To The Moon

The question is what's broken and not when's the pivot...

Equity markets are grasping for signs of the infamous pivot. Weakness in employment data is interpreted as dovish and thus bullish. That's why the S&P has been loosely tracking initial jobless claims over the past few months. The world continues to be upside down where bad news is good news and vice versa.

Cutting of interest rates has shifted dramatically in the last month thanks in large part to the failures of U.S. banks SVB Financial Group, Signature Bank (NYSE:SBNY) and Silvergate Capital Corp (NASDAQ:SI), as well as the emergency takeover of Credit Suisse Group AG (NYSE:CS) by UBS Group AG (NYSE:UBS).

Domino dancing?

Investors are now anticipating aggressive rate cuts by the Federal Reserve before the end of the year. The bond market is pricing in a 56.6% chance the Fed will cut interest rates by at least 0.75% by the end of 2023, up from a zero chance just one month ago.

Rate cuts are typically good news for stock prices, and DataTrek Research co-founder Nicholas Colas said Monday that could certainly be the case in 2023 as well.

Colas said the bond market's recent shift in interest rate expectations could signal that investors believe the credit market disruptions will help alleviate the U.S. inflation problem, allowing the Fed to ease its monetary policy sooner than expected and navigate a "soft landing" for the U.S. economy.

Hard or soft landing?

Yet Colas said it's still too early to assume 2023 rate cuts are good news for stocks: it's possible that interest rate expectations are falling because investors are now anticipating a deep recession ahead.

"In that case, we can assume earnings will decline quickly… That would likely not be good for U.S. equity valuations," Colas said.

Fed pivot causes a decline or the opposite?

Investors are expecting a pivot from the Fed at any moment. Markets continue to rally on bad economic news because it suggests the Fed will be able to cut rates. But it's more likely that the bad economic news will accumulate to a point-of-no-return before the pivot actually happens. In fact, the pivot will signal to markets that the point has been reached and the economic damage has been done.

The markets want a pause. They want a pivot. Every hint of a pivot sends the market into a frenzy. A premature pivot can be bullish for equity markets because it restores liquidity and multiple expansion against the backdrop of an economy that has remained strong. The issue with this thinking is that for the past thirty years the Fed has not pivoted until monetary tightening has caused economic turmoil, often referred to as "something breaking." 

The point is this: the Fed routinely waits to pivot until the manifestation of some sort of crisis forces them to act. So let's beware of what we wish for.

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