One week after JPMorgan’s head quant Marko Kolanovic laid out a surprisingly gloomy outlook for the future of the world’s reserve currency, warning in no uncertain terms that Trump’s “unilateral policies” are the biggest risk “of bringing major powers of China, Europe and Russia closer”, an alliance which “could profoundly impact the USD-centric financial system”, ultimately threatening the reserve status of the US dollar, Kolanovic takes on a different topic in his latest note to clients, namely a look at the implied moves and market reaction from Fed releases this year, and what these mean.
Responding to client requests, Kolanovic and Bram Kaplan analyzed the reaction of the equity market to Fed Chair Powell’s speeches and unexpectedly found that they “resulted in equity market declines this year.” Unexpectedly, because this is a material change from the popular “FOMC drift” observed over the past decade, in which stocks levitated before and just after the Fed press conference.
For his analysis, Kolanovic divided speeches into 2 categories: FOMC Press Conferences and Other Speeches. The average performance and hit rate for S&P 500 declines was as follows
Putting these declines in context, the JPM quant also notes that the average market return (on any given day this year) was positive +5bps. He further notes that the speeches in many cases represented intraday price turning points, “indicating probable causality”, i.e. they were indeed the catalyst for market sentiment shifts.
And while Kolanovic acknowledges that it is not possible to attribute the market impact of each speech with certainty, “simple math indicates that ~$1.5 trillion of US equity market value was lost this year following these speeches.”
So what does the market’s reaction to Powell’s speech convey?
To answer that question, Kolanovic first gives a simple definition of what is a “market”, which he defines as a “wisdom of the crowd” system (likely the most sophisticated one in existence).
It is made up of a broad range of participants with skin in the game, and it incorporates natural selection. Participants who are wrong in their forecast lose assets, i.e. input weight, and those that are correct see their input weight increase.
With that in mind, the question is the following: why was the market reaction on Fed speeches negative this year?
To Kolanovic, the most likely answer is that the equity market’s assessment of the economy and various risks is not aligned with that of the Fed, and “specifically, the equity market likely implies that the Fed is underestimating various risks, and hence is increasing the implied probability of the Fed committing a policy error in the future.”
And since the higher probability of a policy error translates into lower equity prices on the news, Powell’s speeches which hint that the Fed is indeed on the verge of policy error, are increasingly greeted with a market selloff.
Taking this one step further, the next logical question is where does the market disagree with the Fed? To JPM, several places where markets may be diverging from the Fed are the following, paraphrased from recent Fed comments:
Finally, perhaps the most interesting Fed comment is that “equity sell-off warrants attention if sustained.” Here, Kolanovic notes that the equity market liquidity profile and microstructure has significantly changed over the past decade (computerized liquidity, systematic and passive strategies, etc.). This means that if fundamental investors start questioning the cycle – and start selling – “a technically driven selloff could be more violent and more likely to deliver a knock-out punch to the economic cycle.”
In other words, the new microstructure of financial markets would be brutal, violent and instantaneous, and not leave enough time for the Fed to react.
With these three considerations in mind, Powell may want to be especially careful what words he picks for his future public statements, because if he stretches the rubber band between what the Fed believes and what the market believes the Fed should believe, the outcome – for markets – could be dire.
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