With Janet Yellen due to speak in under an hour (in a speech that will be a big dud because as SocGen notes, “little emphasis on the monetary policy outlook is expected at this event”), a recurring question is why does the market remain so nonchalant about the possibility of a rate hike as soon as one month from now.
One of the better explanations on the matter comes from Citi’s Steven Englander, according to whom it boils down to the market’s sentiment about what happens with the Fed’s hiking path after the first hike. As the Citi strategist points out, this is merely the latest feedback loop the Fed has found itself trapped in:
Asset markets have done very well since the fed funds market began pricing in a summer hike. The question is why? We think that investors are trading the equation
an extra 2016 hike but very little else + better Q2 growth data = stronger asset markets
The question is whether this is a sustainable equation. Better growth, if sustained, is likely to induce more hikes. If we go from ~2.5% GDP in Q2 to 1.5-2% subsequently, we are likely to unwind the recent optimism.
Or maybe we won’t, because the only thing more bullish than a hawkish Fed is a dovish Fed. Let’s assume for the sake of this argument that the market is, like it was in December, fixated on the favorable “growth” outcome as a result of an upcoming rate hike (something with Jeff Gundlach mocked two days ago), as the alternative of yet another Fed policy error may be just too much of a shock. Here is why Eglander is cautious in reading this interpretation:
On the better sustained growth/faster hiking scenario, the slope of the Fed’s policy rate path will steepen. This will be another challenge to commodity and EM currencies. It may well turn out that a modestly steeper path of Fed hikes does not damage global growth prospects or asset prices a lot, but that is not likely to be the immediate response.
Alternatively if the hiking path reflects the expectation that better growth is temporary, the recent strength of US asset markets may come into question. The shallow path of hikes now priced in will not take the Fed away from the danger zone of a negative shock pushing them into the incipient negative policy rate. So a resumption of 1-2% growth rates after a solid Q2 may sap the confidence that markets have displayed in recent weeks.
In other words, the market is confident that the Fed’s rate hike itself will be enough to stop any more rate hikes, irrelevant of the data. What the market is forgetting however is that the rate hikes in early 2016 were delayed not so much because of the data, which was already deteriorating as the Fed hiked, but because of the market’s reaction. As such, the “market” is hoping to skip the critical step where it sells off to delay even more tightening. That however is the very problem the market, which no longer can discount anything, would create.
Consider the chart below which shows from bottom to top how many bps of hikes has been added fed funds expectations for July 16 (light blue), Dec 16 (dark blue), Dec 17 (red) and Dec 18 (green). We have 15 extra bps now for the rest of 2016 and only 21 or 22 for the next two years. And obviously there has been no change of expectations for 2018 relative to 2017.
As Englander points out, “literally since the trough of fed funds the market has not even added a full hike over the next three years and about 70% of what has been added is in 2016. By contrast when lift-off expectations were priced into fed funds last October, the outyears moved much more than the near contracts. This suggests that the market then saw liftoff as signaling a steepening of the pace of fed hikes, whereas the recent move is add one but no accelerated pace beyond.”
Or, on other words, one and done. Cue Englander:
The scenario that the market seems to be buying is that the signs of growth that we are seeing will embolden the fed to one but no more additional hike. The rationale may be that EM currency weakness will deter the Fed in the future, although that is not clear. If we look at asset price performance since May 9, oil (dotted green), equities (thick dotted blue), and high yield (solid dark blue) have done the best. EM equities (solid light blue), and non-oil commodities (red) are up but not quite as much. EM currencies overall (solid grey) and non-CNY Asia (dotted thin blue) are down. It is possible that the outperformance of US asset reflects an assessment that the hike won’t damage US growth prospects a lot but could lead to underperformance in EM assets. This is, of course, a very speculative explanation for the lack of conviction that on future fed hikes, despite their reiteration of the 2+ hikes scenario in various speeches and discussions.
Whether this is true or not, and whether the Fed’s rate hike will only damage the “global environment” while leaving the US and domestic corporate profits unscathed, is unclear but what the market makes very clear is that it itself is confident none of that will impact the market itself. What the market is also forgetting most of all, is that the only “data” the Fed is dependent on is the “Dow Jones” – in other words, if the market is pricing in no more rate hikes, it itself will have to crash, a step which the market is hoping it can simply skip at this moment.
Head spinning from all this reflexivity yet? Good.
How does all this get resolved? Here is Englander with the longer explanation:
The way to reconcile these asset price moves is either 1) investors see a temporary pick up in US activity (GDP ~2.5%), but will fall back in H2 to around trend without any significant inflation move, 2) US activity will be ok but not great and the spillover into the rest of the world will be negative enough to deter further hikes.
It is also possible that the outcome is a compromise between optimists who see an extended period of 2.5% GDP growth and the 2-3 hikes that come with it and pessimists who see ongoing soft outcomes and FOMC worries about drifting into recession. Anecdotally, it is hard to find any client or colleague who feels that economic outcomes we will be on the knife edge that the market is pricing – just good enough to prevent disaster but not good enough for anything beyond token subsequent hikes.
But it would seem to us that the equity outcome in the weighted average view is a lot less positive. There are few S&P 2500 optimists even at 2.5% growth but plenty of S&P 1600 or less pessimists on the negative scenario.
Bottom line – one more and pretty much done is unlikely to be as risk positive as recent asset market prices action suggests. But it may allow EM to bounce back a bit once the snail pace of Fed hikes is restored as the baseline expectation. We do not think that EM is as vulnerable to two hikes a year as pessimists argue, but the transition to pricing in two hikes a year is likely to be rocky, even if the EM ultimately bounces back.
That was the long way of saying the market is currently overpriced for precisely the event it is trying to price in, and not correctly accounting for the path of future rate hikes.
The short one is far simpler, and goes back to the chart we showed a week ago.
In short, the only thing that can prompt the Fed to delay a rate hike is neither the global nor the local economy, but the market itself… which because it is back at 2100 shows no interest in actually prompting the Fed’s move that it is “pricing in.” Finally remember: the Fed needs more “non-asymmetric” buffer so, according to its thinking, it can cut rates more aggressively (and from a higher point supposedly) when the next recession hits.
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