“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.