Although Goldman’s David Kostin seems too be taking a pretty benign view of the October U.S. equity rout (at least according to a note out Friday evening), the bank’s Charles Himmelberg is sounding a more cautious tone.
Specifically, Himmelberg appears to be alarmed by the unresponsiveness of the short rate to the selloff in stocks. While the narrative lately has generally revolved around the notion that Jerome Powell is sticking closely to his penchant for data-dependence, Himmelberg says that the lack of a demonstrable rally at the short end is indicative of the market “reassessing Fed data dependency.”
This seems a bit tortured to me and Goldman acknowledges that their “assessment [is not] based on the sensitivity of 2-year yields to actual data [as] the actual data flow in October was uneventful, and thus not inconsistent with the lack of movement in bond yields.”
So what’s it based on then? Well, it’s based on Goldman’s “measure [of] implied macro themes from the cross-sectional repricing of macro assets in October”, which the bank says allows them to “identify a large decline in expected future growth rates.”
The idea here is basically that the market should have repriced 2-year yields lower based on the implied downgrade of expected future growth. Again, that seems a bit tortured to me, but I’m not going to sit here and critique a model that I didn’t create or that I haven’t (and won’t) have time to adequately parse. So let’s give them the benefit of the doubt.
Here, for what it’s worth, is what happens when you plot the 3-month rolling regression of daily changes in 2-year yields on daily changes in the above-mentioned implied growth factor:
The implication is that the short-end of the curve became demonstrably less responsive to a downgrade in market-implied growth expectations during the recent selloff. That, in turn, suggests that the market is in fact doubting Fed data dependency or, more to the point, refusing to take some of the hikes out despite the implicit downgrade of the growth outlook.
Himmelberg also says 2-year yields should have responded more dramatically to the tightening in the bank’s U.S. Financial Conditions index. Here, as a reminder, is what that tightening looks like (right scale is inverted):
“According to our usual rule of thumb, this FCI tightening (due mostly to lower equity prices) was worth roughly four quarter-point policy hikes [and] to the extent that this FCI tightening was more than just a mirror on policy expectations (thus doing some of the Fed’s “dirty work”), the bond market should have taken some hikes out of the forward curve”, Goldman writes, before reiterating that “that didn’t happen [because] 2-year yields didn’t budge.”
Himmelberg goes on to suggest that bonds stopped responding to the market’s implied view on growth expectations due to perceived belligerence from Jerome Powell and some other committee members.
This is somewhat reminiscent of commentary from JPMorgan’s Marko Kolanovic, who on October 3rd wrote that the market’s reaction to Powell speeches this year seems to indicate that traders and investors believe the Fed chair is indeed tempting fate.
Marko divided Powell speeches into post-FOMC pressers and “Testimonies and Other Speeches” and here’s what he found:
- FOMC Press Conferences — average negative return -44bps, 3 out of 3 negative
- Testimonies and Other Speeches — average negative return -40bps, 5 out of 9 negative
What accounts for Powell’s apparently abysmal market record? Well, one explanation is that market participants think he might be underestimating the risks.
“Specifically, the equity market likely implies that the Fed is underestimating various risks, and hence is increasing the implied probability of the Fed committing a policy error in the future”, Kolanovic wrote, adding that “a higher probability of a policy error translates into lower equity prices on the news.”
Goldman takes their analysis to the next level by constructing a stacked bar chart which basically shows how each of seven global macro factors have contributed to October performance in a variety of assets. The overarching point is that 2-year and 10-year U.S. yields haven’t fallen as expected even as stocks generally declined in line with what the model predicted (you’re looking at the difference between the “predicted returns” (red circle) and “actual returns” (green diamond):
The thrust of this is that the circuit-breaker may itself be broken. That is, Goldman is positing that the lack of an “appropriate” reaction in 2-year yields to the equity selloff suggests the market doesn’t believe the Fed will be inclined to respond to a worsening in the data (in this case implied growth expectations) by taking a pause on rate hikes. In that sense, Goldman thinks the market is actually doubting the Fed’s data dependency, only in the “wrong” direction (i.e., a Fed that’s inclined to hike even as market implied growth expectations worsen as opposed to the pre-Powell regime where the Fed was predisposed to being dovish even as the economic outlook improved).
One more time: this is a bit tortured. But, it sure is interesting.
Goldman concludes that going forward, “risk appetite will likely remain on fairly shaky foundations.” Barring a Fed relent, Himmelberg says “the best hope for a bounce in risk assets may simply be the likelihood that markets are over-reacting, equity markets in particular.”
We’ll leave you with his general assessment of the prevailing environment:
Something’s gotta give. Looking ahead, risk appetite will likely remain on fairly shaky foundations as expectations of slower growth and rising rates will likely prove persistent. The best hope for a bounce in risk assets may simply be the likelihood that markets are over-reacting, equity markets in particular. Given the unusual magnitude of the performance gap between US bonds and equities, we’re inclined to think something’s got to give; either equities rally back, bonds rally further, or some combination of both.