"Everyone's Praying But No One's Believing" - The 'Fed Put' Is Dead

Via Scotiabank's Guy Haselmann,

Chalk Outline

Yellen’s detailed speech initially triggered an out-sized market reaction.  Unfortunately, it was mainly due to shallow market depth and weak-hand positions. The ‘risk-on’ trades that ensued seem driven by positional unwinds from short-term traders. These markets will likely reverse back to lower prices once those initial trades are digested. 

Yellen’s speech should quickly begin to hurt over-priced financial assets. The stellar performance of financial prices over the past several years has primarily been driven by central bank accommodation. The double digit average returns (15%+) of the S&P 500 from 2009-2014 was not driven by economic strength, but rather by massive global central bank actions. There is simply a poor correlation between economic activity and the S&P 500 in any given year.

Since the Fed’s balance sheet flat-lined in 2014 (with the policy rate locked at 0%) risk assets have chopped side-ways-to-lower.  Therefore, a sooner (than priced-in) removal of accommodation should be hurting, not helping, risk assets.

The looming 2015 rate hike, threatened by Yellen and other FOMC members, is desirable and plausible in their eyes due to several factors:

1)  confidence that the US economy is on firmer footing and has moved materially away from crisis conditions;


2) a sense of desire and urgency to move off the ‘zero lower bound’;


3) anxiety about not having any ammunition during the next economic downturn;


4) fear of missing the business cycle and with it the opportunity to move off of zero rates, and;


5) as stated in Yellen’s speech, the potential that holding rates too low for too long “could encourage excessive leverage and other forms of inappropriate risk-taking that might undermine financial stability”.

Yellen’s speech was the first time I can ever remember a Federal Reserve Chairperson commenting that inappropriate risk-taking might be undermining financial stability.  This is explicit confirmation that the Fed’s aim of lifting asset prices in the hopes they bolster broader economic activity has reached the end of its useful life.  Barring a financial or economic disaster, the ‘Fed put’ has been put out to pasture.

James Bullard said on TV earlier this week, “the Fed cannot permanently raise stock prices”.

In general, there are three potential conditions for the US and global economy for the rest of 2015: better, worse, or about the same. According to Yellen, the Fed is likely to hike unless conditions worsen materially.  It is not good for financial assets if conditions worsen, nor is it good if the Fed hikes rates.  Until assets move from being too expensive to too cheap, portfolios should reduce risk profiles as much as possible.  Without further central bank steroids, what is going to drive expensive risk assets higher?

Going forward, the risk-reward distribution continues to look skewed to the downside.  Poor market depth and crowded positions could even cause a meaningful overshoot.

Since there are numerous days of trading between now and the remaining 2015 FOMC meetings, there is positive optionality of holding long-dated Treasuries If conditions worsen, all Treasuries are likely to rally.  If the Fed hikes, then the curve should flatten, while credit and equities will likely fall as the dollar strengthens.

The shift in Fed policy toward extracting accommodation is important for market direction.  Lofty US share valuations will be tested by tighter conditions. Higher rates will likely lift the US dollar higher and decrease the amount of share buybacks.  Seven years of easy money has borrowed from the future, indebting many companies and countries globally. The ‘new normal’ is the best case scenario for the next decade.

Moreover, the Fed is arguably hiking after the hump in the economic cycle. Either way, valuations will likely be challenged further as average operating earnings are already decreasing, and since revenue-based valuations currently stand almost 20% above their historical median. The best places to hide are cash or long Treasuries.

“Everyone’s praying but no one’s believing”. –Iron Maiden