Some folks sound frustrated or, at the least, incredulous at the current market zeitgeist, characterized as it is by the “everything rally”, a laughably fraught geopolitical backdrop, aggressive expectations for Fed cuts against a US economy President Trump insists is “the best in our nation’s history” and the assumption that perpetual monetary easing can support risk assets come hell or high water.
Just to recap (as if you need it), stocks are supported on the assumption that a renewed commitment to accommodation by central banks will help the world avert a deeper downturn. Bonds are supported by the same growth worries and collapsing inflation expectations that necessitated policymakers’ dovish pivot. Credit is supported because the bond rally turbocharges the global hunt for yield. Stocks, bonds and credit all benefit from the promise of more liquidity from central banks. Oh, and gold is supported because more easing ostensibly means currency debasement.
This is a simplistic chart, but sometimes there’s elegance in simplicity:
Much of this setup is predicated on the persistence of trade jitters, which are arguably the main factor weighing on the outlook.
The entire fragile equilibrium is only tenable if the worst-case trade and growth outcomes don’t materialize. More to the point, all of this only works as long as the news on trade and the global economy is just bad enough to keep policymakers on their toes (and thereby committed to easing), but not bad enough that an all-out trade war and/or an actual recession materializes.
How sustainable is this? Not very, according to a new note from BofA, which kicks off with the bank reminding markets that i) the Osaka trade truce admitted of no timeline for the lifting of existing tariffs and ii) EU-US negotiations have not even begun, even as the end of a self-imposed six-month deadline Trump set for car tariffs will expire this fall. “Global data has been weakening and inflation expectations have collapsed”, BofA writes, on the way to cautioning that while “this is not a global recession, risks for an even sharper slow-down will increase fast in our view if trade policy uncertainty continues”.
Suffice to say the Trump administration hasn’t done much to calm nerves since the G20. Specifically, the USTR has proposed tariffs on an additional $4 billion in European goods over the Airbus dispute and the Commerce department announced duties in excess of 400% on steel from Vietnam in an effort to discourage opportunistic re-routing. On Monday, the EU’s Cecilia Malmström said she “fears” a tariff fight with the US over the aircraft subsidy issue, as well she should. Bob Lighthizer is pushing it pretty hard and Europe’s efforts to assist Iran in circumventing US sanctions via Instex are likely to play into negotiations between Washington and Brussels no matter how many times the two sides insist the issues are separate. Boeing’s recent trials and tribulations add another wrinkle.
BofA is highly skeptical that the Fed can deliver an outcome that pleases everyone late this month. In the same note, the bank says Powell is “stuck between a rock and a hard place”. To wit:
The NFP print last week was strong. Other data has been mixed or even weak, but the overall picture does not justify the aggressive monetary policy easing that markets are pricing, unless in a trade war scenario, and particularly when we take into account the limited policy ammunition, which the Fed may not want to waste. We see a risk that the Fed may disappoint markets no matter what they do. If they don’t cut, the case is obvious, as markets have already priced a lot. If they do cut, it will not be the beginning of the easing cycle that markets are pricing. In our view, the Fed should have guided markets and should have not allowed them to price so many cuts to begin with.
That ship has sailed. The horse has left the barn. A full cut is priced for July and even that represents a lower bar to clear than what the Fed faced just a short time ago. In other words, as vexing as the situation is for Powell, it was even more challenging (market pricing wise) late last month.
Ultimately, the whole setup is untenable from the perspective of BofA’s Athanasios Vamvakidis who, in summation, is “increasingly concerned about unsustainable inconsistencies that could eventually lead to sharp adjustments”.
Vamvakidis notes the overvalued dollar against Trump’s insistence that the greenback be reined in by hook or by crook. BofA calls valuations in credit historically “extreme” and reiterates that “rate markets are pricing very aggressive policy easing [that’s] hard to always justify based on the data”.
Meanwhile, stocks are of course at record highs, again despite a weakening economic outlook that seems to presuppose the global manufacturing slump won’t eventually bleed over into the services sector, the labor market and, ultimately, find its way down to corporate bottom lines.
Finally, in a passage that will please the policy critics among you, Vamvakidis laments that “low rates and expectations for even lower rates are distorting the pricing of risk” and when monetary policymakers are preventing risk from being priced correctly, “this does not necessarily lead to a healthy and sustainable economy”. That, BofA concludes, is something “we should have already learned from the Greenspan experience”.