Remind Me About The Risks Again

We’ve reached that glorious point in an inexorable rally when all that’s left to do is publish lists of risks.

The first four “sentences” of a prominent Bloomberg article published Saturday were: “Delta cases. Inflation. Fed tapering. China’s crackdown.”

I’m reminded of Donald Trump’s amusing attempts to list his accomplishments as president. He’d mention the tax cuts and then, confronted with a dearth of enacted policies, resort to mentioning nouns with adjectives in front of them (“Second Amendment,” “strong military,” etc). Imagine someone asks you to list the things you did over the weekend. “Mowed the grass, cooked some steaks, baby bird, big truck, red crayon…”

The visual (below) is the obligatory nod to the “tail risks” list from BofA’s Global Fund Manager survey.

The linked Bloomberg article correctly characterized Jerome Powell’s Jackson Hole speech as dovish. It still felt, into the weekend, like too many market participants didn’t quite grasp that, though. Part of the problem may have been the mainstream media, and in this context I don’t mean Bloomberg or CNBC or the Journal. Rather, I mean mainstream media in the truest sense — national media outlets not exclusively focused on finance, markets and/or economics.

I’ll concede I didn’t actually read their coverage, but at least a handful of the headlines I saw suggested the main takeaway from Powell was that the Fed chair “confirmed” plans to roll back stimulus. That wasn’t the takeaway. The takeaway was that Powell all but confirmed a benign (i.e., dovish) timeline for trimming monthly bond-buying and emphasized that the bar for actual rate hikes is not only so high that we can’t even see it from here, but is in fact so qualitatively (and, I guess, quantitatively) different from the threshold for tapering asset purchases, that the two shouldn’t even be discussed together.

The dovish taper was a boon for risk assets in the here and now, as evidenced by Friday’s rally on Wall Street. The explicit (and somewhat forceful) delinking of rate hikes from the taper presents something of a quandary. The point (obviously) was to emphasize that the Fed is still nowhere near discussing liftoff. Indeed, almost every Fed official is on the record parroting some version of that talking point. But someone Bloomberg TV interviewed on Friday appeared to suggest that delinking the two might open the door to rate hikes before the taper is finished depending on the path of inflation over the next 12 months.

To be clear, that person (to the extent I’m not misrepresenting their position) is wrong. The Fed (and especially the leadership) most assuredly isn’t attempting to somehow emphasize their optionality when it comes to using the bluntest tool at their disposal to tamp down a nightmarish inflation surge. The Fed doesn’t need to incorporate any allusions to the “break glass in case of emergency” option when it comes to spiraling inflation. If the US starts to go the way of Venezuela, nobody is going to argue with rate hikes. Powell doesn’t need to sneakily reserve the right to hike rates if the price of bread soars to $45 a loaf. In short, there’s no risk of a rate hike prior to the end of the taper barring some far-fetched turn for the absolute worst on the inflation front.

With that out of the way, I’m starting to believe the taper isn’t likely to pose that much of a risk either. Trillions up trillions in liquidity has quite plainly served to levitate risk assets in the post-financial crisis era, and the post-COVID experience was no different in that regard (familiar figure below).

But there are multiple mitigating factors to take account of as the Fed prepares to gradually pare bond-buying.

First, forward guidance has now become an exercise so recursive that policymakers are telegraphing the telegraphing. That is, traders now get advanced notice when discussions have commenced around how to go about preparing markets for an eventual policy change that will play out over the course of a year. To the extent it’s possible to adjust your mindset for the slow withdrawal of liquidity support, the adjustment period is as forgiving (i.e., long) as it could possibly be.

The read-through from Powell was that September is off the table for an unveil. Goldman agrees, for whatever that’s worth. “Coupled with the FOMC’s intention to provide ‘advance warning’ that tapering is coming, which we assume means a formal warning in an FOMC statement, these dovish comments indicate that the Fed leadership is not considering announcing the start of tapering at the September meeting,” Jan Hatzius said Friday, following Powell’s remarks.

More importantly, it’s not as if the liquidity is going away. Assuming a November unveil and a $15 billion per meeting clip, the taper won’t be completed for a year. The Fed will likely still be buying more than $100 billion in bonds per month in January.

Additionally, there are myriad sources of equity demand to take account of. There hasn’t been a single week of net outflows from global equity funds in 2021 on EPFR’s data. The pace may have slowed, but the annualized figure is quite simply unprecedented (figure below).

There’s ample scope for those flows to continue. On the latest ICI data, there’s still more than $4.5 trillion parked idle in money market funds. If inflation remains elevated, investors would be far better off storing that money in physical form. And no, I’m not kidding. Look at money market fund rates. Now subtract inflation. Tell me it wouldn’t be less punitive to pay whatever cost is associated with storing physical bank notes securely somewhere. Some of that money has to find its way into equities.

At the same time, buybacks are picking up and should accelerate further as corporates ponder what to do with full coffers they no longer need now that the world isn’t ending — or at least now that the apocalypse is on hold.

Finally, you might fairly argue that any rise in real yields associated with even the appearance of Fed tightening conjures memories of 2018, when we learned that in today’s world, equities can’t stomach a rise in real rates even to the “lofty” heights of 1% (figure below).

While acknowledging stocks’ tolerance for higher reals is almost surely lower now, 10-year reals are just ~10bps “above” record lows, with the scare quotes there to denote that we’re still deep in negative territory (figure above). TINA is alive and well.

Ultimately, it’s hard to argue that the impediments to further gains in equities outweigh the bull case, notwithstanding concerns about the Delta variant.

Still, I’d be remiss not to note that if someone at a bar were to slide you a napkin and a pen and ask you to sketch a picture of an asset bubble, you’d probably draw something that looked like the black line in the figure above.