Higher stock prices “would ease financial conditions and therefore be antithetical to the Fed’s goal,” Goldman’s David Kostin wrote, in a note published following the S&P’s fifth consecutive weekly decline.
It’s a familiar refrain. Regular readers are well apprised of the dynamics.
On Thursday, amid an egregious slide in US shares, I suggested the Fed might’ve been pleased to see equities give back gains logged the previous afternoon, when Jerome Powell’s repudiation of rate hike increments larger than 50bps sparked a manic rally.
When it comes to financial conditions, stocks did the heavy lifting post-pandemic. Higher equity prices accounted for a large share of the easing impulse, and some argue they (stocks) should shoulder the remainder of the burden as conditions tighten.
But nothing happens in a vacuum. It’s not possible to orchestrate a controlled demolition in equities with no spillover to credit, and as we’ve seen time and again in 2022, the source of equity angst is often higher bond yields, another input in measures of overall financial conditions. In short, it’s not as simple as cordoning off stocks.
What’s fairly straightforward, though, is the notion that stock rallies are counterproductive for a Fed that’s desperate to tighten financial conditions expeditiously.
Given that reality, “the best case scenario for the economy — and, eventually, for equity prices — probably involves a continued period of constrained equity market returns,” Kostin went on to write, suggesting upside may be capped from here.
Note that other strategists have been explicit on this point. It’s not just that the vaunted “Fed put” is struck far lower due to the necessity of prioritizing the inflation fight. The Fed isn’t just reluctant to support equities, they’re arguably averse to seeing stocks rise if higher stocks means easier financial conditions. There’s a sense in which being bullish is now tantamount to fighting the Fed, a complete reversal of the dynamic investors have enjoyed over more than a decade.
Time and again over the past several weeks I’ve flagged the surge in real yields against deteriorating (at the margins, anyway) economic data in suggesting markets are experiencing a “pure” tightening impulse. Rapidly rising real rates that can’t be explained by an improvement in the outlook for the economy are a reaction to policy expectations and a mechanical function of falling breakevens. While the latter is a good thing to the extent it suggests longer-term inflation expectations are stabilizing, you’re reminded that breakevens can be positively correlated with risk assets, while real yields tend to exhibit the opposite relationship.
The figure (above) shows the rise in real yields bleeding stocks through multiple compression. The S&P, you’re reminded, is heavily weighted towards big-cap tech and long-duration equities, which are very vulnerable to de-rating in the event of rapidly rising real rates.
10-year reals ended the week at 26bps. Consider this: Reals are up 130bps since March 8, when they descended back near record lows around -1.05% in the immediate panic that accompanied Russia’s incursion in Ukraine.
The figure (above) gives you some context for the move. It’s acute, to put it mildly. It’s a small miracle stocks haven’t sold off even harder.
“Looking forward, the path of the equity market will depend on the outcome of the Fed’s battle against inflation,” Kostin said. In Goldman’s base case scenario, GDP and earnings growth decelerate and financial conditions continue to tighten, but a narrowing yield gap helps offset the drag on equity valuations from higher rates. And the US averts a recession.
But, if the odds of a recession rise, the outlook for equities would darken, even if a downturn pushes real yields back into negative territory. Kostin sketched a “recession scenario” in which the S&P drops to 3,600, bringing the total peak-to-trough decline to 24%, conveniently in line with the median drop witnessed during historical downturns.
“Without more clarity on the path of Fed policy and economic growth, stocks will price an above-average recession probability and will be challenged to sustain prices much above the current level,” he remarked.
Just as investors once bought every dip, confident in the notion that the Fed would verbally intervene to prop up equities during better times, traders are now learning to sell every rip on the assumption the Fed will look to quell rallies out of concern for the read-through of easier financial conditions for the inflation fight.