“Two roads diverged in a yellow wood…”: New Year, New Base Case, New Problems
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In 1963, a ten-year-old boy called Jerome lived in a very different America to the one we see today. The death of the great American poet Robert Frost was an indication of the new international world that was hastily approaching as Paul Volcker headed into his second year of working in the US Treasury Department.
Frost often wrote about human experience and its interactions with human nature and ‘The Road Not Taken’ is perhaps one of his most popular poems as it discusses the common experiences felt when it comes to decision making.
At the start of 2023, many analysts were confidently asserting a US soft-landing as the new base case rather than an infrequent possibility. Even Morgan and Stanley’s Mike Wilson revised his stance to being slightly more positive at the end of January. However, this early optimism has been challenged by recent job and inflation reports. So, what happens now as we approach the next FOMC meeting as investors are left to ponder this possible turning point for an extended period?
“...long I stood/And looked down one as far as I could/To where it bent in the undergrowth...”
The first thing to consider is what can we glean from forward-looking indicators. The best indicator is directly from the source itself. In the FOMC’s most recent statement, the tone was slightly more reserved as the committee noted the possibility of future rate hikes to achieve the mandate but noted a move to a more data-dependent stage of the tightening cycle. This aligns with their decision to slow the rate of hikes moving back to 25 bps. Markets took this as a dovish move and positioned despite the warnings of the Fed.
At the time of writing, the market is unsure how to respond and exists in an almost shocked state. Just as the summit was about to become visible, investors were met with another long and arduous climb with a CPI print of 6.4% that underperformed analysis expectations. This data point has made investors re-evaluate their expected rate of change for inflation and as a result, the reaction function for the Federal Reserve going forward as Deutsche noted is this “the straw that broke the camel’s back?”
Either way, the market is scratching its head. Models are churning out mixed readings and at this moment we can only describe where we are as a turning point where opinion on the future is bifurcated. The future is overgrown, and no clear path can be seen no matter what we believe is next.
“I doubted if I should ever come back.”
6.4% is a long way from the 2% mandate but with this reassessment of the rate of change; where does the Fed stand now? Powell will be staring into the face of the market and the next meeting could help tip the balance and give investors the herding push they need to play their part in meeting the mandate.
Figure 1: iShares S&P500 Weekly Volume % Change from Yearly Average Over time.
Figure 1 shows the impact the Fed has on the market as each vertical line demarks an FOMC meeting which is usually followed by a positive peak of volume in the coming weeks in the iShares S&P500 ETF from January 2018 to January 2023. However, with this analysis, it should be marked that this time series encompasses only one security. No matter how popular or liquid it is it will not cover the whole market but still can provide insight. Some key behaviours are important to note, such as the peak in volume after each FOMC meeting (roughly with a one-week time lag). The notable exception was the bull run in 2021 but this normalised in Q2 2022, and we have seen the time series return to pre-pandemic trends.
This feature demonstrates that the Fed plays a key part in shepherding the market over the five-year observation period. Despite not being able to fully appreciate the magnitude of this move from this study it’s something to keep in mind as investors approach the March meeting.
Another point to highlight is the series’ marginally positive average of 0.000005% that demonstrates overall, the moves in the volume are driven by an underlying cycle rather than an upwards or downwards trend. This led me to look further into this FOMC cycle as demonstrated below in Figure 2.
Figure 2: iShares S&P500 Weekly Volume % Change from Yearly Average at x weeks after an FOMC meeting.
What is striking about this figure is the inferred narrative it depicts. During Fed weeks investors are met with shock as they process the recent decision. Moving to the next week, FOMO guilt enters leading to a spike in volume as the portfolios are positioned to match the Fed outlook. After this, investors pause to rationalise their previous decisions as they prepare for the release of the meeting minutes in the following week. After taking time to see what the Fed actually meant by their press release (rather than the market interpretation) new trades are entered after these insights possibly to correct hastily placed orders. Finally, we arrive back to where we started just in time to begin the cycle again with the next FOMC meeting.
This trend holds on average in all years, bar 2020, where the pandemic dictated order flow and 2021, where the only direction of travel that mattered was up.
All in all, this tangent demonstrates that the crucial thing the market has returned to focus on is central bank guidance and policy. Yes, FOMO and froth remain but the focus on the Fed as a policy institution should provide confidence that the mandate tools work within the system and everything is not entirely off the rails despite a Global Pandemic, a war in Europe, sticky inflation, and increasing East-West tension.
“…And that has made all the difference.”
Putting the Fed in the driving seat is the only move that will allow a return to some resemblance of the ‘before times.’ With the vital role the US plays in the global economic system, developments here and a return to a level of normality can only inspire confidence in other economies where prospects are a little shakier, such as the UK. All in all, at this time the best action is to sit and wait to see what the next FOMC meeting holds. As the reaction function has now changed, the Fed have the firm attention of investors. Considering this, the only direction of travel for inflation in the mid to long term is down, and it’s a matter of how hard or soft the fall depending on the policy direction until March is gathering potential.
I believe any correction will act as a reset button for markets. The only question is will markets enshrine this inflation story into the pantheon of tumultuous times to learn from in the future?
Thanks for reading,
Daniel
Disclaimer
This communication is for informational and educational purposes only and should not be taken nor used as investment advice, as a personal recommendation, or solicitation to buy or sell any financial instrument. This material has been prepared without considering any particular recipient’s investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past or future performance of a financial instrument, index or structured product are not, and should not be taken as, a reliable indicator of future performance. I assume no liability as to the accuracy or completeness of the content of this publication.