The “jaws of doom” steadfastly refuse to close.
“Global bond yields have declined further, extending the bond rally since Q4 last year – as a result, bonds have disconnected materially with equity performance YTD”, Goldman wrote Monday evening. “The decline of US 10y yields is the largest since 1995 when a Fed easing cycle started and the S&P 500 correlation with US real yields turned negative”, the bank continued, adding that it’s “common for equities and bonds to rally alongside each other after dovish Fed shifts.”
That latter bit pretty much explains the situation. Stocks are hoping the Fed has enough ammo and credibility to head off a recession and bonds are reacting both to the promise of a return to accommodative policy and the economic weakness which necessitated the dovish pivot in the first place.
Although this is not as “mysterious” as the word “disconnect” suggests, the conversation will continue. That is, until such a time as the purported “discrepancy” illustrated in the chart above, and in the simpler visual below, “resolves” itself by stocks falling, yields rising or, ideally, some relatively benign combination of the two that doesn’t spark a panic, market participants will continue to ask “who” is “right”.
One thing we know for sure is that the market is laughably vulnerable to any sign that the Fed may disappoint expectations. Jim Bullard’s remark that a 50bp cut in July might be overkill triggered a swift reaction across markets on Tuesday afternoon, for instance.
That raises the stakes even more for the G20. Ironically, Trump risks a selloff either way. If he strikes too upbeat a tone after meeting with Xi, the market might start to price out one of the hikes that’s currently penciled into the front-end and that, in turn, risks undermining risk assets. On the other hand, if Trump and Xi can’t agree on anything, the market might decide that no amount of Fed cuts is enough to cushion the blow from an all-out trade war.
Fortunately, it sounds like the US has the “right” idea. On Tuesday, an administration official told Reuters the “plan” (if that’s what you want to call it) is for Trump and Xi to agree to restart talks and, possibly, postpone further escalations. That would probably leave enough uncertainty in the market to keep the Fed on track to cut, while providing enough in the way of “hope” to prevent equities from throwing in the towel and joining bonds in pricing in a trade-related global downturn.
If you ask Barclays, an abatement of trade tensions likely won’t deter the Fed at this juncture. “Our analysis of the FOMC meeting and Chairman Powell’s press conference indicates that there is a distinct possibility that the Fed’s easing path is unlikely to be materially dependent on trade outcomes”, the bank writes, in a note dated Tuesday. The bank then delivers the obligatory nod to subdued inflation and how, even in the face of near-record-low unemployment and a potential thawing of tensions between the world’s two largest economies, the Fed can still justify a cut (or two or three):
While the Fed did cite trade war uncertainties and global slowdown driven by “China deleveraging”, it also emphasized the persistently low inflation. Figure 7 shows that the Fed’s preferred gauge of inflation has remained below its target. Figure 8 shows that market based measures of inflation have declined (albeit not as much as they have done in Europe) and more worryingly, some survey based measures that had been quite sticky have also been trending down. Further, our economists also believe that the Fed will likely ease aggressively given the proximity to the zero lower bound.
Previously, Barclays fretted that a repeat of 2016, when a Fed pause and a stimulus push out of China helped turned things around, was unlikely in 2019. This time, the recovery won’t be V-shaped, the bank has variously warned.
Now, thanks in no small part the prospect of aggressive Fed easing, Barclays says the chances that this will be, in retrospect, an economic “soft patch” rather than a full-blown recession have increased. As noted above, if a recession is averted, equities near all-time highs may end up being “right”, and bonds “wrong”
“Since the 1960s, the Fed has embarked on fourteen easing cycles. Of these, five (in retrospect) occurred outside official NBER recessions”, the bank recounts, on the way to noting the obvious, which is that equities perform a lot better in and around “soft patches” than they do around recessions. To wit:
Equity markets rallied substantially over the next year during soft-patches (Figure 10), and the rallies were almost entirely driven by an expansion in the P/E multiple (Figure 11). In contrast, during recessions, the Fed easing did not prevent substantial equity draw-downs. Note that Figure 10 shows results averaged across the different episodes and masks the fact that the equity draw-downs (which occurred at different relative times) were quite substantial (averaging ~ -20%)
The read-through (in case it isn’t clear enough), is that Barclays thinks the probability of an equity melt-up has increased. A repeat of historical “soft patch” dynamics implies a P/E ratio of around 20X, which would push the S&P to ~3,250.
The bank’s updated scenarios (with probabilities) are as follows:
- Escalation (45% probability): U.S. imposes 25% tariffs on $300B China imports, China retaliates, Fed eases by 75 bp and economic downturn is a soggy soft-patch. Equities selloff by ~7%
- Truce (35% probability): Substantial truce which gets extended as U.S. election nears, Fed continues to ease substantially, and economic downturn is a mild soft-patch. Equities rally ~10%.
- Recession (20% probability): The current industrial recession bleeds into the broader economy and even as Fed eases, equities selloff by ~20%
Place your bets.