Authored by Bloomberg macro commentator and former Lehman trader, Mark Cudmore
No spoilers but the outcome of Federal Reserve Chair Jerome Powell’s testimony is shaping up to be an 0.5% fall for U.S. stocks and a 6bps rise for 2-year Treasury yields. Well, according to my Bayesian beer mat calculations.
Attempting to quantify a nuanced situation, I’ve estimated the probabilities and possible one-day asset returns stemming from the three key focal points of his testimony. It’s just a framework to approach the event, not a conclusive assertion of how assets will react
1. A July rate cut is priced as a sure thing, so either:
- A) Powell validates market pricing = 90% probability
- S&P 500 E-mini futures rise 0.2%
- or B) Powell raises doubt over July cut = 10%
- E-minis fall 1.5%
2. On the post-July policy path, where more than two further rate cuts are priced in over the subsequent 12 months:
- A) Powell is interpreted as being reluctant to cut rates too quickly (hawkish) = 50% probability
- E- minis fall 1.5% and 2-year yields rise 13bps
- B) Powell channels Alan Greenspan and manages to leave rate pricing largely undisturbed = 20%
- E-minis climb 0.5% with no change in yields
- C) Powell is interpreted as willing to be aggressive on rate cuts (dovish) = 30%
- See below
3. In scenario 2C, where Powell is interpreted as being dovish, what is the narrative explanation?
- A) Pressure from President Trump seen as main driver = 30% probability
- E-minis rally 0.8% in what is seen as a sustainable move, 2-year yields fall 8bps
- B) Powell seen as reacting to a worrying economic outlook = 20%
- E-minis fall 0.5% even though 2-year yields slide 6bps
- C) Powell perceived as being bullied by market = 50%
- E-minis rise 1%, while 2-year yields slip 5bps
- NOTE: 3A and 3C are similar but the distinction may prove important
Assuming points 1 and 2 are independent, the overall probability adjusted expected outcome for E-minis is a fall of 0.5% and a 6bps rise in 2-year yields.
- The most likely outcome is 1A, 2A – a hawkish validation of July rate cut pricing. That’s given a 45% probability and would result in a 1.3% slump in E-minis under a mini taper-tantrum scenario
- In a more hawkish 1B, 2A scenario where a July rate cut is back in question, E-minis fall 3%, but that’s only a 5% tail risk, under the assumption that 1 and 2 are independent (which is admittedly flawed, but necessary for the purpose of this exercise)
- In a dovish 1A, 2C, 3C world where Powell validates rate pricing beyond July, E- minis surge by 1.2% to a fresh record. This has a 13.5% probability.
- A 1A, 2B world where Powell does little to change anyone’s thinking would essentially be an anti-climatic non- event for markets. This comes in at an 18% probability or almost 1-in-5 chance
Place your bets and buy some popcorn.