THU 6 JAN 2022
The way price responded to the more-hawkish-than-anticipated December FOMC minutes resembled something from a Quentin Tarantino movie – “Kill [Dollar] Bill” perhaps. However, in truth markets probably should not have been surprised by the Fed’s discussion in the minutes. As we (and others) have noted for some time, the Fed has been materially “behind-the-curve” judged by the level of real rates, the Taylor Rule or actual and anticipated inflation. Moreover, the Fed had already commenced a taper of the QE program at twice the speed of the previous cycle, with policy rates set to rise 3-4 times this year and next.
What appeared to spook long duration “hopes-and-dreams” growth stocks most was the discussion on balance sheet run-off or Quantitative Tightening (“QT”). From our perch, that fear is warranted. As we noted in December, the Wu-Xia Shadow Fed Funds Rate, which is an estimate of the policy rate taking into account the impact of QE, was -1.8%. Therefore, reversing this impact is equivalent to ~7 rate hikes before the Fed even hikes the funds rate. In that context, the policy normalisation is potentially a non-trivial reversal of financial conditions and liquidity, especially given the starting point. For markets, it suggests that volatility is under-priced.
The recent shift in beliefs on rates has also likely been reinforced by positive re-opening expectations and the early labour market data for December that was well above expectations. The correction in expensive growth equity has also probably been a function of self-reinforced capitulation in still crowded positions. Even after this correction, our short basket of non-profitable technology stocks still trades at 10 times sales and remains vulnerable if expectations of rate hikes, tightening financial conditions and liquidity withdrawal persists. On the positive side, as we have often noted recently, the real damage from higher rates tends to occur later in the cycle when policy properly tightens and inverts the yield curve.
While nominal rates have surged since the start of the year, it has mostly been a product of rising real rates, not inflation expectations. Interestingly, there has also been a rise in terminal (neutral) policy rate expectations, with the 16th Eurodollar contract trading near its highest implied yield since early April (chart 1). Of course, real rates remain exceptionally low (negative) and terminal rates are still consistent with “more now equals less later” or a modest tightening cycle overall for the official policy rate.
From our perch, the ISM manufacturing data was also interesting earlier this week. Notwithstanding the point above on strength in the labour market and re-opening, ISM new orders, prices paid and supplier deliveries suggest that macro momentum will likely start to decelerate over the coming months. In turn that would be consistent with a moderation in earnings revisions and might set up a challenging combination of; liquidity withdrawal, decelerating growth and expensive valuations in equities. On the positive side, it might suggest that the maximum point of fear on Fed normalisation might occur by the end of Q1, 2022. The good news for this region is that policy (Chinese liquidity and credit) had already tightened last year and we might be close to the maximum point of US dollar strength. However, our sense is that quality; strong free cash flow, inexpensive and under-levered companies are likely to be rewarded through this phase. We would also note that it is probably too early in the calendar year to extrapolate trends or beliefs.