Did Q4 “make bad news great good again”?
That is, was the dramatic selloff in risk assets and the concurrent deterioration in the outlook for global growth paradoxically just what the doctor ordered for markets to the extent it forced the “epochal” dovish pivot, which in turn catalyzed a risk asset rally and a loosening of financial conditions?
Maybe. Or at least that’s the prevailing narrative and it’s certainly true that the market’s pricing out of future Fed hikes has been coincident with buoyant equities, tighter credit spreads and a loosening of financial conditions in 2019.
The problem with that going forward is that it pretty clearly suggests the Fed is hamstrung in its capacity to lean hawkish as assets become bubbly again, because doing so risks the market starting to price back in hikes, thereby tightening financial conditions and starting us right back down the road we reluctantly trekked late in 2018.
However, a closer look at the situation reveals something that is, on the surface anyway, somewhat surprising.
“If it were the case that more-dovish Fed pricing was underpinning easier financial conditions and higher breakevens, then short-term movements in the former should be negatively correlated with short-term changes in the latter”, Deutsche Bank’s Matthew Luzzetti writes, in a note dated Monday. “In other words, we would expect financial conditions to ease and breakevens to rise on days when the market priced less Fed tightening and vice versa”, he adds.
As it turns out, this isn’t the case – or at least not recently.
In fact, Luzzetti found it to be “the exact opposite” of the case when he checked on twenty-day rolling correlations between fed funds pricing for December 2019 and daily changes in the Bloomberg financial conditions index, the S&P, and five-year forward, five-year breakeven inflation rates. Have a look:
(Deutsche Bank)
As you can see, fed funds pricing for December is actually positively correlated with financial conditions and breakevens in recent weeks.
Does this mean the Fed can just decide, overnight, to go ahead and revert back to the ill-fated “long way from neutral” stance and expect that the repricing of the rate path such a hawkish pivot would invariably engender wouldn’t immediately tank risk assets and cause financial conditions to tighten dramatically?
Well, no – obviously not.
“One thing we have learned over the past year is financial conditions have not been able to sustain lofty readings as the market pushed towards pricing a 3% fed funds rate”, Luzzetti writes.
Rather, what the above means is this (to quote Deutsche one more time):
The conditions under which the market assesses conditions as being sufficient to price a modestly higher fed funds rate also tend to be conditions in which risk assets and inflation expectations are supported.
Or, more colloquially, good news is good news.
Just as long as it’s not too good. Or something.
The Fed rarely changes the Fed Funds rate in an election year. That’s my conclusion from looking at a chart of said rate and inspecting every fourth year from 2016 back. So if the economy starts hotting up by end 2019, the market can party without worrying about the pesky punch bowl taker awayer. But if the economy starts slumping then (slumping more, I mean), there’ll be no Fed riding to the rescue. And fiscal policy is at full blast with $1TR worth of annual stimulus. If all those predictions of a 2020 recession come true, it could be worsen by the forced absence of any corrective policy.