Fed’s Easing Bias Sparks Market Rally Amid Renewed Inflation Risks

Fed's Easing Bias Sparks Market Rally Amid Renewed Inflation Risks 

Nomura's Charlie McElligott warns that the recent surge in stock prices may leave many investors behind once again. Following a significant deleveraging event, fear of missing out (FOMO) is driving a rush into index options, with traders scrambling to capitalize on the rising market.

After Powell's Jackson Hole speech, a predictable surge in demand for upside call options has emerged, as many investors who previously reduced their market exposure are now compelled to reinvest as volatility averages down and the market climbs.

From a macro perspective, Powell's speech was pivotal in triggering this "Everything Rally." He emphasized that labor market conditions have softened compared to pre-pandemic levels, inflation risks have decreased, and the Fed is committed to supporting a strong labor market. This suggests a shift toward a more accommodative stance, with the Fed now focused on avoiding any further increase in unemployment, signaling a bias towards easing.

For the first time since the inflation crisis began, Powell essentially reintroduced the "Fed Put," signaling a green light for the broad market rally against U.S. dollar depreciation. This has revived the old "QE Trade" strategy: going long on U.S. Treasuries, risk assets, and gold, while shorting the U.S. dollar, as the Fed appears poised to rebuild a significant "short volatility" position to stimulate a positive wealth effect in the U.S. economy.

The rationale for the long gold/short USD trade is clear: if the Fed proceeds with a deeper rate-cutting cycle or even asset purchases, it may accept a higher level of inflation as the lesser evil. However, the risk lies in an overly soft landing, where economic strength combined with global easing could reignite inflation, making it difficult for the currently anticipated rate cuts to materialize.

Looking ahead, aside from potential geopolitical or election-related disruptions, the next major macro risk in rates may come in Q1 2025 with the Treasury's refunding announcement. Post-election, the Treasury might signal the need for higher coupon issuance, which could trigger another term premium rebuild in the long end of the yield curve—a development that equities have reacted negatively to in the past.