Description

I recommend betting on more cuts than the market is expecting, much sooner than the market is expecting.

The rationale is fairly simple - you can pick which timing makes sense for you but I like July/September. I believe it's far out enough that you have enough optionality, but not so far that you have a very high bogey like the end of the year.

The core idea is historically, the fed never cuts slowly over time after a hiking cycle; as they say, "stairs up, elevator down". Looking back thru history, the fed has a tendency to move aggressively for fear of being behind the curve, BEFORE the hard data justifies it. Currently, the market veiw seems to be the data do not support cuts. I would look to the 2007-2008 cycle as an example, 2000-2001, even some of the ones in the 80's. It's very rare to see something play out like what the market is forecasting. To see that level of cuts, you usually see them bunched together, it's rare to see them so spread out.

Based on Powell's radical pivot in December, I believe his decision framework has either shifted dramatically, he is relying on different data than the market, or possibly his "I'm powell higher for longer" was a well-executed bluff. In any of those scenarios, I think it's mistaken to believe he is operating according to his stated policy reaction function.

On 12/1/23, Powell said:

“It would be premature to conclude with confidence that we have achieved a sufficiently restrictive stance, or to speculate on when policy might ease,” Powell said in prepared remarks for an audience at Spelman College in Atlanta. “We are prepared to tighten policy further if it becomes appropriate to do so.”

From a bberg article the day of the December Fed Meeting on 12/13/23:

Moreover, Powell’s lack of pushback during his press conference against growing investor expectations for 2024 rate cuts helped spark a massive rally in Treasuries and sent the Dow Jones Industrial Average of stocks to a record high. Less than two weeks after saying it would be “premature” to speculate on the timing of rate cuts, Powell said officials were starting to turn to that question. “That begins to come into view and is clearly a topic of discussion out in the world and also a discussion for us at our meeting today,” Powell said.

In between this time there was no big shift in the data to justify this. This is why the pivot shocked the market. But Powell told us he is data dependent and apolitical. So how do we square these two?

I believe Powell may be attempting to avoid being political by front loading cuts earlier in the year, or possibly he is actually looking at data that is spooking him.

Gundlach recently pointed out 80+% of states are showing rising unemployment right now. You can confirm this for yourself by looking at NY, FL, CA, IL state level UE data.

The market seems to think the Fed cuts will be evenly distributed across 2024. I believe this doesn't make any sense. If you are Powell, the personal risk to being wrong on the soft landing is huge, way higher than needing to wage a 2nd battle against inflation. Policy error causing huge unemployment and a recession, possibly torpodeoing Biden re-election odds, not a great look. And maybe Powell isn't political but he does live outisde DC and I'm sure still likes his cocktail parties.

Another theory as Jim Bianco pointed out its possible there is a dovish dissent faction at the FOMC, and they blackmailed Powell into a more dovish outlook.

There are many possible reasons why Powell might have done what he did, and I'm not saying I know for sure. What I am saying is it's clear he is not using his stated reaction function to make his decisions. So that leads me to think he gets much more aggressive with cuts, and moves faster than the market expects. Currently rates are very restrictive to the tune of 300bps from R* based on the Fed's own projections. And the Fed is projecting 1.4% GDP growth in 2024, so they are clearly concerned about missing the soft landing. So with that backdrop, I think it is a no-brainer to get the rate cuts out there fairly quickly and aggressively, to avoid missing the window to land the plane softly.

Now a lot of this is priced in in theory - currently market is pricing in 3 cuts into July; I like the trade because I think the downside is fairly limited; downside is maybe you're off by one cut, two cuts max but the upside is much more. I think it's not hard to see another cut come back in quickly, maybe even in coming weeks. The real Upside is either they move faster than expected/cut deeper than expected or some signs of a hard landing. You could see an extra 50-200bps in that scenario. So I like the skew basically.

Catalyst

Powell sees his shadow