Walk the Hawk

07 May 2025

One of our favourite expressions in the post-2008 regime was, never underestimate the Fed’s ability to out-dove the market. The implication is that there was an asymmetry in the Fed’s policy bias to defending the left tail or downside risk for the economy (and markets). Although we would argue that the Fed’s desire for “stability” (to smooth the business cycle) paradoxically contributed to instability via a build-up in leverage, positioning (in all forms) and the inevitable unwind. In the current episode we fear that the Fed has a hawkish bias. The implication is that the Fed will cut policy too late to prevent a sharp growth shock.

Short term interest rate markets anticipate only a 2% probability of a rate cut at the May FOMC. Odds are around 33% for a cut in June and 68% in July. The recent trend has been toward fewer, not more, cuts. The probable reason for the shift in short rate expectations is inflation. The good news is that core inflation is in the 0.2% monthly range. However, inflation expectations as measured by the Michigan survey has increased to the highest level (6.2% over the near year) in 40 years. As we noted last week, the prices paid sub index in the ISM surveys is also consistent with a re-acceleration in headline consumer price inflation. The driving principle of Fed policy revolves around whether inflation expectations remain “well anchored.”

The controversial aspect of the Fed’s stance is that there has also been a sharp deterioration in confidence and the best leading indicators of activity. To be fair, the hard data remains resilient (for now). The time series below is the ISM manufacturing and service sector indices relative to private final domestic demand which remains around 3%. Note, the weakness in first quarter GDP was a function of the surge in imports (and the detraction from net exports). However, there was a notable moderation in consumption.

Of course, the Fed’s stance on inflation expectations is anchored on “tariff uncertainty.” From our vantage point, the key issue is that markets are no longer pricing a worst-case outcome. Equities have mostly recovered from the post April 2nd collapse; credit risk premiums and implied volatility remain narrow. However, we are now around one month away from finished and intermediate goods depletion and not a single tariff deal has been announced (yet). While deals might be announced soon, the more important counterparts are China, Japan, India, and the European Union. The central case is more uncertainty and disruptions. China tariffs will likely be de-escalated to around 60% although that is still likely to be very damaging. As we noted above, there is unlikely to be an offset from the Fed or from potential tax cuts.

The labour market is cooling very quickly under the surface. Job openings are now at a maximum convexity point for unemployment (chart 1). The risk for the Fed is that employment starts to deteriorate rapidly with negative revisions to non-farm payrolls over the coming months. While companies might be holding on to labour in the near term, odds are that capital spending (investment) and hiring get slashed. In that context, the S&P500 at 21.1 times forward earnings and +7% consensus EPS growth over the next 12 months feels heroic. The risk-reward on the global risk proxy feels unattractive at current levels. We remain defensively positioned.

Chart 1

Source: Bloomberg

20250507_Walk_The_Hawk.pdf

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