I’d roll out the old standby/boilerplate “as noted in these pages” introductory line here, but it wouldn’t make much sense in the context of expectations for the Fed dot plot, because the fact that market participants are torn on whether “catching” down to the January statement means the new plot will tip one hike in 2019 or no hikes this year is common knowledge.
That is, all you have to do is read a couple of articles about the March Fed meeting posted on any of the major financial news media outlets’ front pages to know that some folks see the Fed going to no hikes in 2019 while others are persisting in the view that the median will still suggest the committee will manage to “squeeze one in”, so to speak.
Read a full summary of analyst projections
It’s at least possible that if the bias to hike (even once) in 2019 remains, it could be interpreted by the market as “not dovish enough”, especially if it’s not accompanied by the announcement of an official end date for balance sheet runoff.
For their part, Nomura’s house view is that the Fed will signal they won’t hike rates this year and the bank’s Charlie McElligott offered the following assessment in a quick Wednesday morning note:
The market is torn on expectations for today’s dots (whether Fed goes to ‘one dot’ for 2019—which Rates market doesn’t “believe” either way, but still too thinks the Fed will slowly rip that band-aid off over the coming meetings—or go to outright ‘no dots’ for 2019, as I’d state that many within Equities seem to be biased-towards—and thus presents a modest risk of “not dovish enough” disappointment.
He goes on to suggest that when it comes to expectations for the commencement of easing (and here that means “actual” easing via rate cuts, as opposed to “implicit”/ “tantamount to” easing via ceasing runoff) in 2020, it’s likely to be a 50bps move in response to signs that the US economy is on the brink of a downturn. Here’s one more quote from Charlie:
One point I do want to begin making as we discuss STIRs / ED$ is that despite focusing on the market view that we have “priced-in a 2020 CUT already,” I think we need to begin thinking that it’s really only HALF a hike….because when the Fed does ultimately begin EASING, they’re not gonna piecemeal it—instead we should expect a move of impact, likely a 50bps cut at a minimum upon acknowledgement that the economy is slowing into recession.
That brings us neatly to questions about how equities would ultimately respond as we get closer to that hypothetical cut.
This is basically the “is bad news good news?” to the extent it means dovish central banks and thereby implicit support for short vol. and carry trades or “is bad news just bad news?” to the extent the outlook darkens enough to warrant a rate cut question(s). The former might be seen as a kind of modified “Goldilocks” (see here) scenario, while the latter is just a recessionary environment which, unless up is truly down and black is truly white in the post-crisis world, is negative for risk assets.
“What type of vol regime follows from here remains far from certain”, BofAML writes, in a note addressing some of the issues raised above. “After all, while a Fed pause has clearly been supportive of equity markets, the conditions that would drive the Fed to cut rates could be less positive for stocks”, they add.
Right. To assess what comes next for equity vol., the bank goes back and looks at “at all major first cuts in Fed Funds since 1972”. Unsurprisingly, all of these “first cuts” came amid a worsening labor market with the exception of two (Black Monday and LTCM).
So, what did stocks and equity vol. do in the lead-up to those cuts? Well, the good news is that the S&P generally does ok. Specifically, “the index was flat or up 5 out of 11 times over the 12 months preceding the cut, and only in the first two periods were equities more than 5% down vs. a year prior”, BofAML notes.
The bad news (depending on how you’re positioned I guess) is that vol. generally “sniffs” things out, so to speak.
“On the other hand, volatility does tend to capture the increase in uncertainty as the change in policy approaches, with 8 out of 11 periods experiencing an increase in vol.”, BofA goes on to say, adding that in 1987 and around LTCM, the causality ran in reverse, where the spike in vol. prompted the rate cut as opposed to vol. rising in response to deteriorating economic conditions which eventually drove the Fed to ease. Here’s the chart on all of that:
The quick takeaway is that equity volatility is more likely to rise into the Fed’s first cut than the S&P is likely to fall. But, as noted, that’s complicated by the fact that Black Monday and LTCM are included and it’s also notable that in the past (or at least since 1989), the rates market was pricing in a hike (or at least some tightening) ahead of time, meaning the cut came as a shock. In that regard, “this time is different”.
In any event, we’ll leave you with one more quick excerpt from the note, which is basically just the granular breakdown around Chart 8 above:
Tables 2 confirms the market stress that triggered the ’87 and ’98 cuts, as well as the more reliable behaviour of vol in anticipation of lower rates. Whether looking back 3, 6, or 12 months, the largest increases in 3m S&P realized vol across all 11 periods occurred in Oct-87 and Sep-98. But vol did rise consistently leading up to rate cuts, as only in 1974 did vol fall meaningfully in the 6 months prior (-6.63 vol pts), while in several cases it rose more than 5 vol pts. As a result, median and average vol increases were consistently positive when looking back 3, 6, and 12 months from the cut. This historical asymmetry in favour of higher vol suggests leaning long vol as a potential rate cut approaches, though one needs to be conscious of the cost of carry.