating a degree of polarization in the economic community as well. They have never seen such a 'job-full recession' before. The structural rigidities of the service economy are a novel problem. Past recessions generated job losses that centered on the goods economy. This economy, built on the inelastic demand function of services, has a much lower transfer coefficient vi-a-vis interest rates. Think factory workers vs restaurant servers, multiply that over an entire economy, and it becomes clear - the Fed is going to have to be tougher than ever.

So maybe not 'higher' rates but certainly, the recent stronger data imply 'for longer' And that message seems to have penetrated the short end of the yield curve as 2-year rates have sharply reversed higher. My long-held view is that a true bull market can only begin after the yield curve returns to 'normal' stands - whichever way that occurs. It follows that the real risk to this market isn't from decelerating earnings and valuation, but from higher long-term bond yields. That could easily come on the slightest rebound in inflation expectations. I'm shorting the long end now on that expectation.

The bond market rally since December has been premised on the fiction that only a hard landing was possible. Now the soft-landing camp is in the ascendancy. There is a narrative change afoot, one that this market seems unprepared for especially the long bond. With Fed cuts begin pushed out in time by the short end, how long before the long-end players give up on their recession fairy tale?

So over to you Mr. Powell. I'm sure you have read the message of the market. Here is your chance for a 'do over'. If he wishes to reset expectations on "higher for longer" he will need to be much more hawkish than he was last week. Fed speakers Bostic & Kashkari have already prefaced that message this week with their negative commentaries. Unfortunately, that message isn't going down well in the market today. They confirmed my suspicions that a resurgence in inflation later this year is a distinct possibility. Today is their chance to say so, otherwise, they risk leaving the job unfinished.

Powell just needs a do-over. Let's see if he's up to the task.

Risk Model: 4/5 - Risk On

The model is 'long' risk mainly as a reflection of the strong consensus around a painless Fed tightening cycle. It doesn't have any ability to test that consensus ex-ante. It tends to succumb to groupthink during strong directional moves. So why use it?

Like a speedometer in a car, you need to know how fast you are going at all times. My car beeps at me when I go over a certain set limit. If the market starts getting ahead of itself, the Model will "beep" at us, but not before we start to exceed the speed limit.

I expect the Model will beep at some point this year. It just seems content to let the lead-footed bulls have their way for now. I'm especially impressed by the low level of implied volatility currently. But like most insurance, you never seem to need it 'til it's too late.