Uncomfortable parallels to Dec 2018

After a day of ruminating on the implications of yesterday’s hawkish surprise by the Fed, I realized that we are an inflection point in the market where the Fed’s hawkishness has crossed a tipping point. There are uncomfortable parallels to Dec 2018, a month when the S&P 500 fell 14%.

S&P 500 in 2018

I remember that month clearly because I was short ES futures while on Christmas vacation, and the market was selling off with enormous volatility. Up until that month, it had been a mediocre year of trading, but I somehow managed to finish up 30% on the year mostly thanks to that one move.

Let’s take a stroll down memory lane. 2018 saw the VIX blowup in February, and a couple selloffs due to US-China trade tensions. The Fed had been steadily hiking rates as the economy strengthened, which resulted in below average or negative returns for most risky assets that year.

Fed Funds in 2016-2018

The Fed tightening cycle caused real rates to rise from 0 to 1.18% from 2016-2018.

US 10 yr real yields

Unemployment was 3.7%, and core CPI had been hovering above 2% for two quarters. ISM manufacturing and services were a spicy 59.3 and 60.7, respectively. However, economic data had been surprising to the downside.

US Citi economic surprise indicator

Despite the strong economy, the market was unsure whether the Fed should hike that month. The day before the meeting, a 25 bp hike was only 65% priced in, and a full hike was not priced in until Jun 2019. Similar to today, the market was expecting one last hike out of the Fed, but unsure about the timing. Perhaps the market felt that monetary policy was tight enough to get inflation back down without causing a recession.

On the FOMC announcement on Dec 19, the Fed hiked 25 bp, and Powell said:

The Committee judges that some further gradual increases in the target range for the federal funds rate will be consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee's symmetric 2 percent objective over the medium term.

Following the hawkish surprise, the S&P 500 sold off for 4 straight days and bottomed 8% lower on Christmas Eve. What helped the market bottom out was Mnuchin getting on a call with the Fed, the SEC, CFTC, FDIC, and Office of the Comptroller of Currency to make sure banks had enough liquidity. The press criticized him for panicking, but the markets were probably relieved that the equity selloff had finally gotten his attention.

In the following FOMC in January, Powell stayed on hold and delivered a surprisingly dovish statement and press conference, indicating an end to the hiking cycle. The press dubbed this the “Powell pivot”, and it ushered in a 14 month rally in equities fueled by the disinflation regime.

There are three similarities between December 2018 and yesterday’s FOMC:

1. Strong economy, but inflecting lower

2. Market pricing in one last hike

3. FOMC delivers a hawkish surprise

It turns out these three ingredients, when combined, spell trouble for the stock market. When the market is in the delicate balance of trying to figure out when or whether the last hike will happen, it is particularly sensitive to hawkish surprises.

Most readers know I have been bullish equities since early this summer. Since that call, the markets have been going sideways to lower. The bullish view was based on my view that inflation would surprise to the downside while growth remained robust. This indeed has happened, but unfortunately it has not translated into a more dovish Fed. While it’s disappointing that my bullish view hasn’t panned out, the realization that I’m wrong presents a new opportunity to reorient my portfolio with conviction. I now believe we will see a selloff in risk, so I will be tactically positioning for a scenario similar to Dec 2018. The trades will be discussed in more detail in the paid subscriber section ahead.