Authored by GoldFixSubstack
Consider at least the possibility that the extreme volatility and lack of liquidity you see in markets is by design, and the Fed will not be deterred by it, but rather that it will be emboldened by it in its singular pursuit of price stability.- Z. Pozsar
Google Translate: Stop Buying The Dip TL; DR
The Fed is focused on controlling inflation and restoring price stability by pursuing demand destruction even if it causes upticks in unemployment.
The Fed is pursuing this demand destruction not just by lowering direct consumption ( rate hikes), but also through manifesting negative wealth effects.
Assuming Zoltan Pozsar is reading the Fed correctly, Homes, Stocks ,and other stores of wealth will continue to go lower until inflation gets better.
The vol, ruptured risk assets, demand destruction, ambiguity are no accident according to him. They are, like the recession, by design
GoldFix: It remains to be seen the Fed will stick with this plan if another black swan emerges or if stocks fall too far too fast.
Overview
On May 13th Zoltan Pozsar released his latest commentary in light of: increased volatility, cratering stocks, exploding Bond yields, and a fruitless search by participants for the elusive Fed put level. The post was a circle-back to his February 16th Credit Suisse post entitled “We Need a Volcker Moment”. Their latest missive updates the path taken thus far, and a prognosis on what could happen next.
In it was an impression of market behavior after that Feb. post1, sprinkled with a couple anecdotes, and dropping a few hints as to what might be good indicators for future Fed actions from a structural/macro perspective.
He opens:
As we discussed in our “Volcker Moment” dispatch on February 16th (see here), there is a strong policy case for the Fed to inject volatility into markets in order to control domestic services inflation (and demand for labor more broadly) through asset prices – stocks, housing, and crypto assets too.
Back in February Zerohedge did a comprehensive cover piece entitled Zoltan Pozsar: Powell Must Crash The Market. From that post:
We bring all this up today because in a startling note from one of the most respected Wall Street strategists, repo market guru and former NY Fed official, Zoltan Pozsar, he not only echoes all of our "tinfoil conspiratorial" thoughts but even goes one step further suggesting that "We need a Volcker moment… a Volcker moment, where Vol stands for “vol” – as in volatility." In other words, Pozsar writes that the Fed needs to crash the market to contain stocks.
And that is precisely what happened. Whoooooooooooooooooshhhhhhhhhhh…
A couple down weeks followed by relief rally and then whoosh- Seven weeks of wealth destruction. The markets more or less behaved as the economist suggested they might.
Since the last two months seemed to prove the concept; It might help to quickly recap the main points of that Volcker Moment post before diving into the “Volkyries” update.
Summary of Zoltan’s February Post
For starters: from the GoldFix follow-up post Cure Inflation "By Forcing Long Term Rates Higher"- Zoltan Pozsar in April.
Since Volcker, the Fed has sought to actually keep long term rates lower by raising short term rates. The second way to lower inflation Pozser says, is “by forcing long-term interest rates higher”.
To summarize his whole February post using very broad strokes, here are three things Zoltan stated must happen while the Fed awaits (but does not bet on) supply-chains getting fixed.
1- Lower the inflation that you have influence over asap: Specifically, domestic generated service types, as opposed to Overseas supply-chain goods inflation.
The author had contended goods inflation (aka supply-side) from imports was not readily controlled by monetary policy anymore. People need what they need; especially those with budgetary restrictions. The Fed can be more effective, he argued, by focusing on domestically created inflation via letting the air out of house values, reducing labor costs, and tamping down service-good pricing while it awaits supply-chain inflation relief.
2- Undo the overly successful “wealth effect” policy that had driven stock-rich people to be relentless consumers: This policy’s diminishing returns and increasing unintended consequences had become evident.
He describes this being done by: raising rates and keeping the market guessing via flexibility to pivot to a more active QT2 In short: stop telegraphing, discourage traders “leaning” on fed flows, and let a little volatility keep expectations honest.To me, Pozsar says, that sounds as if President Biden closed the “wealth window”, much like President Nixon closed the gold window.
3- Let long term rates rise: this is perhaps more of a “how” than a “what” they should do; but not obvious.
By encouraging long-term rates to rise, yields will compete with stocks (driving them lower); mortgage rates will rise (increasing housing costs and lowering house values). Subsequent Fed rate hikes3 will also not look so ugly by making curve inversions (and recessionary alarm bells) so apparent.
March/ April: Walk the Bond curve higher without drawing attention to inversion…
Above is what Fed activity could look like in a graph: a ratcheting yield curve rising ever higher until inflation is truly stopped. They will walk the curve up restoring long term rates to normalcy while managing short term inflation.
On April 6th Bill Dudley reinforced this prescription saying:
“the Fed will have to shock markets to achieve the desired response”, that is, “it’ll have to inflict more losses on stock and bond investors than it has so far”. If that wasn’t clear enough, the former vice chair of the FOMC closed by saying: “one way or another, to get inflation under control, the Fed will need to push bond yields higher and stock prices lower”
As Pozsar notes, Dudley’s message could not have been clearer. This is the essence of the 3rd Fed mandate: to moderate long-term interest rates. For GoldFix means there exits a normative level (range) for long term rates, and getting to extremes in either direction is not healthy for economies. Markets need dynamic equilibrium (balance!!) to avoid systemic risks. Our long term rates, especially with a lower bound, had been too low for too long4.
Ride of the Volkyries’ Main Points
The article then proceeds to enumerate 5 points describing where policy rubber meets the road while ruminating on potential ways to quantify specific price levels from those policies.
1- WHAT STRIKE CALL IS THE FED TARGETING?
First: the Fed is now in the business of writing a call option on risk assets – not just stocks, but housing and crypto as well. Whether we think of the FOMC’s target level for the stock market and financial conditions as a call option or still as a put option just with a lower strike price is semantics. The big question of course is that if the Fed is indeed writing a call option, what is the level that it targets? Does the Fed want to see the S&P give up only a part of its post -Covid gains or all of them ? Or does the Fed want to wipe off some of the gains that accumulated before the pandemic?
We think the fed isn’t targeting stock price. It’s targeting inflation. And unless stocks drop too fast, they will be content to wait to stop the descent. Still, they must be using some historical reference as Pozsar opines that makes empirical sense.