The Convexity for Equity in Rates

2 Dec 2021

Equity price action over the past week has been a little spicy. Through most of Wednesday the stock market appeared to look through the omicron strain and hawkish remarks from Jerome Powell. However, the impulsive sell off in the afternoon of the US session suggested that the markets have not fully digested omicron uncertainty and an accelerated monetary policy cycle (faster reduction in QE and rate hikes). To be fair, positioning was also probably quite stretched after the impulsive rally off the October low. The NASDAQ rallied 15% in six weeks and was probably vulnerable to a consolidation phase on any disappointment in the news flow.

While there has clearly been some re-calibration of beliefs in the fixed income/money markets, rates are still extremely low in real (inflation-adjusted terms) and relative to the Fed’s own sense of equilibrium (chart 1). Although there has also been a concurrent re-pricing of “growth” equities sensitive to a higher discount rate, the proportion of stocks trading at more than 10 times sales is at a record high. The big picture point is that if the Fed really is serious about inflation, the potential correction in some highly valued stocks could be biblical in nature.

The irony about Jay Powell’s capitulation that inflation pressure is no longer “transitory” is that it is stating the bleeding obvious. While I can’t recall the Fed ever being ahead of the curve in the past decade or more, on a range of measures it is now abundantly clear that emergency policy settings are no longer warranted. As we noted last week, based on traditional measures like the Taylor Rule, the funds rate is as much as 600 basis points too low. Even the median expectations of the terminal rate by the FOMC would suggest that rates are 200 basis points too low. Of course, the gap between current policy settings and neutral would never likely be closed rapidly, but a if it is faster than current consensus expectations that could prove disruptive to levered and expensive entities most sensitive to a higher discount rate. For example, if the taper was completed by Q1 and more than two rate hikes of 25 basis points were delivered by mid-2022.

As we have often noted, if rate hikes are accompanied by strong growth they will not end the macro cycle until policy is closer to equilibrium (neutral). However, as we noted above, an accelerated monetary policy cycle could be disruptive for highly levered entities or “growth” companies based on hopes and dreams of cash flows well into the future – the naked swimmers. The big picture point is that the magnitude of liquidity withdrawal and rate hikes has been relatively modest so far relative to a conservative estimate of neutrality or where policy probably “should” be. Moreover, if growth fears relating to the new variant appear misguided, that would also reinforce expectations for an accelerated monetary policy cycle. From our perch, that suggests being long companies with strong cash flow, low balance sheet leverage and avoid (or short) highly levered entities.