Last November, when the S&P was trading just north of 2000, Goldman’s Charles Himmelbrg revealed his first tactically bearish reason (even as the overall firm was rolling out a se to Top 6 bullish Trades 5 out of which were stopped out at a loss just months into the new year) why stocks are unlikely to go much higher. He dubbed it the “Yellen Call“, which was effectively an argument that US risk rallies will be “self-limiting” as a result of Fed intervention, and explained it as follows:
US equity upside: Limited by the ‘Yellen call’
We see limited upside to equities in 2016. Our US Portfolio Strategy team has a 2016 price target of 2,100 for the S&P 500, suggesting a very modest return of 5% (from current levels). Their framework assumes that 1) earnings per share will rise 10.1%, driven partly by ‘base effects’ in the energy sector and partly by improvements in global growth more generally, but that 2) the price-earnings multiple will fall approximately 5% (to 16.3x from 17.1x), as typically happens during rate-hike cycles. And, due to the delayed timing of rate hikes, the downside risk to price-earnings multiples is probably greater this year because the positive growth surprises that would normally accompany rate hikes are arguably behind us. Since our US GDP forecast envisions mild deceleration in 2016, equities and other risky assets will likely bear the brunt of rate hikes without the usual buffer of better growth data.
We also see a risk that the ‘Bernanke put’ will gradually be replaced by the ‘Yellen call’. The ‘Bernanke put’ captured the intuition that when the risks to growth, inflation and market sentiment are skewed to the downside and the Fed has an easing bias, monetary policy reacts aggressively to bad news. Now that these risks have receded, we expect the Fed will shift to an easing bias, implying that monetary policy will likely begin to react more aggressively to good news. The inflection point for this shift to an easing bias will arguably arrive in 2016, beyond which rallies in risk sentiment may be met by less accommodative monetary policy – the ‘Yellen call’.
It didn’t take long for Goldman to admit it had been wrong about the “Yellen Call” – all it took was the market swoon of January and February for the Yellen Fed to revert back to a “Bernanke Put” baseline.
Our notion of the ‘Yellen call’ was the converse of this – that with labor markets approaching full employment and core PCE inflation rising towards target, meaningful rallies in market sentiment would likely be met with a more robust withdrawal of policy accommodation. And this, logically, would tend to buffer or ‘cap’ the upside potential for risky assets. It hasn’t happened. Market conditions have been considerably more volatile and uncertain than we expected over the first quarter. While we correctly anticipated the downside risk to oil prices and cautioned that this would likely weigh on credit spreads (#4 of our top 10 risks), we nonetheless failed to appreciate how widely this shock would reverberate throughout the global economy – and, with it, drag down risk appetite among all risky assets.
Still, Goldman did not give up on its thesis, and speculated that the “Call” would come back shortly…
Where to from here? Were it not for this rocky path of risk sentiment since Jan. 1, we think it is likely that the ‘Yellen call’, having already been exercised in December, would now be posing a material headwind for risky assets (especially in equities, given their higher sensitivity to discount rates and current fullness of their valuations).
But not just yet:
This adjustment says to us that the risk to risky assets stemming from the ‘Yellen call’, in other words, is temporarily postponed. In particular, we do not expect the ‘Yellen call’ to be reactivated until the second half of the year, by which time our economics team expects that US growth will have pushed unemployment rates lower and core inflation rates higher. This will likely justify a resumption of rate hikes in the second half of the year, and likely at a pace faster than is currently envisioned in the ‘dots’ offered by FOMC members. But, between now and June, risky asset markets have been given a reprieve.
Well, the second half of the year is almost here, and sure enough, yesterday Hmmelberg released a new note The “‘Yellen call’: Back in the money post-June” in which it warns – once again – that the time of the rally is over. Here is the brief summary:
- The ‘Yellen call’ is the notion that risk rallies n are self-limiting …
- … because they enable more aggressive rate hikes by the Fed.
- Back in March, when financial conditions were much tighter and Fed chatter was decisively more dovish …
- … we argued that the ‘Yellen call’ would likely remain out of the money until 2016H2.
- Indeed, the sharp tightening of financial conditions instead activated a ‘Yellen put’.
- Financial conditions (GSFCI) have since eased, and are close to their lows of last Fall.
- With equity markets recently posting new YTD highs …
- … we think the ‘Yellen call’ is back in the money following the June FOMC.
And the full explanation why, in other another piece, Goldman is saying the rally is over:
In our “Top 10 Market Themes for 2016”, we argued that the ‘Bernanke put’ might gradually be replaced by the ‘Yellen call’. Whereas the ‘Bernanke put’ was the idea that meaningful declines in market sentiment would be met with aggressive monetary action, thus providing a buffer to downside risk, our notion of the ‘Yellen call’ was the converse. With labour markets tightening and inflation rising, we cautioned that the FOMC would likely respond to easier financial conditions with a more robust withdrawal of policy accommodation. This ‘Yellen Call’, we said, would likely ‘cap’ the upside potential for risky assets.
Such concerns were rendered moot by the sharp sell-off in in Q1. When we last revisited the theme back on 31 March, Chair Yellen had just given a very dovish speech to the Economic Club of New York (foreshadowed in speeches by FOMC members Dudley and Brainard). Chair Yellen emphasized downside risks to the US economic outlook stemming from slower global growth, and cited the FOMC’s “asymmetric” capacity to respond to economic shocks as a key reason for the FOMC’s March decision.
Exhibit 1 below shows how these speeches and other subsequent Fed speeches and events responded to the extreme elevation of financial conditions in early January and February. We have coded these news events as ‘dovish’, ‘hawkish’ or ‘balanced’ based on our assessment of the core message relative to market sentiment and expectations at the time. The solid line displays the GS Financial Conditions Index (GSFCI), which is our preferred measure of financial conditions (constructed as a weighted average of the 10-year rate, the trade-weighted Dollar, BBB credit spreads and equity prices). The shaded area represents the historical range of financial conditions before and after the first rate hike of the previous 4 hiking cycles (March 1988, January 1987, February 1994 and June 2004; the chart looks broadly similar if the 1988 hike is treated as part of the 1987 cycle).
Goldman’s three takeaways from “Exhibit 1”
We draw three conclusions from Exhibit 1. First, the magnitude of the pre-December rise in our GSFCI was somewhat unusual by the standards of historical hiking cycles. Our GSFCI increased by roughly 75bp in the six months prior to the December hike. Our rule of thumb is that a 100bp increase in the GSFCI corresponds to roughly 100- 150bp worth of hikes in the Fed funds rate, implying 4-5 hikes worth of tightening in the second half of 2015. While some of this tightening obviously anticipated the Fed’s actions, the magnitude of the tightening suggests markets were concerned about more than just rate hikes. In addition to the China and global growth concerns that were dominating headlines, we also suspect that rising balance sheet pressures, driven by a variety of factors, including regulation, may have amplified market moves by constraining the availability of ‘efficiency capital.’
Second, and further outside the range of recent historical experience, the GSFCI continued to tighten by another 75bp in the weeks following the December hike. By the time of the January FOMC meeting, it was clear that the cumulative tightening in financial conditions was far in excess of the gradual tightening that the FOMC was trying to engineer. As shown above in Exhibit 1, a series of dovish FOMC meetings and key speeches were activating the ‘Yellen put’. These dovish meetings along with a selection of key (dovish) communications from FOMC members are indicated on the chart as green triangles. As Chair Yellen put it in her speech on Monday, citing turbulent financial markets here and abroad, “… the FOMC decided at its January, March, and April meetings that it would be prudent to maintain the existing target range for the federal funds rate”. When financial conditions eventually eased to the low end of the historical range shown above, Fed speak began to turn more hawkish.
Third, the easing in the GSFCI over the past few months has more than reversed the year-to-date tightening. Financial conditions have eased back to levels that are comfortably back within the range of past hiking cycles. Indeed, Exhibit 1 shows that the GSFCI is roughly back to where it was last October, prior to the tightening that occurred in the final weeks leading up to the December meeting.
And the conclusion:
With financial conditions having significantly recovered, it is
reasonable to expect that the Yellen call will soon be back in the money
following the June FOMC meeting. We believe June is largely off the
table given the weakness of Friday’s employment report and the UK
referendum on its EU membership in June. But we think the July meeting
is live, without our US Economics team seeing a 40% probability of a
second hike. With equity markets posting new highs this week, we think
the ‘Yellen call’ is on track to move back into the money in 2016H2.
Confused? This:
And the Goldman real-time translation: Sell… or maybe that’s Buy. As a reminder, this follows yesterday’s Goldman note in which as we reported, Goldman Turned “Downright Gloomy, Warns Market “Despair” Is Coming, Prepare For A Major Drawdown.” This is shaping up to be the single biggest press by Goldman to get clients to dump their holdings so far this cycle. Which leads to the logical question: is Goldman also joining the selling or is it simply looking to buy up anything its clients have to sell. Of course, no banks has a bigger right of first refusal on what central banks do and say than Goldman, as such the market is either poised for a major crash, or is about to surge far above all time highs. Which probably means that a hedging strategy, betting on a barbell breakout in either direction is the most appropriate at this point.
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