Morgan Stanley: "Market Is So Distorted" The Fed Is Being Forced Into A "Pain Trade"

Tyler Durden's picture

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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LawsofPhysics's picture

LOL!!!  Please The Fed and it's real owners don't give shit.  Post-pain, they will simply create more money with no real work and no real risk and BUY EVERYTHING for pennies on the dollar!!!!!!

same as it ever was!!!!

See the problem yet you stupid motherfuckers!?!?!?!?!

John Kerry-Heinz's picture

Morgan Stanley musta been playin the BIG short prior to YELL ins flip flop last week.


its 7-17-17 today. lots of sevens in there.  just sayin.....

ThirdWorldNut's picture

With every hike, financial conditions ease even more and S&P rises even more. Any one else with such pathetic track record as Fed would have been fired before big bang but here we are. Oh and since she says more transparency would compromise fed's ability to manoeuvre the markets, I think we should continue pushing for auditing fed - be good to know what the lower bound of their ability is.

rado_watching's picture

I'm making over $7k a month working part time. I kept hearing other people tell me how much money they can make online so I decided to look into it. Well, it was all true and has totally changed my life. This is what I do...

Pollygotacracker's picture

Don't make money the focus of your life and it won't bother you as much. I know that this is truly a criminal enterprise on a scale that  boggles the mind. Everyone thinks this shit is great, until it isn't. Be warned.

Grandad Grumps's picture

There is no pain trade for the Fed. They create money out of thin air and can make it go away the same way. It is all phantasmal bullshit. We have based our human society on the propagation of corrupt lies rather than the advancement of our people. One has to believe that the evidence points to a corrupt power behind everything that does not want to human race to prosper independently. They want a slave population of sheep.

Pollygotacracker's picture

He has a name... SATAN. Jesus threw down the tables of the money changers twice. Third time's the charm.

CPL's picture

Die Janet Yellen, die.

Die Lael Brainard, die.

Die Gary Cohen, die.

Die Jamie Diamond, die.

Fisherman Blue's picture

This criminal shit show cannot end soon enough.

Catullus's picture

It's other central banks and international pensions buying US equities. They're the new dumb money. When the tide goes out, it's going be an international currency crisis.

LawsofPhysics's picture

Correct, a.k.a. global Weimar!

steve2241's picture

Imagine being a Wall Street cog having to wallow in this gibberish day after day.

"...and despite the Fed and other central banks warning against misallocation risksthe 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..." 

Clowns on Acid's picture

Gotta write something to get the bloated paycheck at the fiat subsidized Bank...after all the brokerage PAYING clients want to be able to read something to spout in their Fund management meetings.


Clowns on Acid's picture

The guy that wrote that jabberwocky is making about 350k - 500k per year BEFORE year end bonus.....

Cordeezy's picture

I am guessing she doesn't do anything before her term ends

small axe's picture

Fed is a criminal enterprise. Kill it.

RagaMuffin's picture

Pimpin' ain't easy when the junkies turn on their dealers.......

lester1's picture

There is so much distortion because of the world's largest hedge fund The Fed's PPT buying stocks covertly and kicking everyone's asses !!


How do you try and trade against the unaudited Federal Reserve's PPT who can create unlimited electronic money ????

Ban KKiller's picture

She won't allow an audit. THAT SAYS IT ALL. 

joego1's picture

blah blah blah

Peter41's picture

The Fed's cupboard is bare. And then Rover took over.

CPL's picture

You can't convince anyone to step anywhere near that shitty mess.  If noticing ain't no one planning or making plans to come to the rescue of NYC or any the their franchises.  It's WAY more fun sitting back watching them choke to death as the noose they've made from that rope they've stolen squeeze the last breath out of them.  While swinging around they'll sputter and jerk around, their minds attempting to focus on any way to save themselves or convince anyone in ear shot to cut them down.

The crowd says 'no' by staring blankly at twitching forms of fiat faith dealers, most taking secret bets offline as to when the last one stops kicking.

Fartboxbuffet's picture

3 to 1 odds janet is packing a 8 incher under that skirt