‘This Fed Put Comes With A Knock-Out Feature’: One Bank’s Caveat To An Otherwise Bullish 2020 Call

To a certain extent, stocks have been fine with whatever rates wanted to do in 2019.

When bonds rallied (yields fell), stocks rose because the proximate cause of falling yields (i.e., trade uncertainty, subdued inflation and signs of economic deceleration) was also a reason to expect a decisively dovish turn from central banks.

When bonds sold off (yields rose), stocks rallied because the proximate cause of rising yields (i.e., optimism around a resolution on the trade front and expectations of better economic data) was a reason to think the cycle could be prolonged.

Hence, stocks have risen in nine out of 11 months this year, while the long bond ETF (just to use an easy proxy) has had five monthly declines, even as its total YTD gain is spectacular.

This tendency for stocks to find something to like in whatever bonds are ostensibly “saying” during a given month reached its limit in August, when yields fell so far, so fast, that the recession bells started to ring, despite anyone with any sense realizing that some of the plunge in long-end yields (and thus the 2s10s inversion) was down to convexity flows.

“A remarkable market dynamic this year has been the apparent disconnect between equities and bonds, thus even as rates have gyrated in a 30-40 bp range, equities have stayed relatively immune”, Barclays writes, in one section of their year-ahead outlook for US stocks.

The bank goes on to reiterate (in different terms) some of the points made above.

“In our opinion, one way to resolve this conundrum is simply that equity investors assumed that rates would act as a safety valve”, the bank says, noting that “as trade war concerns escalated or macro data worsened, rates dropped but equity investors thought this should counteract the negative macro pressures”, and then, when the macro picture seemed to brighten, “equity investors were comfortable with the back-up in rates”.

Ultimately, this all comes down the nexus with monetary policy.

“This is of course the notable Fed put which apparently has remained effective”, the bank says.

And yet, recession indicators continue to “flash amber”, where that means that despite their base case for an “easy soft patch“, Barclays notes that the curve remains stubbornly flat and some leading indicators remain in the “danger zone”.

(Barclays)

This prompts something of a caveat from the bank, whose target for the S&P is 3,300 in 2020.

“We caution that this Fed put does come with a knock-out feature”, the bank warns. “Fed easing during actual recessions does not avoid a drawdown of ~20% in equity markets”.