One of the recurring laments about the Fed's hiking cycle, most recently from Goldman, is that despite 2 rate hikes so far this year, financial conditions remain the loosest they have been in over two years.Whether that is due to the market being so drunk on the Fed's "punch bowl" it is unable to grasp the liquidity is being dragged away, or for some other unknown reason despite repeated warnings by FOMC members that stocks here are overvalued, markets simply refuse to concede that financial conditions should be tighter, in fact, as Goldman observed yesterday "so far, the Fed’s efforts to tighten financial conditions have achieved too little, not too much."
That, in the view of Bank of America's rates strategist Shyam Rajan is a big mistake because as he explains in his latest note titled "When paint dries, does the wall crumble?" despite the market's repeated unwillingness to acknowledge what the Fed is doing, "recent market moves mark the beginning of a prolonged tightening of financial conditions."
And, more notably, he underscore that despite the benign financial condition regime, the market is missing one key thing: in light of what the market perceives as a "benign flow effect" the risk currently is in the the Fed's balance sheet "stock" and adds that "we think the market is complacent on the stock effect of the Fed's balance sheet decline. Specifically, higher deposit betas, UST supply and/or real rates could all trigger significantly tighter financial conditions."
To underscore his point, Rajan shows the following chart which shows just how vast the upcoming normalization will be, in light of the moves for both inflation expectations and real rates that took place during QE2 and QE3, and how small the unwind has been so far under the Fed's tightening regime. As Rajan explains further (more below), "ever since the conversation for the Fed shifted from hikes to balance sheet after the March meeting, we have seen a significant increase in real rates and a decline in inflation expectations: the anti-QE trade. Recall that the primary objective of an expanded balance sheet was to push real yields lower (when the nominal funds rate was constrained at 0) and inflation expectations higher. As shown in our Chart of the day, when looked at through that lens, the reversal over the last few months is just the beginning of a long process."
Rajan's main point, as noted above, is that while the market has remained focused on the central bank flow which it - erroneously - assumes will not be a major risk factor, what the market should be looking at instead is the stocks. He explains:
With rate hikes in the background, market and policymakers’ attention has squarely moved to the Fed’s balance sheet. In this regard, over-communication from Fed officials to prevent a repeat of the taper tantrum has no doubt helped. Repeated emphasis on the balance sheet being a “passive tool” and the tapering reinvestments being equivalent to “watching paint dry” seem to have convinced markets that the initial steps ($6bn UST, $4bn MBS runoffs) are unlikely to cause disruptions. Yet, while the market appears very comfortable with the flow effect, we think the longer-term stock effect is underappreciated.
Specifically, we identify three areas where the market seems most complacent going into the unwind experiment.
- Does the balance sheet unwind lead to an increase in deposit betas sooner than expected?
- Can the resulting increase in Treasury supply have a significant impact on yields?
- Will the increase in real yields have knock-on implications for other asset classes? All three signal a significant, albeit slow moving, tightening of financial conditions up ahead.
Going back to a point we have pounded the table on since 2011, Rajan notes that the excess reserves created by the Fed have created a liquidity illusion on bank balance sheets, in the form of excess deposits (the same excess deposits which not only are not inert as many erroneously assume, but are in fact what JPM's London Whale used - as collateral - to corner the IG market with notable consequences).
It is these deposits that wil now contract as the Fed proceeds to normalize. Here is Rajan:
Ultimately, as the Fed’s balance sheet shrinks, so does the banking systems’. On the asset side, banks lose cash (excess reserves) while on the liability side deposits leave (to absorb the new Treasury supply) triggering a mirror image decrease of the Fed’s sheet. However, critical to this process is the kind of deposits that leave the banking system. Although consensus remains that given the $2.1tn in excess reserves, competition for deposits will be non-existent, this assumption is heavily reliant on the less stable deposits leaving the system first (corporate, non-operational, etc.) before the more stable ones (FDIC insured retail deposits). Were the first run-offs in October to trigger the more LCR friendly retail deposit outflow, significant knock-on implications could result:
- Deposit betas will be projected to rise faster than expected resulting in a repricing of the asset side of bank’s balance sheets (loans, mortgages etc.;
- If deposit rates were to increase (and deposit-IOER spreads decline), demand for short-dated fixed income, especially at current levels (close to IOER) is likely to dramatically reduce.
- Third, cash will increasingly become an attractive asset to rich valuations across asset classes. This would reduce the safe haven premium of USTs to hedge against a risk-off.
Then there is the issue of issue of Treasury supply-demand imbalance, something we first touched upon at the start of the month in "BofA: "If Bonds Are Right, Stocks Will Drop Up To 20%." This point can be summarized simply as follows: there is $1 trillion in excess TSY supply coming down the line, and either yields will have to jump for the net issuance to be absorbed, or equities will have to plunge 30% for the incremental demand to appear.
Rajan summarizes these concerns below:
An unwind of the Fed’s balance sheet also increases UST supply to the public. Ultimately, the Treasury needs to borrow from the public to pay back principal to the Fed resulting in an increase in marketable issuance. We estimate the Treasury’s borrowing needs increase roughly by $1tn over the next five years due to the Fed rolloffs. However, not all increases in UST supply are made equal. This will be the first time UST supply is projected to increase when EM reserve growth likely remains benign. Note both the 2003-06 and 2009-13 increase in UST supply were met with the largest increase in Chinese buying of USTs. With this unlikely to repeat, we believe price sensitive buyers need to step up. Our analysis suggests this would necessitate a significant rise in yields or a notable correction in equity markets to trigger the two largest remaining sources (pensions or mutual funds) to step up to meet the demand shortfall. Again, this is a slower moving trigger that tightens financial conditions either by necessitating higher yields or lower equities.
Readers can read the full analysis of the Treasury's dilemma at the following link.
Treasury market dynamics aside, BofA says that the third, and perhaps most important, aspect of renormalization is that the forward path of the balance sheet decline is already having an impact on one market in the form of rising real yields:
Ever since the conversation for the Fed shifted from hikes to balance sheet after the March meeting, we have seen a significant increase in real rates and a decline in inflation expectations: the anti-QE trade (Chart 3). Recall that the primary objective of an expanded balance sheet was to push real yields lower (when the nominal funds rate was constrained at 0) and inflation expectations higher. As shown in our Chart of the day, when looked at through that lens, the reversal over the last few months is just the beginning of a long process.
The message from this combination (higher real rates, lower breakevens) is that even though there is a decline in nominal interest rates, the composition is a “bad” decline.
Besides rates, the "bad" decline shown above is negative for risk assets because ultimately "lower inflation expectations (if right) should lower forward earnings growth estimates (as earnings grow with nominal GDP) while higher real rates should raise discount rates for these earnings: an unfriendly outcome for risky assets."
Which brings us to Ra'jan's gloomy conclusion: "Ultimately, all three of the above – a repricing of the asset side on bank balance sheets higher, higher term premium because of UST issuance, and higher real yields – signal tighter financial conditions up ahead."
While slow moving, the knock-on impact on asset classes either through a shift in the underlying supply or demand dynamics is significant. We remain a structural bear on real rates to position for this scenario.
And, if right, the conclusion by the BofA strategist is precisely what Yellen, Fischer, Dudley and others have been desperate to communicate to the market over the past 5 months - unsuccessfully - when pointing out as recently as Tuesday, that “Asset valuations are somewhat rich if you use some traditional metrics like price earnings ratios, but I wouldn’t try to comment on appropriate valuations, and those ratios ought to depend on long-term interest rates."
Judging by stocks' reaction to the latest yield spike, the market may be finally getting it.