Debates about whether markets can “handle” a Fed tightening cycle and/or a reduction of the “flow” effect associated with monthly asset purchases often miss the only point that really matters.
Common sense dictates that the longer markets persist in an environment where price discovery is, at best, suppressed, the more disruptive their re-emancipation is likely to be.
Forget the addiction metaphor for a moment, although I do believe that’s another example of a cliché which, over time, gained quite a bit more explanatory power than it had when it was originally deployed as a kind of passive aggressive attack on central banks.
The issue isn’t so much whether a shallow tightening cycle and the cessation of Fed balance sheet expansion will engender a Wall Street meltdown akin to an opioid addict going cold turkey. Rather, the concern is broader, and more existential.
Prices in various corners of the fixed income universe now have almost no connection whatsoever to any kind of fundamentals. Although I don’t purport to have conducted an up-to-date, systematic analysis over the weekend, we can say, with absolute certainty, that periphery EGBs have, at times, traded so rich to the macro fundamentals associated with their respective sovereigns that allowing price discovery to reassert itself over a compressed time frame would’ve been catastrophic. I’d venture that’s still the case today, depending on the country.
Those distortions found their way into € credit. In August of 2019, for example, some €1.1 trillion of European corporate bonds sported yields less than zero. As BofA wrote at the time, “there are now 100 different issuers in the Euro-denominated credit market that have all of their corporate bonds yielding below zero.” So, there were 100 companies in the € debt market whose entire curve was negative. There were also instances of negative-yielding “high” yield debt, the ultimate oxymoron.
This debate has taken on new urgency over the past several months as developed market central banks ponder the prospect of preemptive rate hikes and other tightening measures to control inflation risk and prevent expectations from becoming totally unanchored. Labor market conditions are, arguably, conducive to a wage-price spiral which only increases the sense of panic.
Although valuations have come down in some assets, others are still very expensive historically speaking. Japanese equities are an exception (figure below).
Note that at ~1.35% (near the local low in yields), the US 10-year was in the 89th%ile in terms of expensiveness versus its 10-year history. One way or another, virtually everything else is priced off the US 10-year. So, ultimately, the bond bubble is embedded across assets, and especially so in duration proxies across equities, where valuations are near dot-com levels.
This is all a bit repetitive for some regular readers (and certainly for those of you who happen to be strategists), but I thought it was worth recapitulating not just due to the proximity of the December Fed, but also in the context of some new commentary from BofA’s Ethan Harris.
Citing the latest installment of the bank’s FX and Rates Sentiment Survey, Harris noted that half of respondents (i.e., fund managers) believe “the pain threshold at which central banks will step in to support markets is no more than 15% down from equity index levels as of early November.”
Harris was quick to point out that such a selloff, were it to occur, “would still leave the S&P 500 up more than 10% on the year.”
He went on to describe what he called “a big problem” with that line of thinking — namely, that “history suggests the economy and markets can easily handle a partial normalization of monetary policy.”
That may have been true in pre-GFC history, but it’s hard to call post-GFC efforts at policy normalization “tightening cycles” with a straight face. The past dozen years have been one long experiment in the administration of asset prices, with brief interludes featuring aborted attempts on the Fed’s part to extricate itself and emancipate markets.
Admittedly, I’m giving Harris’s argument short shrift, but only because I have to at least nod to brevity for the sake of readers’ collective sanity. He makes a more nuanced case, but I found some of the language he employed while discussing QE and equities to be needlessly dismissive.
“History argues that tapering and QT are not nearly as dangerous as some pundits suggest,” he began, before characterizing jitters around tapering in 2013 as “hyperventilation” and calling the QE addiction metaphor “overblown.”
It’s overused, that’s for sure. But it’s not overblown. I’ve been over this on countless occasions. There may not be a tight, near-term correlation between asset purchases and equities, but it’s self-evident that, over time, the ongoing, incremental bid for sovereigns, credit and, in the case of the BoJ, equity ETFs (March’s tweaks notwithstanding), is bullish for risk assets through a variety of channels.
And that’s to say nothing of the rather straightforward “stock” effect, wherein central banks engineer a shortage of risk-free assets by sequestering them away on their balance sheets, thereby creating artificial scarcity, which leads to lower yields (as investors compete for a smaller pool of available assets) and, eventually, pushes investors out the risk curve, down the quality ladder and into various yield enhancement strategies, almost all of which entail being de facto short vol.
That’s just the reality of the situation and BofA’s Harris is of course aware of it. He wasn’t being disingenuous in his latest though. Rather, he was making a more straightforward (i.e., less theoretical, and less existential) argument about the link between QE and stock prices.
In that regard, he did investors a service by tacitly suggesting that when it comes to charts purporting to show the effect of QE on equities and the macro, there’s nothing inherently more legitimate about saying “Ok, now zoom out” than there is about saying “Ok, now zoom in.”
“Neither tapering nor QT seemed to have any impact on the bull market in equities, nor did they do much to slow the steady drop in the unemployment rate,” he wrote, referencing the figures, below.
You can make the data (and, by extension, the charts) say whatever you want them to say simply by adjusting the window. That’s especially true of QE charts.
I’m playing devil’s advocate to my own position here, in case that’s not obvious. I’m fond of Harley Bassman’s “me or your lyin’ eyes” characterization of the effect of liquidity provision on equities (see the familiar figures below).
But quite a bit of the poignancy associated with visuals like those depends on what time frame you use to construct your charts.
I’d note that such push back makes infinitely more sense today than it did, say, a half-dozen years ago. I distinctly remember a social media exchange from 2015 that found a self-styled market maven responding to a major bank’s charts plotting the YoY flow of central bank asset purchases with the performance of equity and credit. He suggested that had the bank used a much longer time horizon, the charts would cease to be compelling. Of course, that argument made absolutely no sense because the charts only have meaning in the context of the post-GFC monetary policy response. Using a 40-year look back would miss the point entirely.
Fast forward to 2021, and there’s now a legitimate debate about whether we should look at slices of the post-GFC experience rather than simply plotting the cumulative amount of QE administered against a 12-year chart of the S&P 500. That chart has arguably lost some of its informational value.
Along those lines, Harris wrote that although “a lot of things were going on” during various attempts to normalize policy, QE shocks generally “turned out to be duds.”
That, Harris concluded, “is consistent with our own long-held view that QE has a very low bang for the buck when it comes to the economy and markets.”
On Sunday, the FT reported that Greece “is planning an appeal for the country’s bonds to remain eligible for new ECB purchases after March” when the central bank’s pandemic QE program is supposed to end.
“Several members of the ECB’s governing council said they were amenable to finding a way to keep buying Greek bonds for the rest of next year when they meet on Thursday,” the article said.
Read more: Do You Remember Snow?
“Past performance may not be indicative of future results”
I’m concerned. Time to trim stock and bonds in tax-protected accounts and wait?
That, Harris concluded, “is consistent with our own long-held view that QE has a very low bang for the buck when it comes to the economy and markets.”
And here in lies the root of Mr Harris’ failure. Fundamentalist Institutionalists often fail to understand that the markets are not the economy and vis-versa. Economically, the through put of fiscal policy has failed to drive much in the way of economic growth. This is however only loosely related to financial assets and specifically risk assets as the gain from the great liquidity experiment mostly flowed to financial assets and not the real economy.
The market has, obviously, won every battle of wills with tightening predilections. Has the market ever “believed” it would lose? December 2018 might have been the closest we’ve come to that belief setting in.
This time might be different. All prior battles have been against a philosophical return to normalcy, a “freeing up of ammo” for IF a tightening impulse became necessary. It is now necessary. 7% inflation with hot employment numbers to boot means that the real economy is the counterbalance to the equation rather than a fed predilection.