Draining The Pool

Markets felt apprehensive Monday ahead of holidays in Asia and a bevy of key US data due over the course of the week.

Equities were ready to whisper January a not-so-fond adieu. It’s been a rough stretch.

Global stocks were down more than 6% for the month, the worst showing since the onset of the pandemic. The Nasdaq Composite was on pace for its worst January ever (figure below).

You can thank surging US real yields for that. In fact, you can thank the 50bps jump in reals for the entirety of the S&P’s recent swoon.

For all the hyperbole, losses on benchmarks aren’t large. Especially not in the context of the rally sparked by central banks’ collective rescue effort mounted in COVID’s wake. Financial conditions finally tightened, but on a long delay vis-à-vis monetary authorities’ hawkish pivot, which began in earnest some four months ago (recall that while stocks surged in October, rebounding from a rare stumble the previous month, rates convulsed).

“The price action in January is largely a belated recognition of that hawkish shock,” Goldman’s Zach Pandl said, noting that the bank expects “the interplay between Fed tightening, financial conditions and growth to dominate the 2022 picture.”

The figure (above, from Goldman) speaks largely for itself. Financial conditions loitered near the easiest levels on record despite the steady pricing-in of Fed hikes. Even after recent tightening, Goldman’s FCI is short of levels hit in March/April of 2021, when rates peaked and the Archegos drama briefly monopolized headlines.

Fast forward 10 months and seemingly every story that’s not about Ukraine is about 50bps in March. I’m “guilty” of succumbing to the 50bps obsession myself. It seems just as likely as not that markets will make a run at fully pricing a “double” hike for the March meeting. In the grand scheme of things, though, that would still leave conditions historically accommodative.

“Debating between 25 and 50 basis points for March is the equivalent to deciding between using a cup or a bucket to start emptying a swimming pool,” JonesTrading’s Mike O’Rourke remarked. “One is larger than the other, but the difference is negligible relative to the task.”

That’s true (and it’s funny, in a deadpan kind of way), but as noted here over the weekend, the Fed needs to be cautious about three things when it comes to large increments and rapid hikes. First, they’re going to approach the market-implied terminal rate fast. And because no one really knows where neutral is, they could overshoot, inadvertently choking an already slowing economy. Second, and relatedly, they could easily invert various curves, especially if the market gets the idea that growth is slowing rapidly and/or some exogenous shock triggers a bid for the long-end. Third, the threshold for what the market is willing to tolerate is lower over time. We learned in January that the mere prospect of rate hikes (simply talking about raising rates) is enough to push US real yields up 50bps in four weeks, triggering a correction in stocks. Goldman over the weekend suggested another 100bps higher on 10-year reals would push the S&P down to 3,800, a bear market.

O’Rourke extended the swimming pool analogy. “The slow but persistent drain created by using a hose is far more effective [and] its consistency also provides certainty,” he said. “Unsurprisingly, using a hose equates to balance sheet normalization.”