Investors have not yet digested
The truth of what Jay has suggested
There’ll be no delay
QT’s on the way
(Unless the Dow Jones is molested)
Given the change in tone from the Fed and a number of other central banks, where suddenly hawkishness is in vogue, the fact that risky assets (read stocks) have only given back a small proportion of their year-long gains is actually quite remarkable. The implication is that equity investors are completely comfortable with the transition to positive real interest rates and that valuations at current nosebleed levels are appropriate. The problem with this thesis is that one of the key arguments made by equity bulls during the past two years has been that negative real interest rates are a crucial support to the market, and as long as they remain in place, then stocks should only go higher.
But consider how high the Fed will have to raise interest rates to get back to real ZIRP, let alone positive real rates. If CPI remains at its current level of 6.8% (the December data is to be released on Wednesday and is expected to print at 7.0%), that implies twenty-seven 0.25% rate hikes going forward! That’s more than four years of rate rises assuming they act at every meeting. Ask yourself how the equity market will perform during a four-year rate hiking cycle. My take is there would be at least a few hiccups along the way, and some probably pretty large. Consider, too, that looking at the Fed funds futures curve, the implied Fed funds rate in January 2026 is a shade under 2.0%. In other words, despite the fact that we saw some pretty sharp movement across the interest rate markets last week, with 10-year yields rising 25 basis points and 2-year yields rising 13 basis points, those moves would just be the beginning if there was truly belief that the Fed was going to address inflation.
Rather, the evidence at this stage indicates that the market does not believe the Fed’s tough talk, at least not that they will do “whatever it takes” to address rising inflation. Instead, market pricing indicates that the Fed will try to show they mean business but have no appetite to allow the equity market to decline any substantial amount. If (when) stocks do start to fall, the current belief is the Fed will come to the rescue and halt any tightening in its tracks. As I have written previously, Powell and his committee are caught in a trap of their own design, and will need to make a decision to either allow inflation to keep running hot to try to prevent an equity meltdown, or take a real stand on inflation and let the (blue) chips fall where they may. The similarities between Jay Powell and Paul Volcker, the last Fed chair willing to take the latter stand, stop at the fact neither man had an economics PhD. But Jay Powell is no Paul Volcker, and it seems incredibly unlikely that he will have the fortitude to continue the inflation fight in the face of sharply declining asset markets.
What does this mean for markets going forward? As we remain in the early stages (after all, the Fed is still executing QE purchases, albeit fewer than they had been doing previously) tough talk and modest policy changes are likely to continue for now. Equity markets are likely to continue their performance from the year’s first week and continue to slide, and I would expect that bond markets will remain under pressure as well. And with the Fed leading the way vis-à-vis the ECB and BOJ, I expect the dollar should continue to perform fairly well against those currencies.
However, there will come a point when investors begin to grow wary of the short- and medium-term outlooks for risk assets amid a rising rate environment. This will be highlighted by the fact that inflation will remain well above the interest rate levels, and in order to contain the psychology of inflation, the Fed will need to continue its tough talk. Already, when looking at the S&P 500, despite being just 3% below its all-time highs, more that 50% of its components are trading below their 50-day moving averages (i.e. are in a down-trend) which tells you just how crucial the FAANG stocks are. And none of those mega cap stocks will benefit from higher interest rates. In the end, there is significant room for equity (and all risk asset) declines if the Fed toes the tightening line.
Looking at markets this morning shows that no new decisions have been taken as both equity and bond markets are little changed since Friday. Perhaps investors are awaiting Wednesday’s CPI data to determine the likely path going forward. Or perhaps they are awaiting the comments from both Powell and Brainerd, both of whom will be facing the Senate this week for confirmation hearings for their new terms. However, we do continue to hear hawkish comments with Richmond Fed President Barkin explaining that a March rate hike would suit him, and ex-Fed member Bill Dudley explaining that there is MUCH more work to be done raising rates.
So, after Friday’s late sell-off in the US, equities in Asia rebounded a bit (Hang Seng +1.1%, Shanghai +0.4%, Nikkei closed) although European bourses are all modestly in the red (DAX -0.3%, CAC -0.4%, FTSE 100 -0.1%). US futures are also turning red with NASDAQ futures (-0.35%) leading the way down.
Meanwhile, bond markets are mixed this morning with Treasury yields edging higher by just 0.4bps as I type, albeit remaining at its highest levels since before the pandemic, while we are seeing modest yield declines in Europe (Bunds -1.0bps, OATS -1.5bps, Gilts -0.3bps). The biggest mover though are Italian BTPs (-5.3bps) as they retrace some of their past two-week underperformance.
On the commodity front, oil (-0.2%) has edged back down a few cents although remains much closer to recent highs than lows, while NatGas (+4.4%) has jumped on the back of much colder weather forecasts in the US Northeast and Midwest areas. Gold (+0.3%) continues to trade either side of $1800/oz, although copper (-0.2%) is under a bit of pressure this morning.
As to the dollar, it is mixed today with SEK (-0.4%), CHF (-0.35%) and EUR (-0.3%) all under pressure while JPY (+0.25%) is showing its haven bona fides. This definitely feels like a risk move as there was virtually no data or commentary out overnight. In the EMG space, RUB (+0.9%) is the leading gainer as traders continue to look for further tightening by the central bank despite the fact that real rates there are actually back to positive already. INR (+0.35%) and IDR (+0.35%) also gained with the rupee benefitting from equity market inflows while the rupiah responded to word that the government would soon lift the coal export ban. On the downside, the CE4 are in the worst shape, but those are merely following the euro’s decline.
There is a decent amount of data coming up this week as follows:
|Tuesday||NFIB Small Biz Optimism||98.5|
|Wednesday||CPI||0.4% (7.0% Y/Y)|
|-ex food & energy||0.5% (5.4% Y/Y)|
|Fed’s Beige Book|
|PPI||0.4% (9.8% Y/Y)|
|-ex food & energy||0.5% (8.0% Y/Y)|
In addition to the data, we hear from seven Fed speakers and have the nomination hearings for Powell (Tuesday) and Brainerd (Thursday), so plenty of opportunity for more hawk-talk.
For now, I continue to like the dollar for as long as the Fed maintains the hawkish vibe. However, I also expect that if risk assets start to really underperform, that talk will soften in a hurry.
Good luck and stay safe