Thread by @dampedspring

Goldilocks and the Three Pivots - 101

This is a story of the Fed and it's next moves

What is a pivot?
What does it mean for markets and the economy
Will it be "Just Right"
How is this one different than any in the last 38 years?
All discussed here

What is a pivot. Well it's really simple. It's an action by the Fed. Not by what the markets are expecting of the Fed but by the Fed itself. In this case the Fed currently is tightening monetary policy using its tools. A pivot would be to a policy of neutrality. Not to easing

Of course in very rare occasions a pivot from tightening to easing could occur but typically the first shift is to neutral policy and then a further pivot to easing policy. The market is forward looking so it prices all future actions by the Fed and currently prices a two step

Pivot from tightening to easing starting in Q1 2023

What does it mean to markets and the economy well that takes us back to the classic story.

Papa Bears pivot is too hot and premature. Inflation has not yet been killed but because of the weakening of growth in the economy

The Fed abandons it's fight on inflation and attempts to support markets and the economy.

Mama Bear's pivot is too cold. The Fed delays action until not only is inflation dead but the economy is also in deep recession.

Little Bears is just right. The Fed kills inflation and

Pivots policy to neutral and the economy has either no recession or a shallow one.

How is this pivot different than any in the last 35 years and how may it be influenced by the pivots in the 70's

Since 1985 or so the world has had a massive secular deflationary wind impacting

Ever Fed decision. This has led to behavior of both fed officials and markets. Essentially when presented with a decision to pivot toward easing it payed off to go early while the porridge was hot. The secular winds would bail out an early decision. The markets figured this out

And risk assets and even bonds would rally on pivots. Perhaps nothing has changed and going early is still riskless. If so any pivot should generate a risk rally that would be sustained.

How is this one different than any in the last 38 years? I look back to the 70's

Due to Nixon abandoning the gold standard and various energy embargoes inflation had a tailwind for the whole decade. Fed Chair Burns was simply overmatched and any pivot in his battle was met with a reignition of Inflation. Each inflation surge was even harder to tame and the

Three pivots were left with only one choice. Tooooo cold. Volcker finally tamed inflation but stock markets and bond markets and the economy suffered tremendously. Today it seems clear that inflation has at least cyclical tailwinds. The long term deflationary headwind still

Exist but are mild in comparison. The Fed which has for 40 years had the luxury of pivoting early MUST be aware of the lessons of the 70's and the risks of not killing inflation.
How does that all add up. Too hot and inflation reignites pushing bond yields higher, and margins

Lower, while growth does bounce also hurting bonds and modestly helping equities. Knee jerk rally as generations are trained to buy a pivot but quick and deep reversal as inflation takes off and future tightening gets priced quickly. This is my worst case scenario.

My best case just right but given the narrow landing place highly unlikely would obviously be a pivot after inflation is killed with only a mild recession. It's unclear if that's even possible but regardless it's a narrow part of the distribution. What I hope for is that the

Fed will kill inflation by waiting to pivot far longer than is currently priced. If they succeed in killing inflation current bond yields can remain supportive of equity valuations, margins can begin expanding, while top line growth will suffer. But the medicine will be long

Term bullish and at current levels leave limited downside for equities who look forward through to a normal economy in 2024 and on.
#fintwit