Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Can the Fed save equities from their worst December in over 40 years?
Peter Garnry
Chief Investment Strategist
Summary: Big macro indicators suggest that the Fed has ample leeway for a rate hike tonight, but a raft of other evidence suggests the central bank should keep policy as is. Whichever path the Fed chooses will be directionally critical to equities in the weeks and months ahead.
Tonight’s Federal Open Market Committee meeting is one of the most critical in years as the central bank is confronted with a bewildering mix of events spinning around furiously. This the list of issues (not exhaustive) with which the FOMC is confronted tonight, is long:
Collapsing oil price (driven by both weaker demand and surging supply) sucking inflationary pressures out of the economy.
Stocks in cyclical industries (financials, real estate, materials and industrials) are declining, rapidly discounting significant headwinds for the economy (see chart).
Credit spreads are widening and this December is the first month (in a long time) of no new issuances of high yield bonds. Leveraged loans are also seeing cracks, indicating that recent rate hikes have materially impacted financial conditions.
Populism is still in vogue and income/wealth inequality is still high, so a policy mistake is significantly more costly for society.
The economy is in the late stage of the business cycle with low capacity in both the labour market and production.
Loud voices from the US president to this Sunday’s WSJ Op-Ed by Stanley F. Druckenmiller and Kevin Warsh (the latter a former member of the Board of Governors of the Federal Reserve System, 2006-2011) are putting pressure on the Fed to stop hiking. Watch the replay of today's Morning Call where our Head of FX Strategy, John Hardy, goes through the various scenarios for tonight’s FOMC decision.
The US-China conflict on trade, intellectual property rights, market access etc. is creating headwinds for the economy.
The Chicago Fed National Activity Index is still suggesting above trend growth and leading indicators in the US are also still high.
Economic activity is slowing in both Europe and China, lowering external demand for US goods and services.
Level 1 liquidity in the S&P 500 futures limit order book is around 80% lower compared to one year ago, so markets are running on such low liquidity that any shock to the system could create large domino effects.
While the big macro indicators are still above trend and thus give the Fed the green light for another rate hike, these indicators are lagging and likely sending false signals compared to more timely signals coming out of financial markets. In a late stage of the business cycle, central banks should put a higher weight on financial market indicators and less on macroeconomic indicators, and if the Fed is doing this tonight they is plenty of ammunition for not hiking the Fed Funds Rate. The risk tonight is that even if they go ahead and hike the interest rate while spinning it dovish with a an indefinite rate pause, the market is likely to sell off as it will be seen as a potential policy mistake.
Collapsing oil price (driven by both weaker demand and surging supply) sucking inflationary pressures out of the economy.
Stocks in cyclical industries (financials, real estate, materials and industrials) are declining, rapidly discounting significant headwinds for the economy (see chart).
Credit spreads are widening and this December is the first month (in a long time) of no new issuances of high yield bonds. Leveraged loans are also seeing cracks, indicating that recent rate hikes have materially impacted financial conditions.
Populism is still in vogue and income/wealth inequality is still high, so a policy mistake is significantly more costly for society.
The economy is in the late stage of the business cycle with low capacity in both the labour market and production.
Loud voices from the US president to this Sunday’s WSJ Op-Ed by Stanley F. Druckenmiller and Kevin Warsh (the latter a former member of the Board of Governors of the Federal Reserve System, 2006-2011) are putting pressure on the Fed to stop hiking. Watch the replay of today's Morning Call where our Head of FX Strategy, John Hardy, goes through the various scenarios for tonight’s FOMC decision.
The US-China conflict on trade, intellectual property rights, market access etc. is creating headwinds for the economy.
The Chicago Fed National Activity Index is still suggesting above trend growth and leading indicators in the US are also still high.
Economic activity is slowing in both Europe and China, lowering external demand for US goods and services.
Level 1 liquidity in the S&P 500 futures limit order book is around 80% lower compared to one year ago, so markets are running on such low liquidity that any shock to the system could create large domino effects.
While the big macro indicators are still above trend and thus give the Fed the green light for another rate hike, these indicators are lagging and likely sending false signals compared to more timely signals coming out of financial markets. In a late stage of the business cycle, central banks should put a higher weight on financial market indicators and less on macroeconomic indicators, and if the Fed is doing this tonight they is plenty of ammunition for not hiking the Fed Funds Rate. The risk tonight is that even if they go ahead and hike the interest rate while spinning it dovish with a an indefinite rate pause, the market is likely to sell off as it will be seen as a potential policy mistake.
The S&P 500 is having its worst December since 1980, eclipsing the December 2002 fall, and is now down 7.8% as of yesterday’s close. Our tactical positive equities view earlier this month post the G20 meeting and Powell’s dovish speech was clearly a mistake, at least judged as of today, but with the VIX Index at around 25, the options market is implying a 30-day move in the S&P 500 of 4.6% with a 68% probability, so a no-hike decision by the Fed tonight could easily erase most of December’s losses.
Broadening the perspective, global equities are now below their average valuation since 1995 (see chart) and this is using data as of November. With global equities down 6.5% in December, this indicator is likely approaching valuation levels not seen since early 2016 when the last bull market began. But when markets are switching into risk-off mode and liquidity dries up, fancy long-term valuation arguments are often not what creates good timing. So take this helicopter perspective for what it is. A compelling case for equities if we don’t see a policy mistake and China delivers on economic stimulus.
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