FRI 28 JAN 2022
An observation that we have frequently made is that the policy error in this cycle and the QE regime has not been tightening too early, but leaving the policy normalisation process too late. The problem with running exceptionally loose policy combined with the asymmetry of the Fed’s implied put is that it implicitly (or even explicitly) encouraged capital into risk assets and the self-reinforcing rise in leverage.
Of course, the new constraint on the Fed in this cycle has been the genuine rise in consumer price inflation to the highest level in 40 years. That has prompted a significant rethink on the pace of policy normalisation this year, though might be mitigated by pricing less tightening later on (pricing of terminal rate expectations still appears anchored around 2% based on the 16th Eurodollar contract).
The recalibration of the policy, liquidity and rate environment has clearly contributed to the violence in equity prices and significant rotation under the surface. It has also caused some participants to fear a “growth scare” precipitated by the Fed, which is somewhat ironic given they have not even started tightening yet. However, it is notable that there has been a material slowdown in new orders relative to inventory which is a decent lead indicator on growth and profits (chart 1).
To be fair, markets are always forward looking which is evident in the material flattening in the yield curve. On the positive side, the curve tends to be a very long lead indicator of the macro cycle and the material risk to growth tends to occur much later in the tightening process once rates are closer to neutral (which is probably around 2-2.5%). While the rates markets have already largely priced that outcome, the actual process has yet to even start as we noted above.
Another interesting aspect of the recent episode has been the relative absence of violence in developed market credit risk pricing. US investment grade credit spreads are only around 20 basis points above the recent trough and still close to the pre-pandemic level. For those of a glass-half-full persuasion the relative calm in credit risk premia is contrarian bullish, particularly given the bearish extremes in sentiment surveys, breadth, put-call ratios and skew in equities.
The glass-half empty interpretation is that the deterioration in credit still lies ahead with the tightening in funding markets and collapse in the SPAC/IPO and pressure on profitless hyper-expensive growth stocks as a warning sign for credit. The long lead of the yield curve on credit spreads relates to the macro cycle itself. Ultimately, the key for credit markets is the underlying cash flow of companies or the capacity to finance debt. That also tends to deteriorate much later in the macro cycle leading to a widening in the credit risk premium (chart 2). That said, recent sharp flattening in the yield curve is still potentially ominous for the cycle and the credit outlook. Stated differently, the cost of protection in credit is inexpensive relative to the potential pay out compared to equity where volatility is now much higher.
The final point to note is the recent impulsive (continuation) rally in the US dollar in response to the recalibration of the rate/liquidity outlook is a challenge for risk assets (chart 3). The good news, is that similar to the re-pricing in rates markets and the large deterioration in sentiment and risk perceptions in the equity markets, the recent move appears well advanced. Nonetheless, a rise in the dollar is often coincident or an important component of a broader tightening in financial conditions.
The key message from the markets this week is that there has been a meaningful recalibration of pricing on rates, liquidity and macro conditions. Broad risk perceptions and sentiment is negative but possibly not yet extreme. Inflation has also likely been a genuine constraint on a reflexive rebound in equities. The general shift in rates and liquidity conditions will also continue to favour companies with high free cash flow and low balance sheet leverage. The evisceration of assets based on hopes and dreams is well appreciated, but is still vulnerable to further liquidity withdrawal in the recalibrated regime. The rise in correlations this week also suggests that there is opportunity to accumulate inexpensive quality.