“It looks as if the market has lost its tolerance for non-zero rates,” Deutsche Bank’s Aleksandar Kocic said Thursday, as US equities struggled through another arduous session.
Whenever the subject is a stock rebellion against Fed tightening or, more specifically, the concept of the “Fed put” and where it’s currently struck, references to Kocic’s 2018 notes are obligatory.
I’ll venture briefly down memory lane using a familiar summary. Kocic, some readers will undoubtedly recall, had perhaps the most accurate S&P “target” on Wall Street in 2018. It wasn’t really a “target,” per se (Kocic is a rates derivatives strategist), but rather a suggestion for where US equities might end the year based on his assessment of the dynamics around the Fed’s effort to re-emancipate markets after a decade of martial law imposed in the wake of the financial crisis.
I wasn’t the only one who documented Kocic’s prescience at the end of the last hiking cycle. Bloomberg celebrated the same prediction in an article which began with this sentence: “There’s one sell-side analyst who managed to predict this year’s volatile markets and he doesn’t come with a wizard nickname.” (The analyst was Kocic, and the wizard reference was to JPMorgan’s Marko Kolanovic.)
Allusions to 2018 are ubiquitous this year for obvious reasons. Then, as now, the Fed was engaged in a double-barreled tightening campaign, shrinking the balance sheet and hiking rates. Then, as now, officials struggled to pinpoint the location of the neutral rate. Then, as now, stocks rebelled until the infamous “Powell pivot” on January 4, 2019.
But unlike 2018, rate hikes have just begun. “[The] recent drawdown in stock prices looks like an exaggerated version of the end of the cycle in late 2018,” Kocic wrote Thursday. “While that was a result of the market’s rebellion against the scope and extent of the Fed tightening, which came after three years of persistent albeit gradual hikes, the current selloff in risk is significantly louder and is occurring as hikes have just barely started,” he added.
On innumerable occasions over the past year, I’ve insisted that the threshold for real rates beyond which equities would buckle was reset materially lower. When the Fed pushed real yields 100bps+ below zero, the read-through was inflated stock multiples. In the simplest possible terms: Stocks priced off deeply negative real rates will respond violently to any material increase, especially a sharp increase that unfolds over a compressed time frame. That’s a recipe for de-rating, which is precisely what happened over the first four months of 2022 (figure on the left, below).
A swift move higher in real rates triggered rapid multiple compression in the most expensive stocks, some of which are heavily weighted at the index level. Now here we are.
“The very mention of rate hikes has caused a 12% selloff in the S&P earlier this year and additional hikes have triggered another 4%, all of this accompanied with high realized volatility,” Kocic went on to say, before asking, “So, what is so special about 2022?” And then answering: “In our opinion: Real rates.”
Kocic documented the 140bps increase in 10-year real yields over two short months (figure on the right, above). “It is the anticipation of a continued rise of real rates that the stock market sees as particularly toxic,” he wrote.
Think of real rates as gravity. For the entirety of the post-COVID rally, stocks operated in a zero-gravity environment. So, they naturally floated away. Now, gravity’s pull is reasserting itself with predictable, albeit surprisingly acute, results. “It looks as if the real rates selloff is overwhelming all other considerations,” Kocic remarked, referencing the poignant visual (below).
Ultimately, Kocic’s conclusion was that with inflation nowhere near target and unlikely to get there anytime soon, a “Powell pivot” redux probably isn’t in the offing.
“If equity prices continue to follow this trajectory of rebellion, they are unlikely to extort the Fed’s concession as they did four years ago, and the S&P will have another leg of decline ahead,” Kocic said. “Taken at face value, its current interaction with real rates could push stocks close to 3700 and possibly lower if reals continue to rise further.”
The “good” news is, an acute growth scare predicated on fears of a hard landing could force reals lower, as appeared to happen on Wednesday. The bad news is the hard landing part.
The Fed is focused on financial conditions rather than stock prices, although admittedly the two are correlated. Credit spreads have widened out, but credit is not yet too tight. The clue that this cycle of tightening is likely to be shorter than some think, is the external value of the US $. DXY is at a level that can cause a financial accident. No the Fed won’t have a put strike price close by for a stock market correction or bear. But you had better believe a credit event will cause a rally in US Treasury and a pull back by the Fed from a rapid tightening cycle. We are a lot closer than M EL Erian or Larry Summers thinks. This is a case of speed of tightening being as important a factor as the amount of such tightening. Could it be crypto? Housing? Consumer spending? EM finances? How about all of them? The ivory tower guys still have not learned.
I’m very hopeful that you’re correct, Ria. I’m also hopeful about resolution of the Russian-Ukraine war in a reasonable amount of time, which would reduce pressure on the price of oil and gas products and provide some good news.
I saw an article about the loss of a Russian battalion of equipment and soldiers while crossing a pontoon bridge over the Donbas River. The volume of the loss is probably exaggerated, but it’s still a significant loss, and with broad media exposure. The Russians may manage the news at home, but they’re laughably unsuccessful internationally.
Even worse than particular losses, Russian soldiers do not seem to be keen to fight. They’re undisciplined and slow to execute orders. Contract soldiers who have served their time are quitting after fulfilling their contracts because the battle with Ukraine is not officially declared as a war. In some cases, individual units are openly disobeying orders. I’ve also heard western military experts suggest it will be difficult for Russian forces to last through the summer due to the volume of equipment losses and casualties.
If matters continue to move in the direction of disabling Russia’s conventional war-fighting capacity, it seems the Russians will eventually have to get serious about peace talks. The question lurking in the background for me is the extent to which Putin will wish to assert his will when it becomes obvious his army cannot hold ground in Ukraine with conventional weapons. Will he choose to use a nuclear weapon? One more parallel question: Will Russian generals and other government leaders have the stones to take matters into their own hands and say “Nyet” to Putin?
The Russia-Ukraine war, which is such a terrible event for the Ukrainians and inspires our compassion and support, also creates worry for the west. But one can reasonably hope questions about the outcomes may be answered before the Russian winter comes. Thankfully, the west is deeply engaged in supporting Ukraine, and the Ukrainian military is a sterling example of the light of freedom burning brightly – a genuine wonder.
CNN’s fear and greed index hit 6 (extreme fear). Curious to know where bofa’s bull & bear index stands, as I assume it also just triggered a buy signal.
Having said that, I’ve already slightly added to my positions on the way down (though still sitting on a monstrous cash position as I can’t find any truly appealing buys). Not comfortable adding more. A ~20% decline in spy may have had much greater appeal in prior bears when it was accompanied with much lower multiples for stocks as a whole, and when stocks across the board sold off hard. Compared to many prior sell-offs, the current one has impacted large caps to a greater than normal extent, yet in general there are few (if any) worthwhile buys to be had, both among the beaten large caps and elsewhere.
I believe we will see a “Powell Pause” before we see a “Powell Pivot.” … Jackson Hole…book it…Aloha…