And the bullish takes on the Fed’s dovish pivot just keep on comin’.
If there’s elegance in simplicity, then the most straightforward take on last Wednesday’s proceedings is perhaps the best: the removal of forward guidance on rates and the explicit reference to balance sheet tweaks tips a reversal of the tightening bias that worked against risk assets in 2018 and so, now the legacy “QE” trade is back.
A more nuanced take might be that by capitulating, the Fed has inadvertently admitted to having already tightened the economy into a slowdown and thus the reemergence of the risk-on trade will be fleeting, replaced in short order by end-of-cycle trades as everyone braces for a downturn. An even more nuanced take is that the Fed is attempting to deftly manage convexity flows and restore the pre-crisis mode of curve functioning and thus attempting to couch their decision calculus in simplistic terms is doomed to miss the point.
In any case, stocks are up some 12% since the overnight lows ahead of Powell’s remarks in Atlanta on January 4, when it became apparent that the Fed was keen on making sure the late December bounce (catalyzed by rebalancing flows) proved some semblance of sustainable.
If you ask JPMorgan’s Nikolaos Panigirtzoglou, the Fed’s January pivot could well mean the “asset reflation trade that had boosted financial assets strongly in the five year period to 2017 could be now returning after a year-long interruption during 2018.”
In the latest edition of his popular Flows & Liquidity series, Panigirtzoglou writes that the “decisive dovish shift, to the extent it is sustained, is removing some of the headwinds that caused the 2018 market rout and sets the stage for 2019 to be an asset reflation year.”
He goes on remind everyone that Fed balance sheet runoff, combined with a smaller incremental bid from the ECB and the BoJ, had the potential to act on risk assets through “four channels”:
- bond supply and demand,
- crowding out of US HG corporate bonds,
- liquidity/funding squeeze in the banking system and
- portfolio rebalancing via investors shifting down the risk curve
We’ve obviously been over all of those point ad nauseam in these pages, but the key point is that, to quote Panigirtzoglou, “the main transmission mechanism for the pricing channel was via higher USD cash yields.”
As USD cash became a viable asset class again for the first time in a decade, it changed the game. Specifically, only 9% of assets outperformed 3M Libor.
T-bills outperformed something like 95% assets, which is pretty much a record going back 120 years.
And here’s 3M Libor rising above the yield on the Barclays Global Agg for the first time since the crisis.
Now, the game may have changed – or actually, the game changed last year and now it looks set to revert back to the pre-2018, post-crisis (so: 2009-2017) dynamic.
“With the Fed removing its tightening bias, not only are markets becoming less concerned about the prospect of even higher USD cash yields, but they can contemplate the possibility of rate cuts”, JPMorgan writes, in the same note mentioned above, adding that “this raises the likelihood of a generalized decline in yields taking place across asset classes this year in a reversal to last year’s increases.”
So, what does this entail? Well, for one thing, it suggests equities could re-rate materially after multiples compressed during last year’s harrowing bouts of selling. To wit, from JPM:
In the equity space, a declining yield environment in reversal to last year’s discount rate increases, implies significant PE multiple expansion from here given the severity of the PE multiple contraction last year. This is shown in Figure 2 which shows the PE multiple based on 12-month trailing operating EPS across four main equity regions. PE multiples had declined sharply by around five points last year, so a potential reversal implies big equity upside.
Additionally, if the Fed does indeed halt balance sheet runoff sooner than expected, you can expect that to benefit IG credit as the burden (on the market) of absorbing ever more net UST supply would decrease, thus freeing up more liquidity for risk assets and catalyzing a move back out the risk curve/down the quality ladder.
The upshot from JPM’s Panigirtzoglou is that “with the Fed making a major dovish shift, last year’s rout in markets is reversing.”
As ever, we would caution that there is no historical analog for the current environment, both from the perspective of monetary policy and domestic politics in the US. That makes it inherently difficult to make sweeping assumptions about what (or, perhaps more the point, how much) a dovish slant from the Fed can accomplish.