Add Morgan Stanley to the list of banks who are lashing out against the Fed’s interminable easy monetary policy (as we pointed out last week, the most notable recent entrant was Bank of America which had a simple message to Yellen: “Take That Punch Bowl Away“).
In a note from Morgan Stanley’s Hans Redeker, which attempts to explain the Fed’s increasingly cautious message on risk prices (incidentally, the same as Goldman which just yesterday cautioned that it was “Troubled By The Fed’s Growing Warnings About High Asset Prices“) the bank’s FX strategist writes that “by now markets have become too distorted.”
Picking up where Goldman started back in March, when the bank lamented the disconnected between the Fed’s rate hikes and easier financial conditions, Redeker writes that DM central banks collectively turning towards a more hawkish stance “leaves the impression of a coordinated approach, explaining the market’s reaction which saw bond yields rising at the quickest pace since autumn last year (when investors put their money on the ‘Trump boom’ which eventually failed to emerge).”
Echoing Citi’s ongoing observations, Redefeker then observes that this time, unlike in 2015, “rising bond yields only led to a small risk dip from where markets quickly recovered once it became clear that central banks may lean against financial conditions, but have no interest in pushing markets over the edge by overly tightening conditions. It is the low level of current and anticipated inflation which suggests that central bank tightening is not inevitable at this stage. It is, instead, an option, which central banks are willing to exercise should financial conditions stay supported from now.”
This too is nothing new as money market participants “have consistently bet against the Fed dots, hoping that US monetary authorities would have to capitulate in front of markets once again.”
To be sure, so far there is no indication to suggest that the market will be wrong in its “standoff” with the Fed, which as Kevin Muir described on Friday, is a classical dare by traders, one which they are convinced they will win as Yellen blinks again. Redeker describes this dynamic as follows:
For several years, markets have undergone this ritual with an over-optimistic Fed eventually acknowledging the power of deflationary forces. Too often, it was the strength of the USD transmitting global deflationary pressures into the US.
However, this time there may be a twist: “USD weakness and abating global deflationary pressures may have sharply improved the chances of the Fed getting it right this time.“
And yet, another problem emerges: according to Morgan Stanley, “by now markets have become too distorted” as “financial conditions have further improved and despite the Fed and other central banks warning against misallocation risks, the US opportunity cost of capital as expressed by the 10-year term premium has only adjusted a little. The gap between the term premium and financial conditions has become substantial (Exhibit 2). At the same time the USD has stayed offered, not taking notice that the term premium no longer trades at the low June levels. The DXY and the term premium have diverged, which either suggests the USD will rally or the term premium will ease back again (Exhibit 3).”
This is a segue to another curious observation: “While central banks may now act at a faster pace compared to previous expectations, this has failed to undermine risk appetite. This does not only suggest that markets are in broad agreement with monetary authorities over withdrawing accommodation, it may also suggest that there are alternative sources of liquidity funding the current risk bull run.”
Morgan Stanley did not have any suggestions as to what this “alternative source of liquidity” may be, however whatever it is, it may be the source of the relentless risk bid that the Fed now finds itself up against.
But going back to the original dynamic, Redeker notes that “markets seem to be assuming that a positive risk environment may require the Fed to capitulate to markets. This is why investors are positioning for yield curve flatness, pushing the volatility curve into steeper territory, and are willing to pay unusually high premiums for out-of-the-money put options on equity indices. In other words, a high wall of worry has gone up (Exhibit 4). Concerned markets rarely turn into full bear markets. We may need to get into a ‘this time is different” mentality of buying everything today before a bigger bear market sequence emerges. In addition, in the past, long-term stability concerns may have been fed by a stronger USD, next to other factors. The USD has weakened over the course of the past six months, which should ease some concerns provided that past relationships still prevail.”
And this is where the unexpected turn may come. Here is Morgan Stanley’s summary why the Fed may have no choice but to push the market into a “pain trade”
Central banks leaning against booming financial conditions. When some DM central banks collectively turned around to express a tighter approach, markets were unprepared as investors focused on undershooting inflation and uncertainty. Exhibit 5 shows the divergence between how often the word ‘uncertainty’ appeared in economic commentaries and market pricing of equity volatility (VIX). It is liquidity feeding into lower volatility, keeping financial conditions supported and pushing valuations higher. Indisputably, ambitious asset valuations bring long-term deflation risks should asset bubbles burst. Central banks tend to lean against this risk.
Accordingly, continued easy financial conditions may push the Fed into action. Should this outcome materialize, a ‘pain trade’ may emerge. Reluctant and hence cash-holding investors would find themselves running insufficiently low risk exposures, and participants hoping the Fed would capitulate to markets may see the central bank staying on course to deliver according to its dots. A reactive Fed operating closer to its dots and risk markets staying supported for now would represent a very different outcome compared to current positioning.
Alas, we have heard all of this before, and while we agree with Redeker, it is up to Yellen to confirm that at least this one time the Fed isn’t bluffing…
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