The Rate Cut Fantasy JUST DIED...

The market's initial reaction to the June jobs report (57,000 jobs added, significantly below the 115,000 estimate) was a rally in stocks and falling Treasury yields. This response was based on the widespread belief that weak job data would lead the Fed to not hike rates, resulting in cheaper money and higher asset prices – the 'Powell playbook'.

Kevin Warsh, the new Federal Reserve chair, operates with a fundamentally different approach than his predecessor, Jerome Powell. Warsh does not rely on forward guidance, preferring a model closer to Paul Volcker and early Alan Greenspan, where the Fed acts first and explains later. His primary principle is that inflation is too high and he is determined to fix it, explicitly stating that anyone expecting an inflation target above 2% will be disappointed.

Warsh's framework is not job-centric; unlike Powell, who closely monitored employment data, Warsh views the economy through the lens of productivity and inflation. This means the market's assumption that bad job numbers will lead to rate relief is based on a thesis that the current Fed chair does not share. Furthermore, inflation is not cooperating, with the Iran conflict pushing US inflation to a three-year high, leading institutions like Bank of America to forecast rate hikes, not cuts.

The 'bad news is good news' trade only works if the Fed chair prioritizes employment over inflation, which Powell did, but Warsh does not. Warsh has clearly stated his intent to address the five years the Fed has missed on inflation. The market's reaction to recent data still reflects a 2023 reflex, treating Warsh like Powell, despite professional institutions updating their models to reflect Warsh's new, more hawkish stance.

If Warsh holds firm, the 'bad news is good news' trade has a limited shelf life. A combination of weak jobs, rising inflation, and a hawkish Fed chair who offers no forward guidance will lead to 'bad news is bad news,' a scenario not priced into the market since the Volcker era. Investors should watch the next CPI print for elevated inflation, the Treasury market for rising long-term yields signaling Warsh's doctrine, and Warsh's communication style for continued avoidance of forward guidance, indicating a shift from rate relief to rate risk. The rules of engagement have changed, and past strategies may no longer be effective, urging investors to adjust their portfolios accordingly.