THU 31 MAR 2022
Oh boy, what a quarter it has been in markets. The round trip on the S&P500 (the global risk proxy) has been -14% from the early January high to the intra-day low and +12% from the low to the relief rally high this week. After all of the growth, inflation, interest rate scares and war in Europe, the US benchmark is only 4% below the record all-time-high. As we noted in February, the conflict in Ukraine amplified key market anxiety over commodity prices, supply chain disruption, inflation and the consequential shift in short term interest rate expectations.
Clearly Jay Powell’s rhetoric since the March FOMC has been hawkish. Immediately following the meeting we described the Fed Chair’s language to be like Volcker. However, his actions were more like Bernanke. From our perch, that is a plausible reason why there has been a relief rally in NASDAQ, in spite of the ongoing sell off in fixed income (chart 1). As we often note, the path to investment hell is paved with naive overlay charts. However, the large and impulsive rise in the discount rate ought to matter for long duration growth equity. To be fair, mega-cap technology in the United States also has superior profits and net cash on balance sheet. Therefore, a higher discount rate is more challenging for profitless technology companies.
Another way to frame the gap between policy rhetoric and action is the rise in short rate expectations (implied in the December 2022 Eurodollar contract) in this cycle relative to what the Fed delivered in 1994-1995 (chart 2). The magnitude and speed is not dissimilar, although the starting point (for yields) in the current episode is clearly much lower. As we noted earlier this week, we don’t know whether the Fed will end up delivering 200 basis points of rate hikes this year. More likely, the funds rate will rise until something breaks. In Q4 2018, a nominal rate of 2.5% (or real rate of around 1%) was enough to break the equity market.
In a financial conditions framework, that likely implies a further 15% decline in equity prices, much wider credit spreads (investment grade spreads are currently 120 basis points) and higher rates (chart 3). Those conditions would also likely be consistent with US dollar strength as well, at least relative to the euro and Japanese yen. The objective, of course, would be to bring growth back below trend to moderate inflation.
The flattening of the yield curve has clearly become the focus of a single story over the past few weeks, especially with the near inversion of the 10-2 year which has historically been a solid (but not perfect) lead indicator of recessions. While the glass half full interpretation is that the nominal and real level of the funds rate is still extremely accommodative (which is unusual given the shape of the yield curve at this point in the cycle) our sense is that it would be foolish to ignore the message from the bond market (chart 3). The yield curve has historically been a long-lead indicator (around 18 months on average). However, this episode has been a much hotter and probably shorter cycle. Therefore, it is plausible that the signal from the yield curve might also be shorter than in previous episodes?
For markets, this leaves us relatively cautious on risk assets. In a typical cycle it is common for equities to cope with higher rates (when accompanied by profit growth). However, from our humble perch, this cycle is atypical or probably compressed relative to previous episodes. As we have noted this year, policy withdrawal is exacerbated by the unwind of the Fed’s balance sheet. Serious bond market volatility is probably kryptonite for assets that are naturally short convexity. Especially if the Fed is hiking into a deteriorating growth environment. In this context, cash provides optionality and the cost of protection in credit, for the potential pay-off is probably still cheap. Stated differently, should we not fight the Fed only when its friendly?