You’d think this was a boring week if you looked at just the S&P 500 return and didn’t watch trading during the day (which no one should – it will drive you nuts!!). But it was actually one of the most volatile weeks since the COVID crisis.
There was a lot of nervousness coming into this week due to the Fed meeting. While stocks dipped slightly after the half-point hike was announced, the market rallied hard after Chairman Powell ruled out even larger hikes in the future. The S&P was up roughly 3% for the day. This was something of a head-scratcher. Powell was actually more hawkish than many expected. He said he thought the Fed would hike a half point at the next two-to-three meetings. The expectation was for just one more half point hike.
And a bit of market trivia – the gain on Wednesday was the biggest upside-day for the S&P 500 on a Fed rate-hike day since Nov 1978!! Like I said, the whole day was a bit of a head-scratcher.
But Thursday was a different matter altogether. Investors apparently decided that Wednesday’s rally was a mistake and stocks went into a sudden and violent tailspin. CNBC was able to roll out its “MARKETS IN TURMOIL” package, much as it did during the early days of the COVID crisis. The S&P was off 3.6% for the day, again, on no real new news (other than a spike in longer-term rates).
Tellingly, the pain on Thursday was most intense in US technology stocks, and especially its frothiest corners, deepening a sell-off that started when the Fed first made a hawkish pivot last autumn. The Nasdaq tumbled almost 5% on Thursday, completely unravelling Wednesday’s 3% gain. Is there a message in any of this volatility? The Financial Times captured it on Friday:
‘Is there a coherent and compelling narrative here? There doesn’t have to be. When the trend is downward, volatility is up, and liquidity is patchy, markets reflect portfolio decisions made under duress more than they reflect stable economic realities.’
If Not Pricing in a Recession…
This of course might be too glib. Market’s may be forecasting a recession – we just don’t know it yet. But so far the data isn’t cooperating. If the market was fearful of a recession you’d expect the yield curve to flatten. However, it’s steepened the last few weeks.
Furthermore, the jobs market remains robust. Friday’s payrolls report came in slightly above expectations and the unemployment rate was unchanged at 3.6% in April.
Of course, we are at that point of the cycle where good news is bad and bad is good. For example, is April payrolls of +428K good or bad?
Good because the job market expanding, growth is doing well.
Bad because it gives the Fed plenty of room to hike rates aggressively without creating unemployment. Or at least that’s the current thinking.
Today everything needs to be viewed through the lens of inflation, not growth, and markets are struggling with a tighter liquidity environment. As we noted earlier, the Fed hiked rates 0.5% on Wednesday, the first half point hike since 2000.
They also said they would start to shrink their balance sheet by roughly $1trn over the next year. To put this in perspective, the Fed currently holds about $5.8trn of Treasury bonds (25% of the total outstanding – chart below) and close to $3trn of mortgage bonds.
How high will rates get by the end of the year? The current betting is shown below. Basically 2.75% and 3.25%.
A Measure of When Enough is Enough
Both the rate hikes and quantitative tightening aren’t unprecedented. But how much does the economy and the markets need easy liquidity? On this question we can’t be so sure.
Chairman Powell has been very clear over the last few months that this Fed is looking to tighten something called financial conditions. Roughly two months ago Powell made the following comments during his press conference:
REPORTER: “When you say ‘to move to a more normal condition for financial conditions,’ that suggests to me that you want financial conditions to tighten further from where we are now. Am I drawing the right inference from that?”
POWELL: “Well, yes. I would say that we look at a broad array of financial conditions, and when we tighten monetary policy, we expect that they will adjust, and sync, over time, with monetary policy. It’s not any particular financial condition, but a broad range of financial conditions, and yes, we need our policy to transmit to the real economy, and it does so through financial conditions, which means as we tighten policy, broader financial conditions will also be less accommodative.”
So, what does this mean? Enter the Financial Conditions Index. This has been around for years, and there are a number of different takes on the model. But basically, the FCI is a weighted average of riskless interest rates, the exchange rate, equity valuations, and credit spreads, with weights that correspond to the direct impact of each variable on GDP.
The chart above is Goldman’s take on it. You can see how conditions got very tight in 2008 and early 2009 as stocks fell, the dollar rallied, and credit spreads widened. If you squint you can see the tightening in late 2018 that caused the Fed to stop hiking rates. The spike in early 2020 is the COVID crisis.
What the Fed is telling us is that they want this line to go higher. How much higher we can’t quite be sure, and that is the uncertainty the market hates. But without question, financial conditions today are still unusually easy. You can see below where they fall historically.
It’s likely, then, that some combination of higher interest rates, a higher dollar, weaker stocks, or wider credit spreads will work to push the FCI higher in the next few months. But at some point conditions will tighten enough to cause the Fed to back off. But we are not there yet. How quickly we get there will depend to a large extent on how many more weeks like this week we have.
Charts We Found Interesting
1. The U.S. economy has almost added back all the jobs lost during the COVID crisis. The only sector that is underwater is the leisure and hospitality sector.
2. The inclination is to sell when assets go down in value. We forget that lower prices can mean better value all things being equal. While this may not mean much for those with a short time horizon, this is really what long-term investors (and those currently saving) want to see.
3. This will unquestionably take some of the steam out of the housing market.
4. What new home buyers are facing.
5. Diesel prices hit a new record this week.
6. Why? Inventories are at rock-bottom levels.
7. European investors should be much more worried about quantitative tightening than U.S. investors. Who will Italy and Spain sell their bonds to if the ECB stops buying? This risk is already starting to show up in wider spreads.
8. Globalization is nothing new!!
Have a good weekend.
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