Going into Thursday, everyone - and we do mean everyone - is scrambling to predict which asset classes are most susceptible to a Fed hike.
As we explained over the weekend, there’s quite a bit of ambiguity this time around and not just because a third of Wall Street has never seen [11] a rate hike in their professional careers.
The prolongation of ultra accommodative monetary policies across the globe (to the point that what was once “unconventional” might now fairly be classified as thoroughly “conventional”) and the failure of the Fed to normalize while it had the chance, has served to create a situation where Janet Yellen is effectively boxed in. Liftoff risks destabilizing an already precarious situation in emerging markets where a Fed hike risks exacerbating capital outflows, pressuring already beleaguered commodity currencies, and ultimately magnifying the scope of the tightening far beyond what 25 bps would normally entail by forcing EMs to liquidate more FX reserves to support their flagging currencies.
There’s also a risk that a hike forces some LatAm central banks to adopt pro-cyclical measures [12] (i.e. hikes) to ensure that continual currency weakness doesn’t result in too much pass-through inflation - this is a potential landmine, as hiking into a soft economy risks choking off growth at a pivotal time. And then there is of course China, where the PBoC’s schizophrenic attempts to find an elusive middle ground between a free float and hard management of the yuan would be immeasurably complicated by a hawkish Fed.
All of the above is made that much more confusing by the possibility that a hike triggers a sudden flight to safety, leading to a rally in the long bond only for everyone to quickly realize that such behavior (the flight to safety) would effectively prove the Fed has lost all credibility at which point the UST bid dries up, creating a situation where risk assets are selling off, yields are rising, and commodities falling, leaving the risk-parity crowd with nowhere to go. As Deutsche Bank notes [13], it’s all downhill from there, because the only place to hide would be the dollar, and that would only serve to perpetuate the effect of the hike: “In this case it is not entirely clear how risk-parity funds would rebalance: A potential candidate for inflows would be currencies, and in particular the dollar, which could be the only game in town. Of course, this would only put additional upward pressure on the dollar, reinforcing the “policy error” nature of the hike via additional traded goods price deflation (including commodities), weakness in net exports, and exacerbating pressure on dollar peggers.
Amid the rampant confusion, BofAML asked fund managers to weigh in. Unsurprsingly, the turmoil that's gripped markets in the wake of the mayhem that unfolded across equities in late August has fund managers quite skittish about how stocks may react in a liftoff scenario. Here's BofAML: "After recent market volatility, it should come as no surprise that 1 in 3 investors now view stocks as most vulnerable to upcoming Fed tightening cycle."
We present the results with no further comment and leave it to readers to discuss:
[14]
