As increasingly more analysts and Fed-watchers have suggested in recent months, the one catalyst that could send the market into a tailspin is for the Fed to get what it has so long wanted: a sudden spike in inflation. From Albert Edwards (who looks at record U.S. vacation plans as an ominous sign of rising wages), to Eric Peters (who warned that pent up inflation could unleash a "nightmare scenario" for the next Fed chair), to Aleksandar Kocic (who yesterday explained why the market is vulnerable to bear steepening of the curve with the Fed "massively negatively convex to inflation risk"), on Sunday Morgan Stanley's chief cross-asset strategist, Andrew Sheets joins the warning and observes that at a time when things are finally starting to look up for the global economy, "this puts central banks in a challenging position. Inflation remains below target. But current policy means some of the easiest financial conditions ever observed, just as growth is picking back up, regulation is backing down and memories of the last crisis fade."
As a result, Sheets believes that "current policy rates and financial conditions look unsustainably easy relative to the strength of global growth." Which means that the response is once again in the hands of Central banks, who hold the key to determining when to push back. "If they do, asset prices face a severe challenge" Morgan Stanley warns, but maybe not yet: "until they do, we should be willing to accept that prices can persist above ‘fair value’."
Andrew Sheets' full note is below:
With rates low and central banks taking great care to avoid surprises, the question isn’t why many assets are expensive. It’s why they aren’t richer. Since the financial crisis, easy policy has been balanced by four powerful counterweights. All now appear to be shifting, opening the door to more volatile late-cycle behaviour.
It’s easy to talk loosely about ‘loose policy’ and ‘easy money’. So let’s be specific. When rates sit below the level of inflation, borrowing to buy almost anything makes financial sense. It’s true for a toaster or a house or a company, and that’s exactly the point; easy policy aims to stimulate and bring forward depressed demand.
And boy do we have easy policy. The G4 policy rate (GDP-weighted) is 150bp below the rate of inflation. G3 central banks hold ~US$14 trillion of assets, compared to ~US$3 trillion pre-crisis. And that’s set to keep increasing through 3Q18, even as the Fed’s balance sheet starts to shrink.
But it’s not just that policy is easy. It’s also highly predictable. Qualitatively, the Fed, ECB, BoJ and BoE have gone to great lengths to communicate policy aims and changes well in advance. Quantitatively, implied volatility on interest rates (a proxy for the uncertainty in policy) is near all-data lows.
- Fiscal tightening: The US, UK, eurozone and Japan all tightened fiscal policy in the aftermath of the Great Recession, despite still-wide output gaps. This rejection of Keynes countered the simulative effects of monetary policy, and certainly contributed to the sluggish nature of the post-crisis recovery.
- Regulation: The crisis exposed huge shortfalls in risk management and capitalisation, and in the aftermath lawmakers (globally) moved to address both aggressively. Stress tests were introduced, leveraged lending was discouraged and tighter rules were placed on securitisation. All discourage risky behaviour, despite the presence of low policy rates.
- ‘Scars of the crisis’: Not all financial regulation came from government bodies. Some of it, we’d venture, was self-imposed. The crisis crushed optimists, rewarded pessimists and created emotional and financial scars that weren’t going to heal quickly. While harder to quantify, we think that this contributed to a level of corporate and financial timidity despite exceptionally low policy rates.
- Low nominal growth: Tighter fiscal policy, financial deleveraging and corporate investment caution all helped to push global growth to levels that left little room for error. From 2011-15, global growth hovered around 2%Y, and lacked synchronicity, with DM initially struggling while EM did better, and then vice versa. If growth is weak (and people expect it to remain so), low rates can lose much of their power.
All of those ‘checks’ are starting to fall, at the same time. G4 fiscal tightening is becoming fiscal easing (US tax cuts at this level of unemployment have little precedent, and our UK economists expect looser spending in the autumn budget). Financial institutions are now well-capitalised and regulation (broadly speaking) has stopped tightening. The scars of the crisis are fading, as more investors wade back into previously off-limits asset classes. And global growth is humming, with our economists seeing the strongest levels since 2010.
This puts central banks in a challenging position. Inflation remains below target. But current policy means some of the easiest financial conditions ever observed, just as growth is picking back up, regulation is backing down and memories of the last crisis fade.
What’s the takeaway? We focus on four:
- Current policy rates and financial conditions look unsustainably easy relative to the strength of global growth. Central banks hold the key to determining when to push back. If they do, asset prices face a severe challenge. But until they do, we should be willing to accept that prices can persist above ‘fair value’.
- Markets, oddly, don’t see this dynamic as unsustainable, and imply easy and predictable G4 policy to persist for years. Our rates strategists believe this provides medium-term support for US 2s30s flatteners, given a view that the Fed will hike more than the market is pricing, and selling the MBS basis, which is exposed to very low levels of rate volatility. Conversely, the recent EMFX sell-off looks outsized relative to G4 rate expectations, and our strategists see an opportunity to buy local rates in Indonesia, Colombia and Hungary.
- Extraordinary stimulus, with fewer breaks against it, increases the chance of a ‘boom/bust’ environment. In equities, we think this makes stock replacement attractive (replacing index with calls), given low volatility and a steep skew. Cross-asset, we think this favours long equities versus credit.
- Higher oil prices would represent a tightening of financial conditions outside of central bank control. We are OW energy in the US and Europe, and think the sector has attractive diversification for this risk scenario.