Until Something Breaks

On several occasions this year I’ve reasoned that the strike price on the Fed put has been lowered and that the active option is now a Fed call:

The Fed May Actively Seek To Deflate Asset Prices

Powell Pummels Prices

Fed Outlook Update

The Fed Pivot Fallacy

An article in the Wall Street Journal reinforces this point as explicitly as I’ve seen.

“Fed officials want higher borrowing costs and lower asset prices to slow economic activity by curbing spending, hiring and investment. They expect that to reduce demand and lower inflation over time.”

The author, Nick Timiraos, is the WSJ’s Fed correspondent and widely seen as one the Fed has on speed dial when it has something to say to the financial markets. Timiraos goes on to suggest one of the concerns leading the FOMC to resist even reducing the size of a putative December rate hike is that it might spark a rally in stock prices. In short, the Fed doesn’t want stock prices to rise, and likely wants them to decline more before entertaining even a first layer of “pivot”.

Until then, the directional pressure on the rates and the dollar is up, and consequently the directional pressure on prices for virtually every other asset is down in dollar terms. US stocks may be the the most front and center in the Fed’s spotlight, and arguably the most vulnerable both in terms of valuation and sensitivity to the pace of the economy, but monetary policy is not a precision targeting instrument. So the fondness for a heathy allocation to cash I first expressed back in January and reiterated several times since continues to hold.

Another facet worth bearing in mind is how the Fed’s reaction function is impacting the relationship between stocks and bonds. Realizing that consumer prices and wages are lagging indicators, the Fed is using stock prices as a leading proxy. Rising stock prices therefore put more upward pressure on the trajectory of policy rates and correspondingly upward pressure on bond yields and downward pressure on bond prices. Although I expect bond prices to reverse to the upside sometime soon, that seems unlikely to happen until stock prices undergo another meaningful leg to the downside. 4.5% on the ten year is not at all out of the question.

I do want to reiterate however that this is mostly an issue of US stock prices. Due in part to historic dollar strength, foreign stocks as a whole are back at prices offering decent forward return prospects. They can certainly fall more, and almost certainly will if US stocks do, but as we discussed in Where In The World Are The Cheap Stocks, they offer a much more comfortable prospective return in relation to the risk. I continue to favor the US for bonds, and the rest of the world for stocks.

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