THE FED IS READY. IS THE MARKET? / THE FINANCIAL TIMES UNHEDGED

The Fed is ready. Is the market?

Why we’re still gloomy(ish)

Robert Armstrong & Ethan Wu

© Financial Times

Good morning. 

A week ago, Unhedged stuck its nose above the parapet, and smelled fear. 

With tighter policy arriving soon, we argued, the market was poised to struggle. 

The market, naturally, responded to our hubris by ripping higher in the following days. 

Should we reassess our gloomy view?

Today we take stock, especially in light of Friday’s inflation report. 

Markets are about to meet tightening face-to-face

After last week’s CPI report — now, in a sign of the times, the most important data release — where do markets stand? 

There are five essential facts and one big question.

Inflation remains very high but is not accelerating much, and there is a bit of hope for deceleration soon.

Friday’s CPI report was greeted with a sigh of relief because it was not worse than the consensus estimates. 

But keep that relief in context. 

The report did not change things much. Inflation is not getting better. 

The numbers (both headline and core) looked a little worse on a year-over-year basis and a little better on a month-over-month basis. 

Here are the core (ex-food and energy) numbers:

The least scary part of the inflation report was the fast price growth for energy and cars. 

Crude oil prices have rolled over and that should show up in CPI before long. 

For cars, everyone expects bottlenecks to subside, supply to improve, and prices to normalise (this point about cars can be generalised, to an extent, to apply to goods inflation generally — it will subside with the pandemic, because of both easing bottlenecks and fall in demand that has shifted over, temporarily, from services).

The most scary part of the inflation report is housing, which is sticky and is a big part of core inflation. 

It rose at a nasty 3.8 per cent annual rate in November. 

The only reason that number is not much worse is that both rent and “owners equivalent rent” (what owners would be paying if they had to rent their houses) are lagging indicators. 

CPI rent dilutes the sharp recent rises in newly signed leases, and OER takes a while to catch up with the housing market. 

So inflation worriers like to point to leading indicators like house prices and big realtors’ rent indices.

But some of those leading housing cost indicators are turning over. 

Zillow’s house price index (the one the Dallas Fed likes to use) is still running at a burning hot 19 per cent annual rate. 

But the month-over-month rate has fallen to 1.4 per cent in October from 2 per cent in July. 

The same pattern in visible in Apartment List’s rent index:

Economic growth is just plain very high.

As we have said before, stagflation this ain’t, not even nearly. 

This is most visible in the jobs data. 

Job opens rose again in November, and the trend for jobless claims is plummeting.

Claims are back at pre-pandemic levels, openings are at a historic high, and friends, we’re in a boom.

The bond market says with total clarity and complete confidence that neither inflation nor growth are going to stay strong for more than a year or two.

Five-year break-even inflation has been falling for a month. 

At under 3 per cent, with CPI running at nearly 7 per cent now, implies a very fast decline in inflation in the next few years. 

5-year, 5-year forward inflation break-evens are where they were in 2018.

The 10-2 yield curve suggests that while the Fed will push up short rates, growth will not be strong enough over the long term to push longer rates up. 

Indeed, ten-year yields are a few basis points lower that they were when Covid hit.

There is no ambiguity. 

If you are worried about inflation or you see sustained growth ahead, the bond market is absolutely shouting that you are wrong. 

Here’s the 10-2 curve and 5-year inflation expectations:

The stock agrees with the bond market, sort of.

If you are one of those investors who believes that the crucial thing supporting the stock market is low bond yields, then the fact that the bond market thinks long yields are going nowhere is very reassuring. 

It suggests we can get through a tightening cycle without crashing the stock market. 

And the fact that the S&P 500 has rallied to new highs once again this week expresses confidence that higher long rates are not going to ruin the party.

Of course there is a logical problem with this way of thinking. 

Low growth means low corporate profit growth, which should offset, in whole or in part, the benefit of low rates (that is, low discount rates). 

That’s just the math of stock valuation.

That said, however, last week we highlighted the outsized contribution to S&P performance of the very biggest stocks in that index. 

And you might argue that these big, bad companies, with their superstrong market positions, are precisely the ones that can increase profits in a weak economy.

But if that’s true, why are highly speculative tech stocks selling off hard — which one would expect to happen if long rates were going to rise? 

Maybe the stock market does not have its head completely sorted out.

Everyone now expects the Fed to announce an accelerated taper of bond purchases this week, and for there to be several rate increases next year.

The consensus is that the Fed has changed its posture, and will signal the change strongly on Wednesday. 

There are better than even odds of a rate hike at the May meeting now, according the CME’s FedWatch tool.

Game on!

The big question: has the stock market really, truly priced in the rate hikes that are coming, or does its euphoric optimism doom it to being surprised?

Historically, rate hiking cycles have been associated with positive stock market returns (sometimes very positive ones). 

In the 2016-19 cycle, it took almost two years (November 2016 to October 2018) of steady rate increases for the stock market to flinch.

But there are a lot of nerves this time, because over the past few years the stock market has performed brilliantly while real interest rates have fallen into negative territory. 

Will the Fed awaken real rates and crash the stock market? 

Well, at the risk of repetition, the bond market says it just ain’t going to happen.

Rates and stock prices do not operate in a vacuum. 

What has Unhedged sticking to its gloomy (or at least gloomy-ish) view is the broader context. 

Higher rates, tighter fiscal policy, high stock valuations, slowing earnings growth, and a slowing Chinese economy are a tricky combination.