Friday’s Silly Rally

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Looking at last Friday’s rally … what we learned and didn’t learn … diagnosing the real source of recent bullishness … the problem for the Fed if it does pivot

Friday’s rally was, well…silly.But it was also very telling.As we reported in the Digest on Friday, stocks surged based on an article from The Wall Street Journal suggesting some Fed officials are growing cautious on the pace and size of coming rate-hikes.From that WSJ article:

Some officials have begun signaling their desire both to slow down the pace of increases soon and to stop raising rates early next year to see how their moves this year are slowing the economy.They want to reduce the risk of causing an unnecessarily sharp slowdown.

This article led to bullish headlines and articles last Friday, such as the following from MarketWatch:

Dow up over 200 points as traders weigh Fed rate-hike outlook after WSJ reportStocks reversed early losses and were holding on to gains Friday morning, with traders attributing the move in part to The Wall Street Journal report early Friday that said Fed policy makers were hurtling toward a 75 basis point rate rise in November but that a smaller December increase might be up for debate.

And here’s CNBC’s take:

Image from CNBC showing the Dow rising based on the potential for a Fed pivot
Source: CNBC

Now, two things can be true at once…Yes, the Fed might, in fact, slow its rate-hikes in December or early 2023…And…Friday’s market rally, based on this WSJ article about a possible rate-hike slowdown, was classic Wall Street silliness.

What new information did we get from this WSJ article on Friday?

None.There’s the paragraph we quoted a moment ago, referencing some officials signaling their desire to slow things down. Okay, we’ve known that. In recent weeks, we’ve seen quotes from a few Fed members who aren’t as hawkish as others.What else?Sorry, that’s it (barring some conjecture which we’ll get to).The article goes on to rehash comments from these slightly-more-dovish Fed members, but that’s all.

For example:Meanwhile, Fed Vice Chairwoman Lael Brainard and some other officials have recently hinted at unease with raising rates by 0.75 point beyond next month’s meeting.In a speech on Oct. 10, Ms. Brainard laid out a case for pausing rate rises at some point, noting how they influence the economy over time.Other colleagues are concerned about the danger of raising rates too high.Chicago Fed President Charles Evans told reporters on Oct. 10 he was worried about assumptions that the Fed could just cut rates if it decided they were too high. Promptly lowering rates is always easier in theory than in practice, he said…“I worry that if the way you judge it is, ‘Oh, another bad inflation report—it must be that we need more [rate hikes],’… that puts us at somewhat greater risk of responding overly aggressive,” he said.

Did you notice those dates?Two weeks ago.The article also references Kansas City Fed President Esther George saying she favors moving “steadier and slower” on rate increases. That quote is from October 14th.All this information is old news.However, upon the WSJ repackaging, the market rallied like it was hot off the wire last Friday.What was even more astonishing was the impact on the CME Group’s FedWatch Tool.Last Thursday, the odds of the target rate in December reflecting two different 75-basis-point increases (one in November, one in December) stood at 75.4%.But on Friday, after the WSJ article?It plummeted to 45.4%.Really?Based on two-week-old recycled news?

So, what is this really telling us?

Well, let’s start with a different question.If these dovish quotes were old news, what was a newer piece of commentary from a Fed member?Well, last Thursday, Minneapolis Fed President Neel Kashkari said:

Core services inflation – which is the stickiest of all – keeps climbing, and we keep getting surprised on the upside.If we don’t see progress in underlying inflation, or core inflation, I don’t see why I would advocate stopping at 4.5, or 4.75, or something like that.

That’s quite hawkish. But the market wants to climb so badly that it ignored Kashkari (while also ignoring the 10-year Treasury yield soaring to its highest level since 2007, mind you), and instead, rallied on stale quotes from 14 days ago.So, what is this really telling us?Just how powerful a sentiment reversal rally can be.From our Digest one week ago:

…We find ourselves in a market that’s ripe for a raging sentiment reversal rally. And we might be watching it start right now.Sometimes, all it takes for this to happen is for news to go from “awful” to “slightly less awful.” That’s because after what feels like an eternity of market drudgery, that faintest whiff of slightly better news produces a fierce hope… that sparks a turn… that blossoms into a full-blown market surge……We might be starting a whopper of a relief rally that could see the market surge 10% – 12% over the coming weeks.

The Fed doesn’t want a whopper of a sentiment reversal rally

Why?The Wealth Effect.This theory from behavioral economics suggests people spend more money as the value of their assets rise.This spending confidence happens even if income doesn’t actually increase one penny. If people feel richer – even if those gains are unrealized – they spend more.And what’s one of the surest ways for people to feel richer?Rising portfolio values.The research paper “Stock Market Wealth and the Real Economy: A Local Labor Market Approach” finds that for every dollar of increased stock-market wealth, consumer spending rises by 3.2 cents per year.You can see where this is going…Surging portfolio values will lead to more consumer confidence and spending. And more spending will only aggravate our already-stubborn inflation. That is not what Fed Chairman Jerome Powell wants.Let’s return to the WSJ article from earlier to describe the Fed’s challenge, if, in fact, it’s ready to soften its rate-hike size:

Markets rallied in July and August on expectations that the Fed might slow rate rises. That conflicted with the central bank’s goals because easier financial conditions stimulate spending and economic growth…If officials are entertaining a half-point rate rise in December, they would want to prepare investors for that decision in the weeks after their Nov. 1-2 meeting without prompting another sustained rally.

That’s going to be tough to do.Wall Street breathlessly awaits the “Fed Pivot.” For many investors, its arrival marks the starting gun for the next great bull market. Scratch that – even the rumor of its arrival is the starting gun.You would think Wall Street would have a better poker face in all of this. But the idea of a Fed pivot makes Wall Street as giddy as a child on Christmas morning. Ironically, that giddiness could, in fact, be a reason that Powell & Co. drag their heels.However, the WSJ article offers a roadmap for how the Fed might have its cake and eat it too:

One possible solution would be for Fed officials to approve a half-point increase in December, while using their new economic projections to show they might lift rates somewhat higher in 2023 than they projected last month.

These hopes are misguided. If Wall Street gets a 50-basis-point hike, the party is on, despite whatever “signaling” the Fed tries to send through the Dot Plot.

Is the Fed pulling an “Inception” move on us with this WSJ article?

You may recall the film, Inception, in which Leonardo DiCaprio is tasked with planting an idea in someone’s mind.Well, what if last Friday’s WSJ article was written with behind-the-scenes, leaked influence from the Fed, intended to prepare investors for a softer rate-hike stance?Cue the swell of dramatic music…Here’s the WSJ article potentially going full DiCaprio:

…Do [Fed members] raise rates by a smaller half-point increment in December?And if so, how do they explain to the public that they aren’t backing down in their fight to prevent inflation from becoming entrenched?

Let’s repeat this nugget while we’re at it:

If officials are entertaining a half-point rate rise in December, they would want to prepare investors for that decision in the weeks after their Nov. 1-2 meeting without prompting another sustained rally.

Whoops.Last Friday, all three indexes soared more than 2% based on this article, and the gains are continuing as I write on Monday. Plus, it feels as though there’s a new bullish mood wanting to take hold.All of this suggests one thing:If we’re getting DiCaprio’d, the Fed is going to have a difficult time tamping down the resulting relief rally.At the end of the day, Wall Street’s tone is changing – regardless of the recent core inflation data.And while Friday’s rally based on no new information was silliness, there’s nothing silly about a real shift in sentiment when Wall Street turns bullish. It can lead to huge market gains in short order, even if the fundamental data aren’t yet supportive of such gains.I guess all we can say about yet another conversation about a Fed Pivot is that hope springs eternal.Have a good evening,Jeff Remsburg


Article printed from InvestorPlace Media, https://investorplace.com/2022/10/fridays-silly-rally/.

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