Hating on the Fed is as American as apple pie

Summary

• Rehashing the macro narrative.

• The duel rally in bonds and equities continues.

• Monetary policy in the driver's seat.

• The escalation in geopolitical tensions in the middle east.

• Are markets forcing the Feds hand?

It’s good to be back after hitting the books for a few weeks … what’s nice is that the macro narrative is pretty clean ... albeit there is a lot going on. Starting from a broad view, economic data hasn’t been tip-top, in fact, we’ve seen some pretty dismal numbers around the world. The US data continues to send mixed signals, with the labor market running near multi-decade lows while softer economic data (consumer confidence and empire manufacturing surveys to name a few) are starting to signal a recession. The good news in all this is that central banks aren't sitting on their hands — both the RBNZ (New Zealand) and RBA (Australia) have cut rates and many more have shifted to a decisively dovish tone. The ECB has hinted towards starting a second round of asset purchases and the Federal reserve fell just short of essentially promising a rate cut come July. The central bank willingness to lower rates, coupled with a slower growth profile has caused global bond yields to fall and yield curves to flatten, if not invert. Although ominous, an inverted yield curve on its own is not enough to “cause" a recession. With that said, a prolonged inversion of the curve will eventually begin to hurt banks and that should feed through to the real economy. Remember that banks borrow on the short end (by using your deposits amongst other funding sources) and invest/lend at the long-end. An inverted yield curve means that their funding costs are higher than their potential return, squeezing their interest margins. The strong rally in bonds is undoubtedly reflecting central bank dovishness (and the growth jitters in which that dovishness is based upon), but the real worry is that the market may be signalling a lack of faith in policymakers to be able to reflate the global economy. I say this because long-term inflation expectations have touched new lows around the world (the chart on the left is for Europe and the chart on the right is for the US [based on the Michigan survey of inflation expectations]). 

Where we go from here will be interesting, the market is certain that we are going to see some form of policy tweaks in the coming months and these metrics on inflation expectations will be top of mind for policymakers. Given all of the above, it comes as no surprise that the amount of negative yielding debt in the world has now topped US$13 trillion (the highest ever) and is now forcing investors back down the quality ladder in an increasingly desperate hunt for yield, in a world void of it. The long US Treasuries trade has now become the most crowded trade on the planet, according to the Bank of America Global Fund Managers Survey, with some of this skewed positioning attributed to systematic flows from convexity hedging in swaps and mortgage-backed securities (MBS). Not to get you propeller heads too excited but I do plan on flushing out some of these dynamics over several emails in the coming weeks. However, for the time being, just be aware that systematic hedging can cause an overreaction in markets and that's another facet to the US rates market.  It's important to look at these dynamics in the context of the whole market because then you can see where positions appear to be "stretched" or in other words mispriced. Right now the US rates market seems a little stretched given that we are currently pricing in 5 rate cuts by the middle of 2021. This seems a little excessive given the economic data we've seen to date. By the closing bell yesterday, US 10-year yield has broken through 2 percent, reaching the lowest level since 2016, and many other 10-year sovereign bonds were also hitting if not flirting with multi-year lows.  Following a dismal month dominated by the escalation in trade tariffs, the S&P500 hits an all-time high, gunning for it’s best half-year since 1997. The trade tensions that dominated the market narrative at the start of May have been brushed off, as central banks stepped up with the promise to provide additional liquidity. Equities were generally supportive of the additional boost, particularly last week, following the 1-2 punch from the ECB and the Fed, as well as the hopes that President Trump and Xi can come to an agreement on trade at the G20 meeting this weekend. Realistically, I think the latter seems pretty optimistic. The more likely scenario is one in which the two presidents talk but nothing is resolved over the weekend, with talks resuming at a later date. The worst case scenario for markets would be one in which the two decide not to talk at all and the US goes through with all the additional tariffs. Either way, equity markets have been eating up the headlines creating an even greater dichotomy between bonds and equities. After all, bonds are screaming recession from the rooftops while equities keep breaking higher and higher. The chart below shows this clear disconnect between bonds and equities.

Now some of the more astute readers will tell you that, with lower rates, equities will mechanically be brought higher via lower discount rates for future cash flows. Although true, that story is incomplete. The problem is that the markets continue to interpret bad news as good news in the sense that a further deterioration of the outlook will actually boost equities in anticipation of a Fed rate cut. The market is basically addicted to this heroin (lower rates/perpetual liquidity) and the Fed (the supplier) can't get the market off of it. The market is completely ignoring the fact that a deterioration of the outlook will undoubtedly have an impact on economic growth and ultimately corporate earnings (for the equity guys... I'm talking about the numerator in your discounted cash flow models). Barring what I just said, there's also a real risk that a quick resolution to the trade war could force the Fed to actually reconsider the rate cuts and push yields higher. On the flip side, if the G20 goes really sour, the market might decide there isn't any amount of rate cuts the Fed could deliver that could save the situation. Either way, there is a real risk of a sell-off over the coming days.

With monetary policy in the driver's seat, market's are reacting in expected fashion, as the promise of continued liquidity supports credit markets. High-yield issuance this week has been stellar, as investors continue to cobble over each other in search of anything that has a decent yield. For those who don't remember, high-yield issuers are companies that are riskier/less stable and as a result, investors demand a higher yield on their debt. These bonds can also be referred to as junk bonds. In terms of currencies, the greenback finally started to respond to the prospect of Fed rate cuts, falling by around 1.5 percent over the week after being fairly resilient all year long. Gold prices rallied, breaking out of a multi-year range, now sitting at the highest level since 2013. Gold tends to be used as a hedge against inflation or in times of uncertainty, and while there is a lot of uncertainty, it is not being reflected in implied volatility. The chart below shows inflation expectations (the US 5Y5Y line) and the VIX Index (1-month implied volatility on the S&P500 as a proxy for uncertainty).

We can see that neither of the above has really followed gold, making it seem like its more of a USD weakness rally than anything else. Interestingly enough, bitcoin has broken above $US 10,000 for first time since it’s collapse after December 2017.

Geopolitical tensions in the middle east have escalated dramatically, giving the oil bulls the pop they were after with, prices up nearly 10 percent over the week. The standoff between the US and Iran has heated up over the past few weeks with the escalation starting with an attack on a pair of oil tankers in the Gulf of Oman 2 weeks ago. With tensions already high, the Iranian military shot down a US drone last week, resulting in the President of the US calling off a retaliatory drone strike just hours before the attack on Iran. It seems that the President does not want to go to war with Iran, despite John Bolton's eagerness to start one, and as an alternative, the US administration decided to impose further sanctions. A shocking development given that I didn't think there was anything else left to sanction. Clearly, Iran didn't see much point in the escalation either, with their President openly telling the US administration that the White House was “ afflicted with mental retardation". As humorous as all of this is, I do think we are closer to war than it seems. I think the most immediate impact to markets, should a war break out, would be a hefty premium on oil prices. Although I'm sure no one really wants a war, a part of me does think that if oil prices jump to 85-100 US$ per barrel, that would definitely pass through to inflation and solve the Feds long-term inflation expectation problem I mentioned above.

With everything that happened the past week, you’d be excused if thinking about the Fed’s independence wasn’t at the top of your mind, but how policy develops over the coming 5 weeks is going to be critical for markets. While it may have been possible to believe that Powell, at the last FOMC meeting, may not have been as dovish as the market was implying, it would have been extremely unlikely to think that Powell would have gone out of his way to push back against a rate cut. The market is currently leaning so hard towards a rate cut that catching the market offside with a hawkish remark would have caused a rapid unwind in bond positions, pushing yields to higher and tightening financial conditions. As a quick refresher, financial conditions essentially reflect how easy it is for individuals or companies to get funding and is a function of equity, debt and currency markets as well as investor sentiment. The important thing to note here is that, had the Fed come out hawkish, it would have tightened financial conditions, forcing the Fed to then lean dovish anyways. Yes, this is very much a case of the tail wagging the dog. I am by no means suggesting that this is the way monetary policy "should" operate, I am just pointing out the fact that this is the way things are unfolding. The only reason the Fed would have come out hawkish at its last meeting would have been to try to emphasize it's independence, given the recent escalation in threats from the President, but even then this would have been nearly impossible to communicate at the press conference. There's a great WSJ article talking about the history of US presidents bashing the central bank that is worth a read for those interested (click here). Now more to the point, why does all this matter? Well in about 5 weeks the Fed will have to deliver a rate cut and keep on delivering cuts through to the end of the year, barring there isn't some development that changes the macro narrative. That my friends is a fine line to walk on if your end goal is financial stability.

Tiago Figueiredo