The New Pain Trade

It can be amazing how quickly investor sentiment can turn. Two Fridays ago, we were concerned about whether a weakening jobs market was a harbinger for a looming recession. Now we have complete faith in the Federal Reserve’s ability to engineer a soft landing thanks to the simultaneous combination of a cooperative economy and aggressive rate cuts. Considering that actual soft landings are about as common as credible Yeti sightings, it is quite possible that investors have boxed themselves into a new “pain trade”.

We came into today’s trading with markets pricing in the certainty of a 25 basis point cut in September, along with a reasonable likelihood of a 50bp cut instead. [If you’re interested in trading on events like these, please check out the IBKR ForecastTrader] Never mind that neither the most recent Federal Reserve Summary of Economic Projections (better known as the “dot plot”) nor rhetoric from Fed officials explicitly back this assumption, this is what the market has decided for them. Heck, the last dot plot, the one that showed a median forecast of one cut for all of 2024, was in June, and things changed since then. That’s fair. But then why does someone like Atlanta Fed President Bostic say that he needs more data before considering any cuts or Fed Governor Bowman say that she “will remain cautious in my approach to considering adjustments to the current stance of policy”? Those are both consistent with a consensus-minded FOMC that is likely to cut rates, but not nearly as aggressively as liquidity addicted investors crave.

This is why I am concerned that investors have set the bar too high for Chair Powell’s speech at Jackson Hole next week. We have said many times that investors don’t really want to hear from the supporting cast, they only want to hear from the lead actor, Powell. Suppose he merely reaffirms the comments he made after the last FOMC meeting in July, implying that a 25bp “adjustment” cut in September was forthcoming, but little or nothing more? What if he reminds investors that a 4.3% unemployment rate, while well above recent lows, is historically enviable, and that the Atlanta Fed’s GDPNow estimate of 2.9% indicates a solid enough economy that hyper-accommodative policies are not warranted? Are those the sort of things that investors want to hear?

One of two things can happen as a result. The market can cheer that the economy is robust. But the investors already know that – they’re hoping for rate cuts too. Or, more likely, investors can fret about the idea that we’re largely on our own when it comes to monetary policy. Equity investors who fear that the economy is moving towards a recession will be concerned that the Fed is too slow to react, while short-term interest rates, like 2-year Treasuries, would likely rise if rate cuts need to be priced out. Neither is friendly to equity markets, especially those that have become very crowded the current consensus trade.

We should also let recent history be our guide. Chair Powell used 2022’s Jackson Hole address to remind investors about the Fed’s resolve to begin its rate-hiking cycle in earnest. At that time, traders were hopeful for a Fed pivot away from their tightening bias and were sadly disappointed when Powell pushed back hard against those hopes.  

Thus, if you’re betting on a soft landing combined with aggressive rate cuts, be wary ahead of next week. But I suppose, in the meantime, why let those concerns get in the way of a freshly renewed FOMO-driven momentum fest?