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Powell can give markets a huge reality jolt this week (SPX)

Fed Chairman Jerome Powell presents a semi-annual monetary report during a Senate hearing

Win McNamee/Getty Images

The stock market has risen dramatically from October lows, and despite all the hawkish comments from Fed officials, the stock market has been rising since mid-October. Jay Powell takes no chances with the blackout period is fast approaching for the December FOMC meeting. He will speak on November 30 at the Brookings Institution on labor market and economic prospects.

This Wednesday could be another one of those times when Jay Powell has a chance to reset market expectations like he did in Jackson Hole in late August. In July and August, markets rallied strongly, easing financial conditions. Today, Jay Powell finds himself in a similar position, with the S&P 500 moving strongly, implied volatility levels falling and financial conditions easing.

The Fed transmits its monetary policy through forward guidance, quantitative tightening and interest rates. Together, these factors contribute to tightening or easing financial conditions. Immediately after his Jackson Hole speech, financial conditions tightened considerably, but since October’s CPI report, financial conditions have eased considerably.

That’s a problem for Powell because the easing of financial conditions has the effect of undoing much of the tightening the Fed has done in recent months. The Chicago Fed’s National Financial Conditions Index recently fell to levels not seen since May 20, when the Fed funds rate was just 75 to 100 basis points.

Financial conditions


Meanwhile, the adjusted national financial conditions index fell back to levels not seen since Sept. 2, when the Fed funds rate was 2.25-2.5% from its current rate of 3.75. at 4%.

Financial conditions


The easing of these financial conditions is having real effects, as the national average 30-year mortgage rate fell from 7.16% on October 21 to 6.67% on November 18. Although rates are still high from where they might have been 6 to 9 months ago, falling rates have increased mortgage applications over the past two weeks. If financial conditions in the economy continue to ease, mortgage lending would likely continue to decline, leading to a further increase in mortgage applications.

Mortgage rates


Over the same period, consumer inflation expectations, as measured by the New York Federal Reserve with a 3-year outlook, rose to 3.11% from 2.76% in August. Meanwhile, the University of Michigan’s 5-10 year inflation expectation outlook fell to 3% from 2.7% in September. Rising consumer expectations could indicate that headline inflation may begin to rise again.



For example, after months of declines, the Manheim Used Auto Index rose for the first time since June.

car prices


These are only minor samples, but they also show why the Fed cannot let financial conditions continue to ease and needs them to tighten back to October levels and then force them to stay there. On top of that, while unemployment insurance claims have started to rise, the number of job vacancies relative to the number of unemployed people is still very high, at nearly a 2 to 1 ratio. It is still significantly higher than where it was before the pandemic, at around 1.25.

Shock/unemployment rate ratio


That’s why Powell needs to fend off recent market trends of lower rates, weaker dollar, lower implied volatility and higher stock prices. He needs financial conditions to tighten, and he needs them to stay tight to avoid further easing and the undoing of everything the Fed has accomplished this year.

The first step to regaining control was the Fed minutes. Some investors seemed to completely miss the point of the Fed minutes, instead focusing on the known “known” of the slower pace of rate hikes. The critical element of the Fed minutes pointed to rates going higher than previously noted at the September FOMC meeting. Meanwhile, the Fed is willing to risk recession if it means beating inflation. Reading the Fed minutes and listening to Fed officials, it looks like rates are bound to go above 5%.

It looks like rates will top 5% in 2023. The next step is for Powell to come out and forcefully push back against the recent easing that has taken place by emphasizing the minutes and telling the markets that the job of the Fed is far from over and the rates will go much higher until their mission is complete.

The VIX index has melted from the October 12 high, falling from around 33 to Friday’s closing value of 20.5. Meanwhile, the S&P 500 fell from 3,577 to 4,026 over the same period.

But there are signs of changing market expectations, with the implied volatility of the VIX beginning to rise, as measured by the VVIX. It is also exceptionally inexpensive to purchase protection and set up hedges. Since November 22, the VVIX has started to rise, the first signs of rising implied volatility, and traders are looking to set up hedges.



This view is confirmed by the SKEW index, which is now starting to rise after months of declines. The SKEW Index measures S&P 500 out-of-the-money options and is a measure of extreme risk. The rise of the SKEW index is a sign that investors are looking to set up hedges, and why not, given its cheapness, based on the low level of VVIX.



Additionally, the Dollar Index has fallen to a critical support zone which, if breached, could cause the Dollar to decline even further. This would be a huge negative for Powell, as a weaker dollar would raise commodity prices and cause import prices to rise again. While the Fed isn’t focusing or commenting on the dollar, Powell knows he needs the dollar to strengthen for financial conditions to tighten further.



What Powell can do, however, is drive the dollar higher, and he can comment on the likely direction of rates, and he must do everything in his power to convince the market that rates are heading north of 5 % to help push the 2-Year Rate higher. The 2-year rate cannot afford to drop below 4.25% because if that happens, it could fall to 4% or even lower, back into the 3% region. The more he can move the 2-year, the more likely the entire curve will rise with him and the stronger the dollar will get.

2 years


It must also give the market something to worry about, invoking the fear necessary to drive the VIX up and, therefore, drive down stock prices. Lower implied volatility and higher stock prices are easing financial conditions. Again, to successfully tighten financial conditions, stock prices must fall and implied volatility must rise.

This is a critical moment for Powell, similar to the Jackson Hole speech. He needs to double down on his rhetoric and tell investors the labor market is too tight, inflation is too high, and he will do whatever it takes to get inflation back to his 2% target, no exceptions. .

This is a watershed moment for Powell as he risks losing control of the markets and his battle against inflation.

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