Dammit, Who’s “Sherlock” Here? BofAML Weighs In On A Fed That’s Behind The Curve

Ok, so regulars will know that I’ve been talking about the juxtaposition between financial conditions as they exist today (i.e. post-December 2016 hike) and financial conditions as they existed at this time last year (i.e. post-“liftoff”), literally since mid-January.

I mean seriously, this isn’t rocket science. Look:


See the difference?

That’s all you really need to know, but because that’s a compare/contrast exercise that a f*cking high school student could understand, analysts the world over needed to make it sound more complicated lest anyone should get the idea that being a rates strategist is an easy job.

There was Deutsche:

The reaction of financial conditions to an initial round of tightening determines how much further the markets will allow the Fed to go. In this regard it is instructive to contrast the reaction of financial conditions to the year-end 2015 and 2016 rate hikes. When the Fed first raised rates in 2015, financial conditions were already restrictive. A strong bout of further tightening ensued after lift-off, with equities falling by more than 10% to their trough in mid-February. This riskoff trade, combined with rapidly diminishing Fed expectations, caused the curve to bull flatten. By contrast, the 2016 hike occurred when financial conditions were relatively benign, and they have eased modestly further after the hike.

The following table shows the attributions of the changes in our weekly FCI to its various components. None of the components has changed meaningfully since last December’s hike, including importantly the dollar. By contrast, at the same time last year, approximately 3% dollar appreciation exacerbated the tightening effect of the equity sell-off.


And then there was Nordea (whose analysis I actually liked because they laid things out in an appropriately concise way):

Remember that what matters for economic activity are financial conditions (the combination of the dollar, equities, spreads, and so on), not only the policy rate. Financial conditions are actually the easiest since September (chart 1).


But doesn’t the Fed need clarity from Team Trump (Wednesday) on fiscal easing before turning more hawkish? Not really. The current mix of financial conditions & growth prospects is more benign than at the Fed’s December meeting, and most indicators suggest a strong growth bounce is in the pipeline.

If the Fed didn’t commit a policy mistake in December, it should seek to tighten conditions even more today than it did December– but it has done the opposite by letting markets ease conditions. In this light, Trump shouldn’t need to unveil concrete stimulus options for the Fed to talk up rate hike prospects.

And then there was Goldman:

While we have long cautioned that the ‘Yellen Call’ could become a drag on risky asset returns, our Top Ten Market Themes For 2017 pointed out that Trump’s proposed fiscal policies would force the FOMC to respond even more aggressively to further easing of financial conditions. Even if the proposed fiscal policies never materialise, the mere prospect of stimulus has already caused a material rally in the animal spirits of households, small businesses and retail investors.


As strong as the case for the ‘Yellen call’ appeared late last year, it seems even stronger now. In December, as shown in Exhibit 1, we forecast our US economists’ Financial Conditions Index (FCI) to show that if the current conditions persisted, the Fed would be faced with a meaningful easing in financial conditions come March. But current financial conditions eased even more than we expected. Financial conditions are giving the Fed the green light to pick up the pace; the ‘Yellen Call’ is back in the money.

So yeah, if you frequent these pages, you’ve already read all of that, and you’ve also read my simple summary. To wit:

See it’s not like a trillion dollar fiscal stimulus program is a bad idea, it’s just that when the economy is already near capacity, dumping $1 trillion in stimulus on top of it isn’t going to translate into appreciably more growth. But what it will do is risk stoking inflation. And there’s your recipe for the dreaded stagflationary nightmare.

Trump apparently isn’t likely to heed that warning which means he’s even less likely to appreciate a still more nuanced corollary: namely that with stocks at record highs and the new administration trying to jawbone the dollar lower, the Fed is backed into a corner. Financial conditions are now so loose that they couldn’t defer a hike even if they wanted to. It also suggests that the pace of hikes may be quicker than those who are massively long risk believe.

No sh*t, Sherlock. Right?

Well anyway, BofAML is out today with the exact same piece that everyone else has already written, which is fine I guess, because you know, that’s how this whole thing works. An analyst says something. I say the same thing. Journalists repeat it. Some other analyst says it again. We all quote each other and then at the end of the day, no one knows who’s “Sherlock.” Maybe it’s me. Maybe it’s them. Maybe it’s the media.

Whatever. Here’s BofAML:

The focus over the last week has been on the Fed’s message to the market. The coordinated attack on March probabilities by Fed officials got a repricing of near-term expectations (and helped our recommended bearish March plays). But even more interesting has been the market’s response to the Fed. Despite the 60% increase in near-term Fed hike probabilities, stocks are higher, credit spreads are tighter, interest rate vol and the VIX is lower. While this has allowed the Fed to have its cake and eat it too at the March meeting, in our view there could be a bigger sign from the markets to the Fed: financial conditions could be at the cusp of signaling that policy is behind the curve. Ultimately, financial conditions that fail to tighten in response to a hawkish Fed could raise concerns of a more hawkish policy stance (higher dots and/or active balance sheet talk). This could translate to higher risk premium in the front end and a steeper skew.


Hikes vs financial conditions: Going back to Dudley 2015. Consider the argument put forth by NY Fed President Dudley back in 2015. In an interview in June 2015 he mentioned “if you actually look at what actually happened to financial conditions over that period — 2004 to 2007 — the Fed wasn’t really effective in tightening financial conditions, so the Fed didn’t really achieve its objective. My point in the footnote was basically to say this was probably a period where the Fed should have done a bit more because we probably should have been tightening financial conditions over that period.” The above failure to tighten financial conditions in the 04 cycle relative to the 94 cycle is best illustrated through Chart 1 and Chart 2. The charts plot the Chicago Fed financial conditions index with the second Eurodollar contract yield in both these cycles. Clearly, Fed hikes translated to tighter financial conditions in the former and barely moved conditions in the latter. Fast forward to today, and our chart of the day shows the same failure in 2004 has repeated so far in the current cycle.



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