First, it was Goldman's chief economist Jan Hatzius, who in a fascinating note explained why the market has totally misread the Fed's tightening intentions, claiming the market surge is "not the reaction the Fed wanted", alleging that the market's dramatic "easing" response was "not the outcome the FOMC aimed for" and concluding that "at the margin, it will likely make them more inclined to tighten policy", a polite way of saying that the Fed may now not be behind the inflationary curve, but that it is certainly behind when it comes to "explaining" to the market that it has run ahead of itself.
Now, in a follow up note, RBC's head of cross-asset strategy makes the exact same point as Goldman, and warns that "the Fed will now view the market response as an ‘overshoot,’ and will perversely be forced to ‘walk-back’ the ‘incorrect’ dovish market interpretation with more hawkish rhetoric in coming weeks / months that will again whipsaw the rates market and likely-drive cross-asset vol higher."
And since Goldman still has a direct hotline, both literal and symbolic, to former Goldman employee Bill Dudley who is in charge of the NY Fed, it would not be surprising if during the Fed's next public appearance, an FOMC member makes it very clear that having both of its core original mandates, inflation and emloyment, supposedly under control, it is now taking on the 3rd one - preemptive market stability, by making sure that risk assets are halted in their bubbly tracks.
Below are the key excerpts from today's note by RBC's Charlie McElliggott:
FED CREATES MORE ROPE TO HANG THEMSELVES WITH
- Despite hiking, the Fed missed a major opportunity to play “catch-up” without disrupting the market—as price-action showed that investors were clearly prepared for ‘hawkish’ outcomes.
- Instead, the FOMC / Yellen’s commentary (in light of the above ‘hawkish positioning’ dynamic) actually created EASIER / LOOSER financial conditions, with real rates collapsing lower on the session. This will make the eventual exit-process that much more difficult—thus, “more rope to hang themselves with.”
- With Yellen noting that the Fed intended to keep its policy accommodative for “some time”—in conjunction with the overly simplistic market take on the lack of movement in the average dot (FAR more nuanced than that) and the ‘hawkish’ buy-side positioning--the Fed also created significant (under)performance frustration across many strategies yesterday, with the exception of a 2 standard deviation ‘+++’ day for many risk-parity portfolios (which essentially run ‘short convexity’ long only cross-asset books, which are now likely to be in-process of ‘levering-up’ off of the ‘vol crush’).
- For the above reasons, I believe the Fed will now view the market response as an ‘overshoot,’ and will perversely be forced to ‘walk-back’ the ‘incorrect’ dovish market interpretation with more hawkish rhetoric in coming weeks / months that will again whipsaw the rates market and likely-drive cross-asset vol higher.
So the Fed hiked….and nominal rates gapped lower, breakevens traded higher, real rates collapsed, and financial conditions LOOSENED. Why? To me, the moves were largely positioning-related, being caught wrong-footed inherently with regards to ‘expectations.’ I do not believe the Fed intended this to be a dovish message, and they are going to have to clarify this to the market in coming weeks, in turn risking / creating more volatility. There is a fixed-income short / ED$ steepener to be laid-back-out soon.
To sum up the ‘by-and-large’ client reaction to yesterday’s post-Fed response (with a touch of relief from the Dutch election sprinkled-in) on a scale of 1 to 10, I’d say the buy-side gave it a “MEHHH.” Optically and absolutely, yesterday WAS of course a day of positive performance for many funds long risky assets, considering SPX +20 handles, EEM +2.6% (+2 SD move), IWM +1.6% (+2 SD move), HYG +1.4% (+3 SD move), LQD +0.9% (+2.6 SD move) et cetera.
Instead though, it felt ‘empty’ or like a missed performance opportunity for many, because despite your longs doing ‘okay,’ many of your shorts were up just as much, if-not-more. And regarding the longs, the stuff that did ‘really well’ yesterday is generally underweighted OR in many cases, has recently been pared-back (i.e. cyclical beta equities). Case-in-point, look at this example within the equities space:
- HF VIP Longs + 0.7% against HF VIP Shorts +0.7%
- High HF Concentration +0.9% against Low HF Concentration +1.0%
- MF Overweights +0.6% against MF Underweights +1.0%
This was an interesting rally because it looked like the old “QE”- varietal, where the interpretation of anything ‘dovish’ (in this case ironically it was a dovish HIKE via a simplified read basically that "unch on median / average dot" countered the recently hawkish momentum / rhetoric / data) actually sent UST's sharply higher (TY largest ‘up’ day since June ’16) / rates sharply lower / USD sharply lower (BBDXY a -3 SD move lower and largest ‘down’ day since July ’16). Real rates lower = easier financial conditions = Risk-on, Vol smoked = ‘short convexity’ vol trigger strategies likely driving mechanical re-levering.
The real news to me in the Fed message was two-fold:
- First, the dot shift was beautifully spotted by Mark Orlsey and Tom Porcelli going-into the event. Looking at the simple scale of the absolute move in the average- or median- dot simply doesn’t ‘cut it’ in the case of “what is to come”—it is far more nuanced. As such, the takeaway I think the market has initially-missed was the fact that the marginal dot ‘shift higher’ came from the bottom of the plot—i.e. IT WAS THE MOST DOVISH FED MEMBERS WHO UPPED THEIR DOTS. This dynamic is going to have to be ‘trued-up’ in coming months considering the data trajectory (new 5 year highs in Bloomberg US Econ Surprise Index yday) and is likely to be a source of interest rate-driven cross-asset volatility.
- The second notable takeaway from yesterday was Yellen’s very modest backing-away from prior comments made from Fed officials regarding an absolute-level FF rate (1.00%) acting as a ‘trigger’ for cessation of reinvestments to shrink their balance sheet. This is important bc again, Fed members have made this a point of focus going-forward, and their time-horizon window is shrinking now. From a markets perspective within the mortgage space, losing the ‘buyer of last resort’ (into the daily Fed buybacks) will cause ripples, because if rates are going higher against you as a MBS trader—which is inherently a negatively convex product—you HAVE TO hedge by hitting TY. This is a down-the-road discussion (now a 2018 story), but again will be a source of rate volatility in the future that could be ‘disorderly.’
Regardless of the medium- / long- term potentials…as such with the rates collapse lower on the day, duration sensitive equities were a large part of the equities leadership—e.g. defensives, divy yielders, low vol types like reits, utes, telcos (outside of energy sector with crude's relief rally), while mega-allocations in tech, consumer discretionary and financials were, relatively speaking, 'dead weight' and lagged index. Of course too, the other leadership driver in stocks was the ‘reflation stuff’ that’s been ‘getting pitched’ over the past month like steels, metals & mining, oil services, E&Ps, high beta materials and industrials etc. That stings for the majority of equity funds with regards to their current sector allocations, long ‘secular growth’ after reducing a fair bit of their 'cyclical beta' / value exposure in 1Q17. Much of yesterday’s leadership was curious ‘late cycle’ stuff, which o/p ‘early cycle’ by an astounding~140bps:
Obviously, the above dynamic is especially frustrating for many equity HF's. When you see the broad SPX tape + 0.8%, Russell 2k +1.6 and R3k +0.9% but as a long / short you were only able to eek-out 40bps to 50bps simply due to you net long exposure, it stinks. Even worse, mkt neutrals strats which simply don't work in 'gap higher' tapes.
Bigger picture macro, the rates move spanked fixed-income shorts, while the Dollar crush crunched longs (especially against GBP, EUR and select EM). Another “ouchy.” And think about the initial "trump reflation" worldview themes from 4Q16 where it was Emerging Markets that was viewed as the "biggest loser"...and now is the "high flyer" (EEM +12.3% YTD) as the protectionist rhetoric is ‘walked-back’ (Navarro comments yday) and some thinking (benevolently) that US growth is soon to be the "higher water which will raise all boats." Long EM over DM is now one of the most popular strategy calls going, FWIW.
But was yesterday really about US growth—was that really the case? I'd say that in light of the recent ‘trend trades’ and positioning dynamics, a day where you see fixed-income, (long) duration-sensitives, defensives, low vol, late cycle and EM leadership ‘run higher,’ it speaks to folks looking to buy the 'stuff that's been left behind" in a classic “PM exposure grab” style, yelling to his trader "find me some cheap stuff!" More "lottery ticket" mode than anything else, as evidenced by GDXJ (Jr Gold Miners ETF) finishing +11.5% higher on the day yesterday--a +3.1 SD-move. ALL OF THE LULZ.
As far as the current framework / narrative we’ve been operating under since midyear ’16, it shouldn't be lost on anybody that this wasn't a “higher growth = higher nominal rates = equities rally" which has obviously been the story of all global markets since secular lows for rates were put in last summer. It was instead an ‘easier conditions,’ central bank driven rally of old QE-era. As described above, this felt a lot more like “...greedy, not growth-y.”
I think there's an important message in there.
RBC US ECON TEAM SHOWS 2017 DOT SHIFT WAS ACTUALLY ‘HAWKISH’:
MARK ORSLEY SHOWS 2018 DOT SHIFT WAS ACTUALLY ‘HAWKISH’ / HIGHER AS WELL: