Last week, we presented readers with the latest note from SocGen strategist. Albert Edwards, who explained why after so many years of false rate hike starts, the market not only responded to last week’s hike in a dovish manner – interpreting last Wednesday’s 0.25% hike as a 0.25% rate cut- but as Goldman Sachs showed previously, the dovish reaction was one of the strongest ones since the financial crisis, in other words: “the market no longer believes the Fed.” This is what Edwards said, citing his FX colleague Kit Juckes:
[T]he Fed’s reluctance to send an aggressive tightening signal, instead preferring to again shuffle upwards its dots just slightly, has disappointed markets. But to be fair, the problem isn’t really with the famous dots. It’s with the market, which just doesn’t believe the Fed will tighten as fast as they say they plan to (see left-hand chart below). If the market took the FOMC at their word and discounted a 3% Fed Funds rate at the end of 2019 and beyond, then we’d probably have a 3% nominal 10-year Treasury yield by now.”
That said, a 3% Fed Funds rate would also lead to steep selloff in risk assets as the dividend yield on the S&P, currently at about 2%, would be about 1% below the risk free rate, leading to a wholesale “great rotation” out of stocks.
And while the market may not believe the Fed is ready – and willing – to push rates that high, the relationship also cuts both ways.
As RBC also noted last week, explaining that while the Yellen put is alive and well, the market will simply not tighten financial conditions on its own, forcing Yellen to aggressively hike further… which the Fed may be reluctant to do.
That is the argument in a note released late last week by Morgan Stanley’s credit strategists, who note that while the party is still going strong, some 93 months into the current cycle, it may not continue should the Fed engage in an aggressive rate hike scenario. This is what they say:
At 93 months, the current cycle is already longer than all but two post-war recoveries (out of 12 total). We could certainly debate why this expansion is already longer than normal, but strong growth is clearly not the reason. In fact, quite the opposite – a lackluster economic backdrop for years, leading to massive central bank support,has likely kept the cycle going more than anything else. Last year is a good example. As we show below, early in the year, with oil collapsing and the economic data rolling over, recession risks were seemingly rising. As Exhibit 3 shows, central banks across the globe responded. Even the Fed provided stimulus (verbally) by allowing the market to go from pricing in almost three rate hikes at the end of 2015 to almost zero rate hikes in summer 2016. Markets recovered, and the economic data followed.
What is Morgan Stanley’s conclusion? Simple: for the party to continue, not only must the Fed revert back to its quasi-dovish mode, but for that to happen the recent economic “rebound” has to end (the sooner the better), extinguishing any reflationary impulse, removing the impetus for Yellen to hike aggressively further, and allowing the Fed to remain on hold for an indefinite period of time. In short: “In our view, for the cycle to last another several years, we want to see more of the same – a continued environment of ‘ok’ growth and low inflation, which allows central banks to keep the party going.”
Hopefully Trump, whose policies threaten to upstage this delicate balance benefitting the 1%, has read the memo.