Via Zerohedge

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%

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%

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
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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.