By Damien Boey at Credit Suisse:
Over the past few days, we have witnessed some very confusing signals from Fed officials:
- Vice Chair Clarida suggested that the Fed should not wait until things get so bad to have a dramatic series of rate cuts. These comments followed and potentially reinforced dovish comments from the New York Fed’s Williams (below).
- Williams delivered a speech about monetary policy near the zero lower bound. He suggested that when a central bank has limited stimulus to use, it pays to act quickly to lower rates at the first sign of economic distress.
- A New York Fed spokesperson later clarified that William’s prepared remarks were an academic speech on 20 years of research. They were not about potential policy actions at the upcoming Fed meeting. For the New York Fed to take such an extraordinary step heading into a black out period was a testament to the confusion caused by the various Fed comments.
In response to comments from Clarida and Williams, the front end of the curve rallied strongly. At one point the market was pricing in a 70%+ chance of a 50bps cut at the end-July meeting. But since the clarification from the New York Fed about William’s comments, the market has pared back the likelihood of a 50bps cut, settling instead for only 25bps cut with a high degree of certainty.
The yield curve has tried to steepen throughout all of this confusion, but has not been able to break out of the inversion zone (long term bond yields below short term interest rates). From a factor investing perspective, value has been equally challenged, with investors trying to express a more constructive view about the curve and growth prospects, but being met with resistance as the pessimists focus on lower rates.
Our perspective is that there are a number of technical factors fuelling the recent bond market rally, which may not be fundamental. For example, with the yield curve inverted, and the swaptions surface in backwardation, investors have been incentivized to short bond market volatility, and buy short duration bonds – a self-reinforcing process. Also, with the debt ceiling looming, front-end yields have been crushed by the prospect of excess liquidity in the interbank market as the government spends (creates money and interbank reserves) without raising debt for a short period of time. The technical factors have supported material “front-end steepening”, dragging the entire bond complex higher (in price, lower in yield). But the technical factors are unlikely to be persistent.
What has thrown a “spanner into the works” is that the Fed has changed its reaction function to bow to the technical rally in bonds. The Fed seems quite happy to make an “insurance” cut to rates in July, even though the economic data may not justify a cut. The Fed has chosen to make itself captive to the markets. In turn, this shift is adding further fuel to the front-end rally, and is putting even more pressure on the Fed to cut deeper. As an aside, we see other central bankers doing very similar things to the Fed. For example, we have seen the RBA capitulating on its previously hawkish stance – making every possible change in its narrative to justify rate cuts largely because the bond market has priced them in. We suppose that if it is acceptable for Fed Chair Powell to do this, then it must be acceptable for the RBA to do likewise …
How then might we break the circularity? We suggest thinking about whether the US economy is headed for a sharp and imminent recession, such that the Fed is hopelessly behind the curve. If this is indeed the case, then there is a case for further flattening and inversion of the curve, even as the Fed cuts rates. But if not, history tells us that there is plenty of scope for curve steepening:
- The economic data are not falling off a cliff. Forward-looking, or timely indicators such as US retail sales, and regional Fed surveys are actually pointing to re-acceleration in demand after a brief lull. Backward-looking indicators such as core CPI and employment are not showing clear weakness in the economy either.
- If there is recession risk to worry about, the initial signs are not to be found in the economic data. Rather, the starting point should be in markets. And in this context, the pertinent question is whether or not US equities can rally in response to higher, rather than lower bond yields. Many would argue at this juncture that they cannot. After all, with global trade deteriorating, it is only a matter of time before we see global earnings downgrades at a time when US equities appear quite expensive by historical standards. In other words, many are of the view that US equities are priced less attractively than bonds on various horizons, making it essential that interest rates fall to give credibility to the Fed put, and keep equities from falling. Perhaps this line of thought explains some of the technical factors in place to support the recent bond market rally. However, we struggle to reconcile this view with recent market dynamics. Equities are rallying from expensive levels. Volatility is contained. Carry trades are working. To be sure, all of these developments are happening against the backdrop of falling bond yields. But if we are really of the view that Fed easing can do little to steepen the curve and improve growth (if not sentiment), then none of this should be occurring to begin with.
- In almost every past Fed easing cycle, short rates have been able to fall faster than long term bond yields, resulting in mechanical yield curve steepening. We think that this cycle should not be an exception, especially when we consider how expensive bonds are right now, as evidenced by deeply negative term risk premia.
We expect to see the yield curve steepen as the Fed cuts rates. We expect that the curve will even re-enter positive territory. If and when this occurs, we should expect value factors to perform well, even as lower rates generally support the quality end of town. What is interesting is that if value matters, it should matter a lot, because multiple dispersion between the “haves” and “have nots” is so extreme. Put differently, even if value matters a lot less than quality, many value stocks still screen well on our screens simply because they are so cheap in an environment where uncertainty is extremely high.