Since the 2s5s inversion earlier this month, we’ve variously suggested that market participants might be talking America into a recession or otherwise forgetting about their own role in shaping the story that the bond market is supposedly “telling”.
The inversions in the 2s5s and 3s5s played out during an extremely manic week that started with a G20 relief rally on Monday, December 3, and proceeded to feature all manner of chaos, including multiple flash crashes/fragility events, en masse stop outs of tactical steepeners and a dramatic repricing in the short end. In other words, there was a lot going on and getting a “clean” read on it was well nigh impossible.
Additionally, there are all manner of reasons to believe that the curve might not be as reliable an indicator this time around, although the usual caveat about never trusting anyone who says “this time is different” clearly applies and you’ll find no shortage of commentators willing to call you a moron for suggesting that the curve can be safely ignored.
While the yield curve certainly deserves our “respect” (which, by the way, is an absurd way to characterize things because after all, the yield curve isn’t really a thing – it doesn’t exist without us), one can’t help but suggest that the market has become completely disconnected from the real economy.
Unfortunately, this has the potential to become self-fulfilling in the absence of something or someone interceding to break the loop. After all, falling stocks tighten financial conditions and the ongoing bad press around the selloff makes people nervous which has the potential to impact investment decisions and consumer spending. On the former point, Goldman’s financial conditions index has now tightened some 140bp since early October.
Well, in his latest note, Wells Fargo’s Chris Harvey underscores how all of this can feed on itself. Here is the simple “equation” (if you will):
Lower equities —> wider credit spreads —-> higher costs of capital —–> diminished access to capital ——> less investment and risk taking ——> slower economy, with the cycle repeating and feeding upon itself.
That’s the danger and Harvey echoes BofAML’s Chris Flanagan in suggesting that the Fed has now “closed the loop”, so to speak. Here’s Harvey again:
Tenured equity investors have seen this story before and it typically ends with the Fed cutting not raising Fed Funds. In 2019, growth was already expected to decelerate and now we have the potential for the capital markets to amplify the anticipated slowdown. In the near term, we see little to mitigate the cycle’s acceleration. Adding insult to injury, the capital markets turmoil potentially gives the Chinese some trade leverage.
That last bit is notable. This is the same argument folks have been making for the past six months, only now, the tables have turned. Since the trade war really heated up, analysts and pundits have variously argued that the ongoing deceleration in the Chinese economy and the bear market in Chinese equities weakened Beijing’s bargaining position. Now, that same logic is being applied to the U.S. Xi’s warnings have finally come to pass – the U.S. cannot hold up in the face of global tumult forever.
Harvey goes on to discuss the outlook which, from where he’s sitting anyway, doesn’t look particularly sunny. “Overall, we think the die has been cast and the odds of an accelerated slowdown have just increased”, he writes, before noting that while the market is “predictive”, the Fed is “reactive.” That means that by the time Powell realizes what he’s done, it may be too late.
“If the economic data comes in weaker, then yes the Fed will react because they’re data driven, [but] by then what will the capital markets look like?”, Harvey asks, before answering his own question as follows:
Let’s just say probably not very good. The cycle we highlighted will be in full swing and inertia take control.
By way of reference, here’s how things have developed over the past year in terms of the market’s pricing for the Fed in 2020 versus stocks and credit spreads.
After cautioning that credit and equities tend to “feed off each other” when things begin to get dicey, Harvey proceeds to throw in the towel on his 2019 SPX target. He delivers the bad news in rather foreboding terms that again echo BofAML’s Chris Flanagan, including a reference to Bernanke.
We’ll leave you with a couple of excerpts from the section in Harvey’s note that finds him explaining the decision to slash his target. These are presented without further comment from us.
Our 2019 S&P500 Price Target drops to 2665 from 3079. In our calculation, we lower our expected EPS figure by about $7 to $166 from roughly $173. This is due to our more comprehensive understanding of the Fed’s near-term philosophy and the belief that it will cause the growth deceleration to intensify. The main driver of our lower price target was a ratcheting up of our Risk Premium from 1.4% to 2.0%. We’ve increased our Risk Premium to the high end of the range because to us the current situation is reminiscent of the Summer of ’07 but with a less motivated Fed. Then the Fed was more focused on inflation than on the messages being sent by the markets resulting in a major misjudgment. In the months heading into Aug’07, Bernanke had not fully appreciated some of the telltale signs of market stress. The yield curve (2s/10s) had been flat or inverted for about a year. Credit spreads were widening all year from a very low base. Equity volatility had been picking up after a very placid ’06. Earlier that ‘07 (Feb), the Shanghai equity benchmark dropped 8.8% related to Beijing trying to crack down on speculation, and this sparked a 4% S&P500 sell-off providing the warning signs. The liquidity situation eventually forced Bernanke to act but significant damage had already been done. Not dissimilar to today.