Trading Market-Contingent Guidance: Taking Stock of the Fed Put
February 4, 2019
Markets received a Fed-inspired whipsaw in December and January. Leading up to December, the Fed gave plenty of warning that liquidity was on track for tightening. Even so, consistent rate hikes tightened liquidity enough that year-end dealer balance sheet adjustments triggered to some serious de-risking.
Apparently, the Fed thought a 15% decline in an equity index meant things were out of hand with respect to the stability of markets. So… they reversed the hawkish tone and language. The Fed walked back its four planned hikes in 2019 and stopped short of saying there would be no hike in March 2019 or quarters later. The Fed indicated that balance sheet shrinkage would be a data dependent process, without hitting the pause button on asset sales.
This quick turn shouldn’t be too much of a surprise given that the Fed always had an implicit asset price target and their forward guidance is moving closer to making that price target explicit. Fed guidance in 2008 was time contingent: “policy accommodation for an extended period of time” changed to “at least through 2013”. By 2012, Fed guidance became data-contingent: “appropriate at least as long as the unemployment rate remains above 6 ½%”. By 2015, guidance looked like this: “an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into a recession.” Fed guidance so far in 2019 seems to indicate stability of financial markets is a key policy variable in and of itself.
Talking seemed to do the trick enough to trigger short covering. As always, good times for the nimble, and tough for the inflexible. There’s no point in whining and moaning over the reversals and inconsistencies in Fed communication. Instead, let’s take stock (pardon the pun) of the meaning behind the reversal and review some time-honored rules.
As an aside, those rate hikes are awesome because cash as an asset class is back. The benefits of this are enormous. First and foremost: it now makes sense to de-risk. The long bond isn’t de-risking, but ZIRP made one feel like it. Another related benefit is that a ~200 basis point cash rate makes the current term premium look ridiculous. True, the bizarre condition of deposit rates being near zero even though a one month note yields 200 basis point persists. This and other distortions will eventually resolve provided cash remains a viable asset class. In summary, the Fed restored an economic return on cash—which will go a long way toward financial market normalization.
The current state of the world is that the Fed is ushering in a phase of market normalization and as markets do so, the Fed is vigilant to support prices. Here are some rules to trade around this state of the world.
Time-honored rule: The Fed incorporates an implicit target on equity prices in their reaction function.
Modification: The Fed may not publicize it, but there is an implicit put in place. Figuring out the strike is the key.
Remarks: December’s S&P 500 price action can be interpreted in two ways. Either the strike is either based on a level, or on a % drawdown. If the Fed put is based on a level, then the Fed signaled that an S&P500 around 2350 is the “strike” on their put. At or near a 2350 level, it makes sense to be long risk, be it credit or common stock. If the Fed put is based on a drawdown, then December tells us that a 15% decline in the S&P 500 means it is time to re-risk.
Time-honored rule: Don’t fight the Fed.
Modification: Follow the Fed’s lead and adapt as they do. They will adapt every 3 years or so.
Remarks: The Fed more than ever must be ready to adapt on short notice. Why? The global economy is more levered than ever, which makes it more sensitive to interest rates and in turn more unstable. World debt hit 318% of GDP at the end of 2017, 48 percentage points higher than the bubble-peak just before the Lehman crisis. Emerging market debt is particularly sensitive after jumping from 145pc to 210pc. Nobody including the Fed knows what these rising borrowing costs will do to a global system habituated to a decade of zero rates and emergency liquidity.
Time-honored rule: Markets test central bank resolve.
Modification: Central banks are in the business of fostering price, financial, and economic stability, not necessarily in that order. They aren’t going to sacrifice these objectives for the sake of theory or rhetoric.
Remarks: Markets and central banks are in a symbiotic relationship. Neither completely dictates over the other. Markets supply conditions, and central banks act in ways intended to improve market conditions. The Great Recession led to QE, and a reduction in this liquidity led to a market sell-off. This in turn led to a change in, at least, the Fed’s communication regarding policy and a change in market conditions.
The Fed has made clear that they now understand that the US and the global economy is more unstable than historical condition due to interest sensitivity. That doesn’t mean there isn’t a rate rise coming in March 2019. The next big test is likely Mario Draghi’s "do whatever it takes" credo. If it no longer holds, there is no sovereign backstop except on political conditions that sovereigns increasingly refuse to accept. Bond markets are certain to test this one too.