Fed meetings get everyone excited…

Prices move a lot, so there’s a trading angle.

There’s plenty of interpreting the Fed’s message and “reading between the lines”… so there’s also a narrative angle, making mainstream television watchable.

But not all Fed meetings are the same.

Some surprise the market… some only seemingly do.

The one on Wednesday belongs in the latter category. Nothing said caught the market off-guard.

In contrast, the one on September 21 was an example where the market wasn’t just surprised but stunned.

That’s why the Nasdaq 100 (QQQ) fell 5.6% over the next seven days, almost without pause. That was unusual because price reactions often revert and retest preannouncement levels on FOMC days (as with most economic releases).

Only when there’s a true element of surprise do we see the kind of follow-through we did in September.

And following the Fed’s September raise, we highlighted three areas that would cause the market to start pricing in to the downside… which we’re seeing play out now.

Lag in the Economy and Inflation

The three areas we called out in September were:

1. A top in real estate

2. Fed Chair Jay Powell conceding to a recession (without saying it outright)

3. Lag

Right now, I want to focus in on the third of these areas…

Lag refers to the time it takes for the economy to really start to feel all this “cumulative” monetary tightening, as the Fed acknowledged on Wednesday.

It also refers to the time from the start of monetary tightening to when inflation starts to fall…

So there’s a lag in the economy. And there’s a lag in inflation.

The lag in the economy drove the “hard landing” and “Are we in a recession?” debate… There needed to be a clear sign that the Fed’s monetary policy was finally having a negative impact.

One signal arrived with corporate earnings…

Three bellwether stocks in three different industries felt compelled to preannounce abysmal earnings results a few weeks ago… The sign was right in front of us.

On October 7 in The Opportunistic Trader, we wrote:

FedEx…Nike…And now Advanced Micro Devices [pre-announced less than expected earnings]. That all points to one thing… The effect of all the rate hikes and inflation is getting harder to control and is finally taking its toll on corporate earnings.

And based on the showing from big tech this earnings season… that theory is holding up well.

Companies like Amazon (AMZN), Meta (META), and Microsoft (MSFT) all got hammered. Even Apple (AAPL), which initially saw a 3% reaction to its earnings release, is now trading well below preannouncement levels.

And in terms of the effect of lag in inflation…

There comes a point when inflation keeps rising because of factors other than lag…

That’s why on September 30 we wrote:

This next step is when inflation permeates the economy to a point where it becomes almost mainstream… entrenched in our behavior and perception. That’s a dangerous place to be, and that’s what the Fed is scared about. They’re scared of “everyone knows that everyone knows there’s inflation.”

Here’s what I mean by all this…

It’s well known that the commodities bull market had a big influence on inflation. But the CRB commodities index topped out in late April and has been in freefall since.

That was six months ago. That’s a lot of lag considering how the consumer price index (CPI) keeps rising. So despite the offset to inflation from prices paid at the pump… the continued growth of inflation in other areas more than makes up for it.

Six months is a lot of lag time…

So maybe it’s not lag anymore… maybe it’s entrenchment.

The other way to know if inflation is becoming entrenched in the economy is to ask your children if they know what inflation is. If they do, that’s a bad sign.

Not a Surprise

So it’s a good thing that the Fed acknowledged this Wednesday that there’s a lag to the effects of “cumulative tightening”…

It means they’re aware that they can hike too much, too fast, and guarantee an economic crash that could have been avoided.

This addition to their policy statement sums it up: “The Committee will take into account the cumulative tightening of monetary policy, the LAGS with which monetary policy affects economic activity and inflation, and economic and financial developments.”

That came out at 2 p.m. on Wednesday.

Pundits and mainstream economists quickly ad-libbed their take according to second-by-second price action (ironic when you think about how they bill themselves as “long-term” investors).

The market wanted to see a Fed that leaves the door open for a dovish pivot if need be. They wanted to see a Fed that wouldn’t fully trade an all-out recession to avoid the ill effects of inflation…

And that’s what they got… The market popped 1.5% immediately following the news.

Yet a little after the start of that press conference, at 2:37… everything reversed course.

Here’s a chart of how it all unfolded…

Observers were quick to state that the market was “surprised” by Powell saying that the final “terminal” rate they settle at may be higher than previously expected… which triggered the sell-off.

But despite the initial upside price reaction… that news was by far a surprise.

The Fed Fund swaps market had already been pricing in a slowdown in rate hikes going into next year for quite some time. And Fed Funds swaps for May 2023 were already trading above 5%.

The median estimate according to the Fed’s dot plot was at 4.6%… meaning the market was way ahead of Jay Powell’s statement on the eventual rate.

Another way to look at this is to imagine the process of buying and selling in big institutions.

The people making these decisions aren’t sitting around watching Powell’s press conference on CNBC with one finger on the buy button and one on the sell… they make the buy and sell decision in advance.

Only once in a while (like in September) will “Fed day” change their minds.

What’s really going on in the action we saw is that the market is continuing to react to earnings.

That is why we saw the Dow Jones Industrial Average (DJIA) have its best month in decades while the Nasdaq 100 barely rose. And it’s why we will likely continue to see the tech sector continue to get hit relative to everything else.

The selling was ongoing… And the quick pop in the market on Wednesday was just an excuse to sell more.

What’s really driving this market is earnings… not the Fed.

And it’s why in my previous essay, I left off by saying:

At the end of the day, everything in the market comes down to earnings (or the hope of earnings growth in the future). That’s the end all be all. And more and more, as earnings season continues, the theory that earnings have peaked is starting to become fact.

The title of that essay was “Tech Earnings Aren’t Dragging the Market Down… Yet”…

They are now…

Regards,

Eric Shamilov
Analyst, Trading With Larry Benedict