Breaking Point

Markets moved closer to what felt like a breaking point Friday. FedEx’s bleak remarks on the macro outlook may be seen, in hindsight, as a “last straw” moment of sorts.

In the latest installment of his weekly “Flow Show” series, BofA’s Michael Hartnett captured the tension. “The inflation shock ain’t over, financial conditions are tightening, gold is breaking down as US real yields [rise to] 1% from -1% six months ago, US mortgage rates are 6%, CNY is now above 7.00 [and] if the BoJ fails to budge on yield-curve control next week, the risk is a quick move in the yen above 150,” he wrote.

It’s death by a thousand cuts, but it’s brought to you by one knife: Expectations for Fed tightening, which are driving up US real rates and pushing the dollar to multi-decade highs.

Market-implied terminal rate expectations are up 50bps this week (updated figure above) to ~4.50%.

I said last week that the ongoing rise in US real yields was irreconcilable with the relative calm in stocks. I reiterated the point on Wednesday morning, following Wall Street’s worst day in two years.

Recent de-rating in equities was insufficient for multiples to fall commensurate with the rise in real yields, which are up across tenors near 2018 highs (figure below).

That’s kryptonite for risk assets — “pure poison,” as Nomura’s Charlie McElligott put it. As is the stronger dollar that goes along with it.

I try to avoid speaking deterministically (about anything), but it often feels as though, for the majority of everyday investors, this is poorly understood. Stocks will struggle in the face of ever higher real rates. It’s as close to a guarantee as you’re going to get.

All of the developments cited by BofA’s Hartnett come back to the same financial conditions tightening impulse, which manifests in terminal rate pricing and US real rates. The Fed is turning the screws, and everything is breaking.

Critically, the Fed isn’t anywhere near reversing course or even taking a pause. It’s very likely that financial conditions will tighten further until something (and likely several somethings) snaps, whether it’s the yen, the yuan, the housing market, the economy or something else entirely.

In a new note, Goldman’s Dominic Wilson and Vickie Chang took a look at what sort of FCI tightening impulse would be needed if the Fed does indeed acquiesce to what some insist is the necessity of engineering a recession or, at the least, a material increase in the US unemployment rate in order to bring down inflation.

Goldman’s approach produced two hawkish scenarios, one “moderate,” one “severe.” The former entails an additional 90bps increase in five-year US yields and another 4% rise in the dollar versus the bank’s own forecast, while the latter, “severe” scenario would see five-year yields rise 180bps and the dollar a further 8%.

When considered in conjunction with the tightening already delivered this year, either outcome might seem especially onerous — draconian, even. But, as Wilson and Chang wrote, the implied FCI impulse wouldn’t be unprecedented. The figure (below) shows the history of the bank’s financial conditions index, for context.

The moderate scenario in Goldman’s analysis implies a cumulative FCI tightening of 460bps. In the “severe” scenario, it’d be roughly 600bps, inclusive of the tightening that’s already occurred.

“The larger of these two is comparable to the financial conditions tightening during the Global Financial Crisis and the recessions of the early 1980s,” Wilson and Chang said. “While those may seem like extreme comparisons, the current tightening cycle comes on the heels of a period in which financial conditions were historically easy, and these scenarios are designed precisely to describe a situation in which the Fed must push policy into a tight enough position to engineer a sharp recession.”