The Fed May Be About To Unleash Hell On Stocks
0The big moment will arrive tomorrow at 2 PM when the FOMC will release its monetary policy statement, followed by a press conference with Jay Powell at 2:30 PM ET. Given the latest CPI and PPI data, the fate for an accelerated taper appears to have been sealed and what is likely to be a much more hawkish tone out of the Fed. While the equity market has lived in fantasyland over the past week, rallying off a massive drop in implied volatility, the reality is beginning to set back in that the Fed is no longer the stock market's friend. Since the beginning, the bond market and the currency market have read this correctly. Their message is of grave concern and indicates further economic slowing and tighter financial conditions as a result of the more hawkish Fed. As I have warned now for months, the equity market is forecast to see a massive drop-off in earnings growth in 2022 while trading at a historical high PE, all as the Fed is pulling back on QE, which is already tightening financial conditions. It is a recipe that continues to be a disaster-like scenario for stocks unfolding in slow-motion. The Fed To Taper Faster The Fed is likely to announce that it will double the pace of the taper from $15 billion a month to $30 billion a month. Additionally, I expect them to shift their tone from fostering just maximum employment to one where their focus is on taming high inflation rates to avoid it becoming persistent and leaving a permanent mark on the economy. More hawkish expectations have resulted in the bond market flattening the yield curve and dropping inflation expectations. The 10-yr breakeven inflation expectations have dropped to 2.41%, down from a peak of 2.75% on November 15. Meanwhile, the 5-year inflation expectation has fallen to 2.72% from a peak of 3.25% on November 16. Falling inflation expectations can indicate changes in economic growth trends. Over the past ten years, the trend in inflation expectations has been a good indicator of GDP growth. The declining inflation expectation indicates that economic growth is likely to slow dramatically, most likely due to higher prices or overtightening by the Fed. Additionally, the yield curve has flattened dramatically, with the front of the curve rising sharply and the back of the curve falling over the past six months. The 10-2 year spread is the most closely watched spread, and it has fallen to 80bps from 1.30% in the middle of October. The flattening yield curve also indicates slower growth in the future. With the front end of the curve rising due to expectations of a Fed tightening cycle near term, the back of the curve falling due to expectations of a weaker economy over the long term. The current technical structure of the spread would suggest another steeper leg lower is coming once support around 80 bps breaks. The bearish pattern suggests the spread to drop to around 50 bps, indicating further flattening. The Equity Market Lives In The Land Of Make-Believe To this point, the equity market has refused to believe the narrative the bond market has been telling us since the middle of October, which is one of a Fed becoming much more hawkish in the future, with that hawkishness and higher prices leading to an economic slowdown. Instead, the equity market has foolishly held near the highs, basically giving the Fed the green light to be as aggressive as it wants to be. How could the Fed not take an SP 500 trading at its all-time highs going into a very well telegraphed accelerated tapering plan as a green light? The problem is that the equity market will soon learn that the Fed is not only serious about tapering faster. But will also find out the Fed is tapering faster into an economy that has slowed dramatically as the third quarter GDP indicated and is likely to slow even further as projected by the bond market. On top of all of this, earnings growth over the next twelve months is expected to slow to just 8.2%, while the SP 500 trades at 21.2 times its NTM earnings estimates, with no sign of multiple compression since the beginning of May. It suggests a more hawkish Fed has not seen one inkling of being priced into this market yet, none. The only time the SP 500 has seen higher PE multiples in modern times is in the late 1990s. Recession Warnings Additionally, the SP 500 real dividend yield or the SP 500 dividend yield minus the CPI is -5.58%. Historically, it has only been lower to other times in modern times, 1974 and 1980. Every time the real dividend has fallen below -2%, it has been accompanied by a US recession and a very steep drawdown in the SP 500. The only time it didn't happen was in 2005. The SP 500 real dividend yield supports the narrative the bond market is now stressing about the direction of overall economic growth The equity market is about to be dealt a very harsh dose of reality tomorrow at 2 PM.