Words of Dove

Don't do as I do, but as I say. That seems to be the takeaway from the Fed's post-decision press conference in which Chair Powell was backed into a corner by a flock of doves and basically caved. The expected quarter-point rate hike and the higher-for-longer rhetoric in the statement were quickly forgotten as he anointed the soft landing scenario as 'still a possibility". By mistakenly stating that financial conditions had tightened since the last meeting, he destroyed what tattered remnants of credibility he may have enjoyed. You can see by the market's reaction that nobody believes him anymore when he tries to pretend to be an inflation-fighting hawk. Talk is cheap, and this guy is as low-rent as it gets.

So the last bastion of hope for the bears has washed away in a broad-based rally in virtually every risk asset on the planet. And for the bulls, if it wasn't for good news, there'd be no news at all. Supported by growing conviction, fund flows out of the money markets, full to the brim, are tipping the scales in favour of the bull case as investors continue to reposition portfolios in a more aggressive stance. Market behemoths like Tesla and Meta, have cost cut their way to earnings beats that are 'better than feared'. And market technicians are now cheerleading the rally as breadth and volume have confirmed the regaining of 200-day moving averages by the S&P 500.

So having missed out on the rally (or been forced to cover their shorts) pessimists are throwing in the towel. But when the consensus is so wrong that's what you get. Late last year, the threats from the impending economic deceleration and universal acceptance of the inevitability of a recession forced the herd into an extreme level of bearish sentiment and under-investment. Look no further than the suddenly weaker U.S. dollar for confirmation of the effects of positioning on short-term market movements. Last year, when everyone was long the Greenback, there were no marginal buyers left, and an abrupt inflection was inevitable. Score another one for the bulls.

US Dollar & Net Speculative Positioning

So the mother of all short-covering rallies has been extended by the growing conviction of a less-threatening dovish Powell who is hostage to a market he can't control. With ample support from a structurally tight labour market, soft-landing fans continue to push the Fed into a corner. They are now pricing in an immaculate disinflation and a soft landing for employment. That's as likely as a first-round playoff win by the Toronto Maple Leafs, but hope springs eternal. (Just reflect on last night's Boston debacle as an ominous preview).

All that's left is for the jobs data to turn suddenly lower. That's how it should work in the 'lead-lag' models of economic reaction to monetary policy tightening. But the lag has extended into a second year. Tight labour markets are mostly to blame, but you can add stronger-than-normal savings courtesy of Covid relief to the pot as well. So play this rally carefully. If we start to extend the weakness seen in this month's ISM data to the labour markets, many of today's emboldened bulls will scurry back into their corners like cockroaches under a light. Tomorrow will see the release of critical payroll labour data that could, if still strong like today's weekly jobless claims, extend the rally. But that would be whistling past the graveyard in my view.

ISM

Markets seem comfortable rallying because monetary tightening hasn't shown any degree of success in slowing the service economy. It remains to the goods sector to continue to ratchet down the inflation threat that was unleashed by a Fed that stayed too late to the risk-on party of 2020-21. Maybe that part of the inflation story was "transitory" after all.

But the bounce in the used car prices and housing markets this month is showing a degree of support for the soft landing case. Currently, the yield curve is expecting no more than 2-2.5% for inflation and a 100 basis point real yield. That may seem like a good bet when commodities are declining but have you seen Lumber lately? (below) Can Gasoline be far behind, once the weak seasonality is over? Maybe terminal rate expectations are too low, as they overstate the effect of the drop in goods prices on long-term inflation expectations. Commodities often rally into Q2 economic seasonal strength, so watch for a revenge rally from the bond vigilantes.

Lumber

For now, I suggest clipping a few day trades if that is your bag. But the current rally, prompted by short-covering and over-sold bounces in low-quality stocks, could quickly dissipate. Stronger than expected data generated by the soft-landing scenario could roil the bond markets thereby challenging the Goldilocks view now embedded in sub-4% ten-year yields. Conversely, weaker employment data, likely by the second half of the year, will dampen any earnings optimism that remains, leading to weaker stocks. Either way, this year is looking like a sideways trader's market.

But I'm guessing those are not the 'words of dove' you wanted to hear.

Risk Model: 3/5 - Risk On

The low levels of volatility, positive seasonality of fund flows, and the bombed-out sentiment starting point have conspired to crush the bears so far this year. But is that all we need to create a durable backdrop of support for risk assets? Not when the conundrum of a bond market priced for perfection on the inflation front meets up with a stock market priced for a soft landing that has yet to arrive. But that's the hand we are now being dealt.

My much-maligned model has had it right so far this year and is hanging on by a thread in a bullish tilted posture so far. Maybe this is a year to ignore the macro and just trade the micro? Like a good baseball coach, my advice is to hit 'em where they ain't. All the junkiest stocks are performing the best as the year-end window-dressing of '22 fades into history. When there is too much money lying around the urge to spend it is sometimes greater than you want to believe. It's still there! (see chart below)

Last year the economy did better than the stock market by only slightly decelerating. This year, despite all the economic threats but with gobs of unrisked cash, it seems that it could be the other way around!

Money Market Assets