“A Rage Of Unwinds” – As Stocks Soar, Nomura Is Worried About This Forward Scenario

Today’s PPI reaction on top of yesterday’s CPI impact was simply about cutting the odds of the inflation “left tail” scenario and the negative implications that more upside inflation surprises would have had on further escalation of Fed hawkishness / tightening of financial conditions.

Instead, as Nomura’s Charlie McElligott notes, post the CPI downside surprise, the now-upgraded probabilities of the “right tail” are pricing in a soft-landing “Goldilocks” outcome for the economy, the Fed and markets… as opposed to the prior “Recession” base-case for many now being re-priced “lower”.

McEllligott points out that there was never any real question from the market in yesterday about inflation moving well “off peak” in the coming-months – the market’s squeeze higher reflexively confirmed the goldilocks outcome and the Biden White House messaging did the rest.

The issue is that with ‘Services’, Shelter and sticky inputs staying high, and with Median CPI and Trimmed-Mean CPI coming-in at 6.3% and 7.0% respectively, that broad-based pressures and the risk of “wage / price spiral” from such a tight labor market will make evidence of “clear and convinced” drop in inflation back to the arbitrary 2% “target” unrealistic in the medium-term.

All of which explains why we heard the same old trope from Fed speakers on “higher / tighter for longer,” and certainly little-to-no realistic potential at any sort of “dovish pivot / Fed easing” in the near- / medium- term horizon.

All of which the market simply ignored and eased rate-hike expectations…

In the meantime, however, financial conditions are again EASING to the chagrin of the Fed, after this “risk-on” post CPI interpretation from markets: USD is getting hammered, Credit Spreads are gapping tighter and Equities Vol is being butchered (CPI event risk cleared, “left tail” cut, earnings “less bad than expected and clearing,” earnings “dispersion”)…

But, the forward scenario / sequencing that the Nomura strategist most worried about from here is likely early / mid 1Q23, where instead of a smooth glide path of Inflation averaging lower over time, the market sees just how “structural” much of the “embedded” inflation has become, and that we are “stuck” in a much more “shallow” than anticipated Inflation glide path which stalls in the +4% – 5% range and unable to revisit “target,” as Shelter’s gains over recent years continue to contribute in lagged-fashion, and while Energy and Labor’s “structural” shortages keeps those Inflation inputs firm as well.

This is the “Then What?!” scenario which should keep Fed participants up at night, and leave them biased to run “restrictive for longer” in the meantime…

…because many in the market the market will have already assumed “end of Fed tightening cycle” by 1Q223 – so the risk is that after a pause – which is potentially then “mistakenly” perceived to have been signaled as a premature “all clear” and / or “dovish pivot” – that the Fed could in-fact need to TIGHTEN again (see 70s and 1980 analogs), and risk one last shot at “risk-off” on the forward policy uncertainty thereafter.

In the meantime, the bludgeoning “stop-out” of previously sized-up “Short” books / baskets is getting hard to watch, just a rage unwind / forced de-gross.

McElligott warns that the S&P 4200 level is a potential “short Gamma” launch point on a breakthrough, as there were some LUMPY Call Spreads which traded in the mkt over the past few months where clients were short that as their upper strike – zoom to Spot 4235 last, post PPI coming-in “light” as well.

The decay from now-roasted Puts struck lower between 4150 and 3800 risks spinning-off more Dealer “positive Delta” hedge covering, with 4330 (the 200DMA) as a target.