The market was broadly expecting the Fed to deliver a 75 basis point rate hike at the September FOMC meeting. But the Federal Open Market Committee (“FOMC”) managed to surprise even the most restrictive estimates. The median interest rate for 2023 is now available at 4.5-4.75%, again sending a strong signal to the markets that the Fed is not planning to pivot anytime soon.
Most notably, in the press conference following the interest rate decision, Chairman Powell aggressively confirmed that bringing inflation down was the committee’s most pressing goal — even if it did cause a recession. Unsurprisingly, stock markets sold off sharply following the announcement, with the S&P 500 down about 1.7% and the more growth-sensitive Nasdaq 100 down 1.9% each. Powell commented:
We have to get inflation behind us. I wish there was a painless way to do this… (But) there isn’t.
After the FOMC meeting, I’m confident to reiterate my bearish thesis that a major re-rating of the S&P 500 (SPX) is imminent. I contend that the S&P 500 could fall to levels as low as 3,000. And investors should hedge this scenario by buying 95/85 percent moneyness put spreads.
The September FOMC meeting
The Federal Open Market Committee meeting was held on September 20-21 and after hotter than expected August CPI print, markets were anticipating a hawkish tone. And rightly so. How the Fed is”determined to bring inflation back to its 2 percent target,” the FOMC raised the federal funds rate by 75 basis points to a target range of 3 to 3.25 percent for the third consecutive day.
The Fed’s dot chart has also changed significantly. The FOMC committee now forecasts that rates will end 2022 at around 4.4% and soar even higher to 4.6% in 2023. Traders reacted immediately and the yield on the 2-year Treasury note rose to a 15-year high of over 4.1%.
But the overnight rate is not the only variable that has undergone a major revision. Notably, all major economic variables showed a strongly unfavorable rate of change. According to the Fed, GDP growth will now be just 0.2% in 2022, compared to 1.7% three months earlier. GDP for 2023 was reduced to 1.2%. At the same time, unemployment expectations rose – the forecast for 2023 rose from 3.9% to 4.4%.
The projections, including the scatter plot, represent “each participant’s estimate of the value to which each variable would be expected to converge.”
Impact on Investors
Fed Chair Powell hinted at what the market already knew and feared: there is little chance of taming inflation without plunging the economy into recession. That means lower employment levels, lower corporate earnings, lower consumption – and consequently falling asset valuations – are a price the Fed is willing to pay. Powell commented:
Higher interest rates, slower growth and a declining labor market are all painful for the public we serve, but they are not as painful as the failure to restore price stability and the need to come back and do it again later.
Powell’s comments in September stand in sharp contrast to the soft landing scenario communicated in June. And I argue that stock markets still have to price in the changing situation.
The thesis is simple: if you can earn more than 4.1% on “risk-free” government bond yields, how attractive is the S&P 500 at a yield of 5.3% (ratio 1/PE, 1/19 ) who is subject to EPS contraction? Not very much, I would say. And I believe traders and investors will rerate the index until a risk premium of about 3% is restored. This would mean a P/E ratio for the S&P 500 of around x13 and an index valuation of 3,000 (based on a consensus earnings estimate of $231). Given Chairman Powell’s rhetoric, I argue that there is little hope that the Fed will support the market with a liquidity put above this index level.
My personal takeaway from the FOMC statements, economic forecasts and September press conference is that in order to achieve lower inflation, one must accept the following a lot of slower economy and as an indirect consequence of lower asset prices. Accordingly, it seems to me that the Fed is actively trying to bring the stock market down. And as a relative valuation trade to risk-free 2-year Treasury bills, which now yield over 4%, a re-rating of the SP&P 500 to levels as low as 3,000 would not be unreasonable.
Personally, I contend that there is no better trade right now than buying 95/85% money PUT spreads on the SPX. Keep in mind that valuation is still high relative to both yields and historical levels, and that multidimensional risk looms over the markets – waiting to push the market to new yearly lows. That said, I’m guessing and targeting 60 DTE, which would give a payout of around 5:1 if the SPX closes at 85% moneyness at expiration (reference, around 3200 strike price).