The Breakdown - Why Markets Viewed the Fed's Latest 75 Basis Point Hike as 'Dovish'

Episode Date: July 29, 2022

This episode is sponsored by Nexo.io, Chainalysis and FTX US.   Yesterday was “Fed Day” and the U.S. Federal Reserve announced its second 75 basis point interest rate hike in a row. Despite the fastest pace of monetary tightening in a generation, markets rallied after Chair Jerome Powell’s presser. On today’s episode, NLW explains why so many in the market interpreted the Fed’s Q&A as dovish, and what it means going forward.  - Nexo is a security-first platform where you can buy, exchange and borrow against your crypto. The company safeguards your crypto by relying on five key fundamentals including real-time auditing and insurance on custodial assets. Learn more at nexo.io. - Chainalysis is the blockchain data platform. We provide data, software, services and research to government agencies, exchanges, financial institutions and insurance and cybersecurity companies. Our data powers investigation, compliance and market intelligence software that has been used to solve some of the world’s most high-profile criminal cases. For more information, visit www.chainalysis.com. - FTX US is the safe, regulated way to buy Bitcoin, ETH, SOL and other digital assets. Trade crypto with up to 85% lower fees than top competitors and trade ETH and SOL NFTs with no gas fees and subsidized gas on withdrawals. Sign up at FTX.US today. - “The Breakdown” is written, produced by and features Nathaniel Whittemore aka NLW, with editing by Rob Mitchell and research by Scott Hill. Jared Schwartz is our executive producer and our theme music is “Countdown” by Neon Beach. The music you heard today behind our sponsors is “The Now” by Aaron Sprinkle. Image credit: Drew Angerer/Getty Images, modified by CoinDesk. Join the discussion at discord.gg/VrKRrfKCz8.

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by nexus.com, and FTCS, and produced and distributed by CoinDesk. What's going on, guys? It is Thursday, July 28th, and today we are asking, how come markets viewed the Fed's latest 75 basis point hike as doveish? Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dig deeper into the conversation, come join us on the Breakers Discord. You can find a link in the show notes or go to bit.L.Y slash

breakdown pod. Lastly, a disclosure, as always, in addition to them being a sponsor of the show, I also work with FTX. All right, so yesterday was Fed Day, the big event that markets hang onto like a kid with Christmas or something. And before we get into what happened, I think we need to do a super-fast synopsis on where we are. We are currently in the midst of the most significant monetary policy shift in a generation. The Federal Reserve had up to this week raised rates three times this year and is doing so at the fastest pace since the 1980s. The goal, of course, is to curb the tide of inflation before it becomes endemic. And specifically, before expectations about future inflation become entrenched to the degree that people start acting

like inflation will be with us forever. The reason this matters is that inflation can be a self-fulfilling prophecy. If people expect prices to keep going up over the medium and long term, it makes rational economic sense to buy more today before those price increases happen. Indeed, this is clearly on their minds. Fast forwarding to the Powell Press conference today, he described exactly this. Quote, we're trying not to make a mistake. We do see that there are two-sided risks. There would be the risk of doing too much and imposing more of a downturn on the economy than was necessary, but the risk of doing too little and leaving the economy with this entrenched inflation only raises the cost of dealing with it later. To the extent people start to see it as just a

part of their economic lives, they start to factor high inflation into their decisions on a sustained basis. We don't think that's happened yet, but when that starts to happen, it just gets that much harder and the pain will be that much greater." End quote. Indeed, part of what's happening is that the specter of the 1970s is looming over the Fed and the rest of us. The Federal Reserve of that decade is widely seen as aiding and abetting inflation by not having the conviction to follow through on hawkish monetary policy to the degree that was needed to actually stem the tide of inflation. By taking their foot off the brakes before inflation was really tamped down, it was allowed to get out of control, and it wasn't until Paul Volker came in and ripped interest rates into the double

digits, which, by the way, caused a major recession and double-digit unemployment, that inflation actually came down. Jay Powell is determined not to be Arthur Burns 2.0, the ignominious Fed chair who preceded the now legendary Volker. So that's the setup, but what has been happening? Well, going into this summer, the market widely expected two 50 basis point raises, one in June and one in July. But then the May inflation numbers surprised to the upside, and the expectations for June's meeting got revised up to 75 basis points just a few days before the meeting. That was indeed the decision that the Fed made, and the last time we raised 75 basis points, or 0.75% in a single meeting was all the way back in 1994.

When June's inflation numbers came in above 9%, many in the market started to speculate that the Fed would actually do a full 1% rate hike. This is important to our story today, because in the short, short term, much of how the market reacts is about expectations, not about raw numbers. If the expectation is 1% and we come lower, even if 75 basis points seem still really high by historical standards, the market could view that as a positive. And that is sort of what happened. Yesterday, the FMC meeting concluded in Powell held as presser and here's what we learned. The Federal Open Market Committee raises the target range for the federal funds rate by 75 basis points.

That brings the range to 2.25% to 2.5% overall. This was a unanimous decision. What's more, the Fed continues the process of, quote, significantly reducing the size of the federal balance sheet. Powell started off his statement, my colleagues are strongly committed to bringing inflation back down and we're moving expeditiously to do so. We have both the tools we need and the resolve it will take to restore price stability on behalf of American families and businesses.

Quick note, expeditiously is one of the latest examples of. of Fed speak. So where does the Fed think they have been successful in cooling the heels of the market? Powell went on. Recent indicators of spending in production have softened. Growth in consumer spending has slowed significantly, in part reflecting lower real disposable income and tighter financial conditions. He also noted that housing has cooled, reflecting increased mortgage rates, and business fixed investment looks to have declined in quarter two. A quote from the press conference, are we seeing the slowdown in economic activity that we think we need? There's some evidence that we are at this time. Then again, the Fed still faces challenges in their mission. Again from

Powell, the labor market has remained extremely tight with the unemployment rate near a 50-year low, job vacancies near historical highs, and wage growth elevated. He notes that labor gains are widespread with benefits to low-income African-Americans and Hispanics, and that the participation rate has changed little since January. This indicates that underlying aggregate demand remains robust. Powell goes on, notwithstanding the recent slowdown in overall, all economic activity, aggregate demand appears to remain strong. Supply constraints have been larger and longer lasting than anticipated and price pressures are evident across a broad range of goods and services. So it's hard to interpret this as anything other than Powell saying that they have more

room to tighten. Quote, we anticipate that ongoing increases in the target range for the federal funds rate will be appropriate. The pace of those increases will continue to depend on the incoming data and evolving outlook for the economy. While another unusually large increase could be appropriate at our next meeting, that is a decision that will depend on the data we get between now and then. We will continue to make our decisions meeting by meeting and communicate our thinking as clearly as possible. As the stance of monetary policy tightens further, it likely will become appropriate to slow the pace of increases while we assess how our cumulative policy adjustments are affecting the economy and inflation. Now, there is a lot to say about this section in terms

of what it means for the way that the Fed is giving forward guidance, but we'll come back to that point in just a minute. Powell, in both his prepared statement and in the Q&A, did make clear to leave room for surprises. Quote, further surprises could be in store. We therefore will need to be nimble in responding to incoming data and the evolving outlook. And what about the possibility of a recession? Well, quote, this process is likely to involve a period of below-trend economic growth and some softening in labor market conditions. But such outcomes are likely necessary to restore price stability and to set the stage for achieving maximum employment and stable prices over the long run. Below-trend economic growth

is a new fancy Fed speak for recession, of course. Now interesting, as it relates to this below-trend economic growth, Powell did more to connect the twin mandates that the Fed has, price stability, and full employment than we've seen before. He said, price stability is really the bedrock of the economy. Nothing works in the economy without price stability. We can't have a strong labor market without price stability for an extended period of time. We all want to get back to the type of labor market we had before the pandemic, where race and gender differences were at historic minimums, where participation was high. That's not going to happen without restoring price stability. That's something we see is something we simply must do. We don't see it as a trade-off with the

employment mandate. We see it as a way to facilitate the sustained achievement of the employment mandate in the longer term. We're trying to have just the right amount. We're not trying to have a recession, and we don't think we have to. We think there's a path for us to bring inflation down while sustaining a strong labor market along with some softening in labor market conditions. So the interesting thing about this is basically Powell is saying that even within the context of the dual mandate, price stability has to be the underlying precondition for the long-term health of the economy. And if to get to price stability, there is short-term volatility in the labor markets, that may just be the cost that we have to pay for what we need to achieve.

In times like these, security of your assets should be your number one price. If you want to offset risk as much as possible and still stay in crypto, you need a trusted partner by your side. Nexo is a security-first company that manages risk by relying on mechanisms such as over-collateralization, real-time auditing, and insurance on custodial assets. Learn more about Nexo's reliable business model and start your crypto journey at nexo.io. That's nexo.io. Eager to make more informed decisions around crypto, chainalysis is here to help. Chainalysis demystifies cryptocurrency by providing industry-leading compliance, market intelligence, and investigations support for all crypto assets.

For organizations like Gemini, Crypto.com, and BlockFi. Gain unparalleled visibility and maximize your potential with the leading blockchain data platform by visiting us now at chainalysis.com slash coin desk. The breakdown is sponsored by FTXUS. FtXUS is the safe, regulated way to buy and sell Bitcoin and other digital assets with up to 85% lower fees than competitors. There are no fixed minimum fees, no ACH transaction fees, and no withdrawal fees. One of the largest exchanges in the U.S.

FTXUS is also the only leading exchange that supports both Ethereum and Solana NFTs. When you trade NFTs on FTX, you pay no gas fees. Download the FTX app today and use referral code breakdown to support the show. Now, an interesting question to ask is what was different, if anything, about this meeting? And the biggest thing is that they are really, really backing off forward guidance. A key feature of most Fed meetings is that they sort of guide markets to how they're thinking about future rate hikes and additional tightening. They did do some of this, skimming, for example, some sense of expectations. about balance sheet tightening. Powell said he thinks it will be two to two and a half years to get back

down to the desired equilibrium for the balance sheet. But when it comes to continued rate hikes, he is really leaving it to the data. He is saying that the decision that will be made in September and beyond will be based entirely on what we see as relates to inflation data in particular. This is something a little bit different than for markets to have to figure out how to interpret. Indeed, less forward guidance, sort of leaves a lot more room for people. people to push their own views on to how the Fed is thinking. In other words, the less the Fed says, the more room market participants have to interpret what they didn't say. So how was the market's interpretation? Well, it must be said that markets responded to this as though it was extremely

dovish. Markets soared in the wake of the meeting. The S&P 500 was up 2.6% and is on track for its best month since October. Nasdaq was up 4%, which was its largest one-day gain since March of 2020. On the day, Bitcoin was up 8.6%, and Eath was up 15.7%. So what were the reasons that the market might have seen this as dovish? Part of it was that there was some expectation of a 100 basis point hike. The fact that the Fed didn't do that, even after a 9% inflation print, was to sum, a dovish signal. The second was that the Fed characterized the 2.25% to 2.5% federal funds rate as neutral, which is kind of weird given that inflation is 9%, and that in 2018. when the federal funds was in a similar place, Powell called it far from neutral,

a point that a very skeptical Wall Street Journal editorial pointed out this morning. But the other piece of this was the end of forward guidance. Many in the market seemed to be interpreting the fact that everything is moving to meeting to meeting and data-driven as the best signal yet that the Fed thinks we might actually be at a peak, though we might have crested peak hawkishness, in other words. However, not everyone agrees. And in fact, one of the strongest themes in the chatter right now, is the markets are misinterpreting this. Black Rock's Jeffrey Rosenberg writes,

this market move is the victory of hope over experience. I'd be a little bit cautious here. The market is hanging on the slowdown and the pace and not really contemplating as much that the more the markets rally here, the harder it is for them to continue. Roberta Pairley, the head of global policy research at Piper Sandler, says the market may be interpreting Powell's meeting-to-meeting attitude as a sign that a peak rate is near. That interpretation is wrong. He didn't decline to give forward guidance because he thinks that they are nearly done, but because he genuinely doesn't know. In fact, he talked about the possibility of another unusually large move next month. Powell did not pivot back to Dovish today. Jonathan Farrow

and anchor at Bloomberg writes, we read Chair Powell's press conference is more hawkish than the market's interpretation. We continue to expect core inflation to push the Fed to hike more aggressively than they or markets anticipate, with a 75-bases point hike in September, and policy rates reaching 4% by year end. Jake Gordon at Bespoke noted that Fed Day rallies usually reverse in the following week. Rallies are always fun in the moment, but historically, when the S&P 500 performs well on a Fed day, it has typically been followed by a hangover in between meetings. Jonathan Farrow again from Bloomberg pointed out that on the June 15th Fed Day, the markets

rallied 2.49% only to fall by 4% the next day, and that in May on Fed Day, the markets rallied 3.41% and fell by 5% the next day. Samir Samana of Wells Fargo Investment Institute said, quote, once the positioning is more even, the macro backdrop will remain much the same. Sticky inflation, a tightening policy bias, and a weakening economy and consumer. The risk reward from current levels is pretty poor, since a further rally in risk and easing of financial conditions will push the Fed toward even larger hikes. Now, one of the most important concepts just to try to start to round out here is this idea

of a move to neutrality. Macro Alf wrote a great threat on this that I'm going to quote from now. Powell hikes 75 basis points and yet NASDAQ and Bitcoin are going to the moon. What the heck? While I disagree with the unfolding market narrative here, let me try to explain why we are witnessing such a rally. Despite openly recognizing economic growth is softening, the Fed unanimously decided to hike by 75 basis points. It's all about inflation, inflation, and inflation. But markets convincingly started rallying only when Powell went ahead and said the following. We are now at levels broadly in line with our estimates of neutral interest rates, and after front-loading our hiking cycle until now, we will be much more data-dependent going

forward. Let's find out why this was so relevant. The neutral rate is the prevailing rate at which the economy runs at its potential, without overheating or excessively cooling down. With this 75-bases-point hike, the Fed just reached its estimate of neutral rate. From here, they aren't contributing to economic overheating anymore. But that also means any hikes from here are going to put the Fed in an active restrictive territory. The bond market knows that every time the Fed becomes restrictive, they break

something. So Powell was asked a couple of very important questions. What about bond market pricing? What about financial conditions? What about forward guidance? Quote, from here onwards, we are fully data dependent. Boom. He ditched it completely. Why is it relevant? It all starts from the very strong opinion the bond market has developed about inflation over the last few months. It's going to move down and very fast. Between July 23 and 24, CPI is priced to print at around 2.9%, basically at Target. So if Powell is not nearly on autopilot anymore, and markets have a strong opinion on inflation and growth collapsing, they can also price all other assets around this base case scenario. If you look under the hood, market action also validates this narrative. Who's outperforming here?

NASDAQ and crypto. If the Fed isn't going to force tighter financial conditions on autopilot anymore, real yields will actually start declining again. When real yields decline, value-intensive and risk-sentiment-driven asset classes outperform. That's because the marginal return for owning cash becomes less attractive, and the incentive to chase risk assets is larger. Do I think the rally has legs? I can rationalize the narrative being built post-FOMC, but no forward guidance equals a very, very volatile Fed ahead of us. One small hawkish turn, and it's all gone. You must price in some additional risk premium here, less. Finally, what's the bond market saying? We priced away some hikes between now and December, and this is how we are left. 50 in September, 25 in November, 25 in December, done. 50 basis points

of cuts in 2023. A higher likelihood that peak-fed hawkishness is behind us. So this is really the narrative to watch. Is peak-fed hawkishness behind us? Macro-Alpha, as you heard, gives the thesis for why, but also argues that there are so many conditions that could change that very quickly that you have to price in some risk around it. Now one final note as relates to crypto, is this new narrative creating space for investors to be seen as making mistakes by being too bearish? Is the new narrative of peak-fed hawkishness behind us creating enough space for internal crypto narratives to become the drivers again, and for investors to be seen as making mistakes for being too bearish. That's a theme being explored by people like Alex Kruger.

He wrote, Today's upwards moves so large, crypto funds who missed it must now be praying for Amazon or Apple to report horrible earnings tomorrow or for a negative GDP print to load the dip. Hard for a crypto fund to explain to its LPs it missed the Ethereum merge trade because of concerns about the macro. This August shall be bear hunting season. In particular, crypto investors who learned about macro in 2022 remain way too bearish. Will we trade new lows later? Will we trade new lows later? Later on, maybe. Could be a bad winter. Who cares now? First, pump forcing those in the sidelines to buy late and in anger. The key is the Fed being at peak or close to peak hawkishness, rendering itself somewhat irrelevant for the time being, which is very bullish when most are panicking about

the Fed. So I think the theme here is that we are moving into a moment, a period potentially, of much greater volatility, which doesn't really seem possible, right, given how wild things have been for the last few months. But you have to remember, volatility can be to the upside or the downside. We just don't really know. But for those of you who are hoping for not a long, extended, boring crypto winter, at least for now, your wish has come true. I want to say thanks again one more time to my sponsors, nexus.io, chain aliasis and FTX. And thanks to you guys for listening. Until tomorrow, be safe and take care of each other. Peace.