Rear View Mirror

Markets and the Fed have a lot in common now. They love to drive in the rearview mirror. Since the Fed's early '21 monetary pivot to easing, the road behind has been smooth. Both the economy and markets have basked in the warmth of easier monetary policy. The soft landing has been achieved despite the naysaying. But please take a look ahead—it looks like a rough ride.

The Federal Reserve's data-dependent mantra is dangerously complacent in this era of abrupt change. Last Friday's better-than-expected U.S. Payroll Report gave the impression that economic growth was strong. But it was a last-minute rush to get ahead of tariffs that inflated the data. Today's trade report of a record import deficit confirms this. A 'pull-forward' of buying the previous tariff-free goods and a rush to build low-cost inventories only reinforces my belief in the fallacy of the bull case for risk assets. This ensures that Chair Powell will stay hawkish longer than needed. Despite this, bulls keep buying stocks until the hard data catches up.

Such are the hallmarks of a bear market rally. The recency bias of an ever-rising bull market has duped investors into chasing any headline that gives Trump's tariff war a 'Art of the Deal' spin. By reinstating auto tariff relief on USMC-compliant cars and hinting at imminent negotiations with China, investors hit the "buy" buttons last week. But make no mistake, the longer-term theme of using tariff revenue to pay for tax cuts argues for the stagflation that got the market into trouble in the first place. Trump has painted the U.S. into a corner that will take years to unwind.

This policy mix will lead to lower growth and higher interest rates, creating a harsh environment for risk takers. Tariff inflation effects will work through production, crimping affordability. Investment planning has ground to a halt. Should they get through Congress, the tax cut extensions will balloon deficits and pressure long bond yields, thereby offsetting any consumer benefits from lower taxes.

The hype of deregulation benefits also has Wall St. reflexively bullish despite an analysis of the second-level effects. Weak oil prices from OPEC production cap removals have dramatically reduced activity in the U.S. shale patch. This flies in the face of Trump's "Drill, Baby, Drill bullshit. Opening federal lands won't be the incentive that the Administration believes it to be. Nor will allowing logging in National Parks.

So, how will markets deal with the hard data drop that should appear as early as the May Employment report?

It had better not look down.

Risk Model: 2/5 - Risk Off

The same flies are in the same ointment this week as last. Sentiment, Cu/Au, and 3 Mo VIX say stay out. However, the RSI and 200-day indicators, derived from recent surprisingly strong price action, are calm and collected. Who's right?

The market, like traffic control at Newark airport, is flying blind. We don't know what earnings will be, as corporate forecasts are an endangered species. Interest rates, stuck in the 4 - 4.5% range, will soon break out given the huge tail risks in both directions. As we saw in March, the stock market now has a hair trigger as a result of last year's 'U.S. Exceptionalism' rally. There is little wiggle room now.

The Fed has little incentive to support markets now because financial conditions are already highly supportive. Credit spreads, although widening out from last year's ultra-low levels, are normal. The yield curve has normalized as Covid-19 fiscal support staved off the inversion threat. Only implied volatility looks dangerous, but it logically reflects investors' uncertainty from Trump's bombastic economic mismanagement. The chart below has a long way to go before the "Fed Put" kicks in. Weaker credit and equity markets will do the trick.

The bottom fish is over. The "All Clear" I signalled just three weeks ago is history.

Sell this rally.

FED Financial Conditions Index