You’d be forgiven for throwing in the towel on trying to understand exactly how to reconcile the inexorable rise in equities, the resilience of EM, and the weak dollar with what’s supposed to be a Fed tightening cycle.
Yes, Trump and some members of his inner circle have tried to jawbone the dollar lower at various times this year and yes, the administration’s seemingly intractable Russia problem has led the market to price out Trumpian reflation (e.g. bull flattening and a weaker greenback), and finally, yes, realized inflation has remained elusive undercutting the notion that the US economy will be able to ride without training wheels.
That said, this is a Fed that, the dovish slant applied to the March hike notwithstanding, has demonstrated a propensity for adopting aggressively hawkish rhetoric at various times even if they’ve been subsequently forced to walk it back.
So how to explain easier financial conditions? Well, Deutsche Bank’s Dominic Konstam suggests the following:
The logic here is that the (rates) market remains fearful that the Fed’s push for normalization runs the risk of lower inflation and weaker real growth that will undermine equity valuations. The self-inoculating response is therefore lower rates (5 years and out) and as we wrote last week, bonds act as a crutch to equities.
Here’s the passage from last week’s note that Konstam is referencing:
We seem to live in a world where bond yields are kept low due to supply demand dynamics where excess demand dominates and the “cheapness” of equities is a necessary consequence. The wrong conclusion to draw – and many equity folks do – is that equities can continue to do well because they are cheap to bonds. And as soon as the demand supply dynamics in the bond market flip around, this will be abundantly clear. This is wrong for the simple reason that is misses the dynamic that has had equities cheap to bonds. It is not that equities are cheap to bonds and therefore equities can keep rising and drag bond yields; instead it is that bonds are expensive to equities and by staying expensive can allow equities to become more expensive. Bonds serve as the crutch to the equity market.
Basically, the market thinks that Fed tightening ahead of a sustained uptick in inflation is likely to short-circuit growth, so we’re seeing a “self-inoculating” response where bonds become even more expensive, allowing equities to look cheap by comparison, thus green-lighting stocks to become even more expensive.
So what can the Fed do? Well, the short answer is probably “nothing”. As Konstam outlines in this week’s note, they’ve got two options but really, they’ve already tried one of them and it didn’t work.
The inevitable conclusion: “the path of least resistance is therefore a soggy dollar, low yields and robust equities.”
So maybe start your own risk parity fund…
Via Deutsche Bank
We think equities continue to move higher and bond yields lower.
Financial conditions continue to soften. Our index was at peak tightening in January 2016, the index level was at -1.53 with the previous peak tightness -1.73 in February 2011, before twist and -3.29 October 2008. The recent local peak softness was November 2016 (-0.71). Since then the softening has been driven mainly by dollar weakness, contributing 47 percent of the easing in financial conditions. Mortgage spread narrowing and some recovery in FX reserves have each contributed another 20 percent or so in softer conditions 1 while equities 7 percent.
The irony is that faster Fed tightening has neatly coincided with an easing of financial conditions. One might be tempted to suggest that if the Fed wants to tighten financial conditions for fear of overheating the economy, it is going about it the wrong way. The logic here is that the (rates) market remains fearful that the Fed’s push for normalization runs the risk of lower inflation and weaker real growth that will undermine equity valuations. The self-inoculating response is therefore lower rates (5 years and out) and as we wrote last week, bonds act as a crutch to equities – equities are anyway cheap and whatever is good for the bond market at least since 2008 has never been sustainably bad for the equity market.
Ironically, if the Fed wants to tighten financial conditions two possibilities would be
- an overt policy error to be much more aggressive and short circuit the mild expansion but without the smoking gun of inflation – that should see equity declines despite lower long dated yields with spread widening. Ironically the dollar might weaken as an offset.
- Or go the other extreme and take a time out to be more overtly behind the curve and allow higher inflation expectations via a steeper curve that might raise the dollar, soften equities and spreads (hunt for yield dissipates).
Neither of these directions is necessarily guaranteed to succeed nor appear particularly appealing – and arguably the recent faster pace of tightening was supposed to look a bit like the former but is clearly back firing. The conclusion is that the Fed can’t do a lot that appears credible to the market. The path of least resistance is therefore a soggy dollar, low yields and robust equities.