Until Something Breaks
FRI 25 MAR 2022
There has clearly been a shift in the prevailing bias on the path of future short term interest rates this week. The upshot is that the Wall Street consensus and the money markets have already priced more than 150 basis points of additional rate hikes this year. Indeed the December 2022 Eurodollar contract has increased to 2.6% which is not far from the estimate of neutral or terminal rate. We don’t know whether the Fed will end up delivering on that estimate. More likely, the Fed will continue to hike (and reduce the balance sheet) 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.
As we noted earlier this week, bond market volatility is kryptonite for assets that are naturally short convexity. Historically, phases where fixed income yields rise sharply and rapidly tend to lead to an increase in cross asset volatility as there is an intimate link between liquidity, volatility and leverage. While the Federal Reserve obviously sets the official Funds policy rate, the market anticipates the future path of short term interest rates.
Although the Fed has only delivered one 25 basis point hike so far in this cycle, the US benchmark mortgage rate has already increased to 4.55% and corporate bond yields have already risen to around 3.6%. While the absolute level of yields is still low in a historical context, the speed of the recent move has been breath-taking and rates are now comparable to the episode in 2018 (chart 1).
Looking further back to the Great Financial Crisis in 2008, the increase in mortgage rates was ultimately the key factor that broke the markets. Clearly excessive leverage in the private sector and size of the housing market exacerbated the episode, but ultimately it was the rise in rates and withdrawal of liquidity that triggered the unwind.
From our perch, key housing market indicators actually provided major warning signals well in advance of the crash. At the time, we were watching the National Association of Homebuilder Sentiment Index peak in June 2005 and plunge through 2006 and 2007. The absolute and relative performance of homebuilder equities in the United States peaked in July 2005, more than two years ahead of the S&P500 (chart 2). Put another way, the internals of the equity market were flashing a major warning signal for the broader market. The reason we identified the episode early was due to a little known Australian company called James Hardie that had purchased a Mexican cement producer CEMEX with large exposure to the United States that was a crowded long among domestic fund managers Down Under.
Returning to the current episode, the big picture point is that the housing market tends to lead the broader macro cycle. Clearly household, private and financial sector leverage is considerably less levered than it was in 2008. However, the speed and magnitude of the increase in mortgage rates and corporate yields might contribute to a renewed volatility episode in markets. We are sympathetic to the “hotter, shorter cycle thesis” indeed the recent impulsive move in yields could reinforce that belief. The Fed is materially behind the curve in this cycle, but the ultimate path and level of policy rates will depend on when something breaks. Homebuilder equities have now underperformed the S&P500 by 17% over the past 12 months.
In this region and in conclusion, markets are already priced for more challenging macro conditions and China has started easing, not tightening. However, given potential fragility in the global risk proxy (the S&P500) this suggests continuing to hold a decent amount of cash for optionality.