TUE 11 JAN 2022
Former Chairman of the New York Fed and now Bloomberg opinion columnist Bill Dudley suggested that the FOMC needs to “tighten financial conditions” given the recent evolution of the macro news flow. Of course, the irony of this hawkish observation is that Bill was one of the most dovish members of the Committee when he was at the Fed. Nonetheless, as we (and many others) have argued for several months, policy is exceptionally (and inappropriately) loose in the context of inflation and labour market conditions. As Bill noted, in order to tighten financial conditions, the FOMC will have to raise rates by more than 4 times this year as that is already priced into the fixed income markets and (we would add) consensus beliefs.
As we have discussed before, a key for the Fed’s focus on broad financial conditions when judging policy is due to Dudley. He developed the framework at the famous investment bank, which is an assessment of other factors that affect financial conditions such as the dollar, equity prices, credit, in addition to interest rates. Of course, given the inclusion of market based measures in the framework there is reflexivity or a self-reinforcing relationship between the Fed’s reaction function and risk assets (the S&P500).
The challenge in the current episode is threefold. First, the level of financial conditions is extraordinarily loose or the starting point (based on the Goldman Sachs index) is lower than pre-2007 and pre-pandemic levels (chart 1). However, the rate of change matters and that is already slowing. Third, in contrast to the 2018 episode, consumer price inflation is around 7% and will likely force the Fed to hike policy rates and implement QT (balance sheet run-off) regardless of what happens to equity prices in the very near term.
As we have also noted recently, the balance sheet run of or quantitative tightening is also equivalent to rate hikes. Indeed, the Wu-Xia Shadow Fed Funds rate, which is an estimate of the funds rate adjusted for the impact of QE (when rates are at the zero bound) has already increased from -2% to -1.1% (chart 2). That is already equal to at least 3 rate hikes and is a plausible explanation why liquidity beneficiaries and hyper-speculative assets have already corrected sharply. In the 2018 cycle, the impact of QT was probably equal to around 300 basis points of tightening on top of the actual increase in the funds rate. As we noted above, inflation pressure is considerably more persistent in this episode, even if goods price inflation is likely to ease over the coming months.
For markets, the risk is that the Fed might be forced to hike rates and tighten financial conditions by more than what is already priced in December Eurodollar markets. In addition, the rate of change in financial conditions is consistent with a deceleration in growth and profits over the coming months (chart 3). While equities can still trade well into the early phase of tightening, our sense is that conditions will remain challenging for levered and expensive entities. This has become a more widely appreciated consensus belief. However, valuations remain heroic in many of these names. In contrast, we prefer companies with high free cash flow, low balance sheet leverage and sustainable dividend growth.