mor·al haz·ard
"Lack of incentive to guard against risk where one is protected from its consequences"
Investors are caught in what I call a moral hazard death spiral. Having been conditioned for 14 years to buy every Fed bailout, investors are now continually front-running the Fed, thereby making the Fed’s job of bringing down inflation impossible.
Which means that the Fed must respond to every rally with a further tightening of monetary policy, which has been the theme of 2022. Once again at the peak of this latest rally, two Fed members (Bullard, Williams) have come out this week to inform investors they are too bullish. This Wednesday, Powell will give a speech ahead of the FOMC blackout period next week. The odds on bet is that Powell will once again pound markets down as he did this past summer. Markets have been rallying into slower rate hikes to begin in December, but what they are not prepared for is another hawkish ground and pound. In the chart below, we see via the Fed's "National Financial Conditions Index" that since the summer, financial conditions have actually eased. This despite four back to back .75% rate increases in a row (June, July, Sept, Nov). Now, financial conditions are the loosest since May of this year.
Bullish pundits constantly blame the Fed for policy errors, but ironically, THEY are the ones to blame for this conundrum. Clearly, they have no clue about moral hazard. By encouraging investors to buy every dip, they are prolonging and increasing monetary tightening. In the end they will succeed in imploding the economy while at the same time encouraging investors to buy stocks ahead of financial depression.
The Fed's goal is to force markets to RISK OFF, when that happens they will have cover to pivot to neutral. Ironically, over-eager bulls are preventing that from happening.
The Fed and investors are locked in what I call a moral hazard death spiral.
The overwhelming majority of money managers now believe that stagflation is the most likely outcome in 2023. Meaning, not a soft landing, not a hard landing, a Goldilocks landing that requires only nominal de-risking ahead of time. Plausible deniability for when it explodes.
“Central banks will tighten too much, pushing economies into a moderate recession"
The stagflation thesis assumes the Fed can avoid deleveraging of the likes seen post-2008 and post-Y2K. It fits with the so-called "worst case scenario" of 40% stock market downside as predicted by the "uber-bearish" Morgan Stanley and Bank of America. Which happens to be a mere 15% below the October lows.
The fly in the ointment is the fact that by the end of this year the Fed will have tightened almost twice as much as they did in December 2018, the last time they imploded global markets.
In addition, this is by far the weakest Nasdaq rally of 2022.
In summary, bulls and bears are both waiting for the same "event". They just have a different interpretation of its outcome.
With two weeks until December FOMC, the odds are increasing that soon we will find out who is right.
