I thought I would share the two charts that I think are most important to what is going on with equity markets and with the Fed. The top chart shows the correlation of the S&P and the Fed balance sheet. As I wrote last week, the markets love a bailout. The economy has clearly slowed through the first quarter. Credit availability is sharply contracting and earnings estimates for the S&P in Q1 are expected to decline by 7% y/y. So why are risk assets rallying? I think this chart tells you all you need to know. I would also add that when so many macro investors (Hedge Funds) are positioned short, that creates a bid under the market as those entities have to cover their short positions to manage risk as the market rises.

The second chart tells you why the Fed is likely to hike interest rates again in early May and why we think the market is wrong to be pricing in so many cuts in the back half of the year. Wage growth is actually accelerating. We are 500bps deep into this tightening cycle and the Fed has made negligible progress on wages.

On one hand, the economy is slowing. Leading economic indicators from consumer and small business sentiment to the historically inverted yield curve are screaming recession. On the other hand, the recent regional bank crisis necessitated the Fed inject liquidity, high end consumers have far greater accumulated savings than before the pandemic and wage growth remains beyond resilient.

The Fed is in a tough spot. They understand the long and variable lags. They know credit conditions have tightened. We know from the Fed minutes that the Fed staff is now projecting a “Mild Recession”. But they simply cannot pause when wage growth which drives their “Super-core” services ex-housing measure of inflation is running this hot. We remain in the “Higher-for-Longer” camp and reiterate, that the only way we see the Fed cutting rates this year will be if we see worse than a mild recession. As for now, financial conditions are too strong, and the Fed has more work to do to take asset prices and wage expectations down.

To perhaps state the obvious, if we didn’t have a secular labor inflation problem, the Fed and Congress could respectively keep printing money and running massive stimulative deficits. Unfortunately, the Great Moderation is over. The decades of cheap labor, cheap energy and cheap debt are behind us. That is a paradigm shift that the market has clearly not yet accepted.

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