Over the weekend, JPM addressed the question of whether "asset price inflation, produced by 7 years of zero interest rates, has to morph into asset price deflation when the Fed starts hiking rates." It further adds: "We have for years argued that the driving force pushing up all asset prices has been falling uncertainty in the presence of no return on cash. Does this logic then not imply that the coming end of easy money must turn asset price inflation into price deflation, or a generalized bear market?" Unlike Goldman, which is so terrified of the rate hike it takes every opportunity to assure its few remaining flow clients that the only thing more bullish of ZIRP are rising rates, JPM covers every base: "the answer is Yes, No, and Depends."
Here is the breakdown:
On the No side, we see improved US growth (a 3% pace instead of the 2% of the first five years of the recovery), no real pick up in inflation and only a relatively slow pace of tightening by historic standards -- 250bp over the first 18 months. This is not 1994 when the Fed did 300bp in less than one year. In addition, the Fed will likely only be joined by the BoE in hiking while the ECB and BoJ look set to remain in easing mode. This means that global liquidity will likely remain plenty and that the resulting dollar appreciation can substitute for higher rates in tightening monetary policy.
All of this, of course, assumes it doesn't snow in 2015, or 2016, or 2017, etc. It also assumes that the "improved growth", which right now is tracking at the lowest annualized GDP for 2014 since Lehman, doesn't flip on the back of Europe's triple-dip, or China's suddenly crashing economy, which over the weekend posted the weakest metrics since Lehman. So yeah, two of the three biggest economies in the world grinding to a halt, while Japan just posted an nightmarish -7.1% GDP print. What can possibly go wrong for the US "improved growth" thesis?
Which brings us to...
On the Yes side, raising the return on cash creates an alternative to other assets. In addition, raising rates after seven years of zero-return-on-cash increases uncertainty, as we all assume that some asset classes and investors could have become overly dependent on easy money. The evidence we have on past tightening cycles, reviewed last week, cannot be directly extrapolated to this one as the Fed has never held rates at zero or for such a long time. On average, there were only 15 months between the last cut and the first hike since the 1960s, with the longest lasting 37 months (early 1960s). This week shows that investors intuitively pull back from all assets into cash when pricing in earlier rate hikes.
Or, to summarize, since the Fed's central planning has never lasted longer, JPM has no clue what will happen. Moving on...
On the Depends side, we mentioned last week that higher growth as a reason for higher rates is much less disturbing to markets than higher inflation. In addition, there remains the open question of whether the market can organize an orderly transfer of OTC risk assets, primarily credit, in the absence of easy-to-expand bank balance sheets, when shorter-term oriented investors try to exit. The hope of many is that yield-oriented insurers and pension funds will effortlessly scoop up any better-yielding bonds discarded by retail and hedge funds. The risk is, though, that the former will take their time when they see the falling knife of falling bond prices and will only enter at rock-bottom prices.
Which brings us to JPM's conclusion: "we anticipate that the start of US rate hikes will do damage to markets in the short term" although only early on, because obviously that's when the PPT will kick in, or as JPM puts it "there will be greater differentiation over a more medium term between liquid and less liquid assets."
That's the good cop.
Here is bad cop again: "In the short term, investors sell what they can, making liquid assets more vulnerable."
And since no bank can end on a dour tone, here, to conclude, is good cop: "But over a matter of months, we think liquid risk assets, such as equities, will fare better than less liquid credit, adjusted for their normal volatility."
Translated: JPM will be selling "more liquid" stocks to "investors", while buying less liquidity debt. After all, remember: the Fed's definition of "high quality collateral" is, debt. Not equity [12].
And it is precisely debt that all the banks are desperately trying to load up on as they sell every last stock in their possession to what little is left of the retail investor as possible.