The communications by Federal Reserve policymakers has been eerily similar and indicative of a coordinated game plan that was made at last week’s FOMC meeting.
Comments from Chicago Fed President Charles Evans, Dallas Fed President Richard Kaplan, and New York Fed President Bill Dudley all point to the Fed being on hold through September and most likely December unless inflation data surprises strongly to the upside.
Additionally, all have made note that the flatness of the US yield curve is problematic for their policy goals. Because we live in a very financialised world, the Fed always wants a steep yield curve.
Clearly, all of the above is already reflected in market prices with the unconditional probability of the Fed hiking interest rates again in September around 12% and December at 25%.
Instead of raising interest rates in the next six months, the Fed will begin the process of running down the balance sheet – possibly announced at the September meeting – which in their mind is “like watching paint dry” as it will be running in the background.
While the Fed may believe that the balance sheet process is a non-event for the financial system, market participants think otherwise.
Over the past week, the US Treasury 10/30-year yield curve has flattened to a new cycle low, indicating that running down the balance sheet is still tightening.
In our experience, this part of the yield curve operates independently and is only sensitive to the relative tightness or easiness of what the Fed has done and is priced into the market, relative to what underlying growth or data may be able to support.
Given the historical relationship of when the yield curve is at such a flat level, you should infer that the market thinks the Fed is already neutral at 1.25% and any move to run down the balance sheet will make them “tight.” It is also not a coincidence, then, that 5-year real yields (i.e. US inflation expectations have fallen faster than nominal yield) have made a new 24-month high in recent days.
Using this thought process, it becomes a bit easier to connect the dots with the recent pressure in emerging markets and high yield, driven by higher real yields.
The NASDAQ-100 (NDX) top companies are grouped into the factor called “secular growers.”
If you look at the price behavior of the NDX following the US Presidential Election – weak in the immediate aftermath in anticipation of reflationary fiscal policies and strong as expectations for those reflationary fiscal policies were pushed back – we could make a strong argument that the NDX is nothing more than a fixed income yield curve flattener expressed in the stock market.
Since the day former FBI Director James Comey testified before the Senate Intelligence Committee, which appeared to provide relief to President Trump, the NDX has shown the most erratic price action and underperformed.
A rotation out of secular growers – FANG, FAANG, FAAMG – would be no different than the fixed income yield curve steepening on account of political overhang being reduced and fiscal stimulus expectations pulled forward similar to what occurred in the immediate aftermath of the Presidential Election.
Below is chart of the NASDAQ 100 E-mini future (NQ1). The trend-channel and 50-day moving average are clustered in the same place, not by coincidence. A break of 5665-5643 range on a closing basis would argue further rotation out of secular growers.
Yesterday, there was an unsettling feeling yesterday across the professional community.
On the one hand, real interest rates rose significantly, and crude oil retested the early May lows. There have been two instances of that rare combination this year. In each case, distress was seen across asset classes except for equities. However, yesterday, weakness, even if only intra-day, was felt in equities, especially NASDAQ-100 again. At the same time, risk parity and carry strategies struggled. For the last few months, risk parity strategies have held up well or outperformed because when one leg was not working it was held up by the other. The combination of higher real rates and a surprisingly stronger US dollar led to emerging market weakness.
On the other hand, while the breadth of assets or investor strategies that struggled were widespread, the absolute weakness in any one strategy was contained. For example, the S&P 500, while closing down, closed near the same levels as the previous 10 trading sessions.
Our key takeaway from seeing three of these events this year is that there is no good approach to avoiding a rise in real interest rates. Should there be a continuation, the most likely casualties in this scenario are emerging markets and the carry trade.
Never in the history of the Federal Reserve has a meeting outcome been the opposite when the probabilities are this skewed towards an event occurring. Meaning, if the Fed does not raise interest rates today, it would be a blood bath in fixed income, period.
Currently, the unconditional probability of a September hike is 28%, or 3 to 1 against one. This is essentially “probably not” or said a different way that the Fed is more than likely done raising interest rates after a hike today.
Therefore, the discussion is not about whether the Fed raises interest rates at today’s meeting or not; it is about whether new life is breathed into the September FOMC meeting for an interest rate hike.
A focal point for today’s meeting will be the timing of the attempted running down of the Fed’s balance sheet. Most in the market expect it to be a December or January conversation. If they indicate they could hike in September (or any variation) and then begin running down the balance sheet on October 1st – for example – this would be viewed as a hawkish event.
The highest ranking general in the stock market, Apple Inc. (AAPL), is trading below the flash crash lows of Friday afternoon.
While the Russell 2000 small cap futures are outperforming the NASDAQ-100 this morning, the fact is the Russell 2000 is negative on an absolute basis.
So, unless you are pairs trading – long Russell 2000 vs. short NASDAQ-100 – the prevailing mindset to start Monday is that if you shoot the generals, all risk assets die.
What that means is, unlike last Friday, that the S&P 500 should not be flat today if the NASDAQ-100 goes down again.
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