Appetite for (Self) Destruction

MON 07 FEB 2022

The lead guitarist of Guns N’ Roses has been described as a “train-wreck within a train wreck.” Nonetheless, Slash is likely one of the greatest of all time. While there was warranted focus on the crash in the stock price of Meta last week, the train-wreck within the train wreck was probably in the fixed income markets and with it the reflexive implications for equity. Last week ended with the large upside surprise in the US employment report (more on that below). However, the impulsive rise in sovereign yields was much broader than just the US and was challenging for the low-rate-forever prevailing bias. We repeat our observation from last week that the edge of chaos with maximum complexity occurs between paradigm sifts.

Both payroll and wage growth exceeded the maximum forecast in the Bloomberg survey last week. From our perch, the large upside surprise was flattered by the BLS benchmark revisions. In short, the BLS revised the job data back to 2017. The total revision was +211,000 or +3,500 per month which is a rounding error on a labour force of 150 million people (or so). The recent revisions of +709,000 to November and December were largely offset by the -974,000 revision to May-July last year.

The big picture point is that total US employment is still around 6 million jobs below pre-pandemic levels (adjusted for population growth). However, as we noted last week, record job openings suggests that the shortfall does not relate to the demand for labour, but insufficient supply. In turn, that is consistent with the 5.7% annual growth in average hourly earnings. For markets, the hawkish reaction in fixed income and money markets to price higher short term rates and faster balance sheet run-off appears warranted.

The challenging start to the year equities, particularly “growth” equity commenced with a sharp correction in bond prices (rise in yields) and spread to financial assets more broadly. As we have noted, the good news is that markets have clearly started to price the swing from the super-abundant liquidity regime, to something much less accommodative. That sift also occurred in European fixed income last week with a similar impulsive rise in yields. German 10 year yields are no longer negative and the money markets have priced a hike in the European Central Bank deposit rate for the first time in seven years. The implication for financial assets is much broader, as negative yields in Europe have been an anchor for fixed income assets elsewhere and the demand for carry trades.

As we have noted for some time, none of this should come as a shock to investors. Afterall, headline inflation in the US is 7% and similarly elevated elsewhere (the January CPI is reported this week). Policy rates probably shouldn’t still be at emergency (near zero) levels. Of course, for markets, speed kills and the convexity of the re-pricing in fixed income can exacerbate the liquidity withdrawal, reduction in leverage and the reflexive impact on duration-sensitive equity/asset prices. As we noted recently, the recent move appears disturbingly similar to the taper episode in 2013. Although the inflation backdrop appears considerably more challenging in this episode.

While there has clearly been a material re-pricing in long duration growth equity and equity volatility more broadly it is notable that credit spreads (both investment grade and high yield) remain well below average. Stated differently, the cost of protection in investment grade CDS remains inexpensive relative to the potential pay-off and compared to equity volatility (chart 1). Investment grade fixed income also has a greater sensitivity to interest rate (duration risk). The post 2008 crisis prevailing bias that low inflation, growth and rates are a permanent state has been seriously challenged. The potential train-wreck in fixed income is also a plausible train-wreck for rate sensitive equity. Welcome to the Jungle!