Premature Potential Pivots...
The Fed puts itself in a quandary, the gilt crisis comes to a close, the BoJ embraces rates divergence, and the one question Goldman thinks everyone should be asking…
Welcome back to Market Making, your weekly dose of sell-side research and insight.
⏱️ Estimated Read Time: ~43min
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📚 This week’s Reading List has been updated
Part 1: Central Banks Ease as Shorts Squeeze
In the first part of last week’s newsletter I wrote about the significant rise in yields that occurred across the curve until Friday morning when a well timed piece of “reporting” by Nick Timiraos of the WSJ, combined with dovish commentary by the Fed’s Daly, produced a substantial reversal.
In closing the section titled “Breakdowns and Blackouts” I wrote the following about the not-so-subtle campaign to talk down yields that occurred…
What makes all of this more notable is that the Fed’s blackout period - in which no Fed member will be giving speeches or be making comments - began on October 22 and will run through November 3 (the Thursday following the FOMC meeting).
So the mix of Fed rhetoric we got Friday - which was decidedly dovish - can be thought of as trying to set the tone into the meeting. However, if we get a strong market rally in risk assets into the FOMC meeting, the Fed may decide to pull another Jackson Hole and talk down the market once again.
The issue with trying to subtly coerce markets as the Fed was attempting last Friday is that markets tend to not handle subtlety well — to that end, this past week saw one of the largest periods of easing in financial conditions this century…
To a certain extent, I’m sympathetic to the Fed’s position from last Friday. Given the tumult in long-dated gilts that recently occurred, along with the increasing illiquidity in treasuries, the strong sell-off in treasuries last week did raise some concern.
Ultimately, the Fed wanted to avoid the very remote possibility that treasuries continued to sell-off and create market instability during the blackout period. Which they thought they could accomplish by saying that the pace of hikes wouldn’t continue at 75bps ad infinitum.
They were certainly successful in their mission to talk down yields. But instead of having markets enter into a period of calm before the rate decision this upcoming Wednesday, they spurred risk-on sentiment that was then only compounded by the actions of other central banks this past week who came in more dovish than expected. Thereby creating the narrative that has been driving markets this week around a globally coordinated “step down” in rate hikes now being underway.
Last week, when discussing the gilt crisis, I made the purposefully provocative claim that volatility was actually a virtue for the BoE — and here was my rationale for making this seemingly counterintuitive claim…
As this week closed, with UK markets trading relatively orderly despite the incredible political tumult on display, it’s worth reflecting on whether or not all of this volatility was actually a good thing.
This can seem like an absurd statement on its face, as this was a deeply embarrassing episode that saw the currency and rates market of the sixth largest economy in the world whipsaw like a fledgling emerging market.
However, the last three weeks have materially tightened financial conditions, without the BoE needing to raise rates, while also getting fiscal policy to go from counteracting BoE policy to being entirely supportive of it.
There is a central irony that has bedeviled the Fed throughout this hiking cycle: they want to tighten financial conditions and the market is at times willing to do some of the heavy lifting on their behalf.
But whenever this occurs the Fed has a habit of stepping in with dovish rhetoric which then causes risk assets to get immediately bid and then causes, ironically, the Fed to need to get tougher on rate hikes to quell the risk-on sentiment they created.
We saw this most cringingly in late July when Powell, at his press conference after raising rates to the 2.25-2.50% range, said that the Fed was now at its neutral level. This caused NDX to rally over 4% on the day.
As a general principle when you raise rates 75bps and the index covering the riskiest equities flies up that same day you’re being told by markets that you haven’t actually materially tightened financial conditions.
Powell finally got the hint after watching financial conditions continue to ease for the next month before delivering the Jackson Hole speech, in late August, which swatted down markets once again and began a period in which financial conditions did materially tighten.
What Did Goldman Think of This Week in Equities…?
Here’s a nice quote from a trading desk at GS yesterday that summed up the week…
The largest & most successful companies on the whole missed badly this week causing their stocks to gap lower and the market reaction is to chase stocks to fresh highs?
It’s rare new bull markets start with the biggest members of the index gapping down as they did this week. And this is while nominal US GDP is running at +11%?! What do numbers look like in a slowdown?
So beyond the dovish rhetoric that came out last Friday from Timiraos and Daly, what else drove this week’s price action in equities and why exactly is the Dow on pace for its best month since 1976?
Factor 1: Improbable Risks Off the Table…
It’s easy to overlook the fact that in weeks past there were risks overhanging markets that were unlikely to metastasize but, if they were too, would have been very disruptive to markets.
For example, at the height of the gilt crisis there was not only the forced selling of long-dated gilts to fund collateral calls but also the selling of US equities which is partly why an odd degree of sterling strength was exhibited during that period.
However, as I discuss later in the newsletter, this week saw the closing of this chapter of the gilt crisis as normalcy returned. Further, the concern among some regarding the yen and the need for continual interventions funded by selling treasuries, thus spiking yields, was diminished on the back of the USD weakness we saw this week.
Even the concern - that I found somewhat manufactured, as I described last week - regarding treasury market illiquidity was eased this week. It turns out, as I wrote last week, that fundamentals do matter and the rally in treasuries (in price terms) led to the return of more liquidity to the market.
Note: It’s still my view that we’ll have treasury buybacks occur and we saw that an increasing number of market participants are increasingly of this view as well given that off-the-run treasuries have suddenly got bid up even more this week.
Anyway, this was the first week in which there weren’t any large systemic risks overhanging markets putting a damper on sentiment — no one likes getting too invested in a market with fat tailed risks and so this week provided a green light.
Factor 2: Mediocre Earnings Were Enough…
This week also wrapped up most of this quarter’s earnings. While there were certainly some hefty losers - primarily among the big tech names - in the end it was a disappointing but not terrible picture relative to earnings estimates…
It seems that the market, after having been battered for months, was simply relieved that things weren’t terrible across the board and that fact, paired with the potential for a premature pivot, was enough to get folks back into the equity markets again.
Factor 3: Supposedly Dovish Central Banks…
Following the RBA’s surprisingly dovish decision earlier in October, the Bank of Canada followed suit raising it’s overnight lending rate by just 50bps on Wednesday despite the market having priced in around 70bps of tightening.
Governor Macklem justified the dovish turn by pointing to slowing activity domestically and internationally, along with the heightened possibility of Canada entering into a technical recession in the coming quarters.
In the immediate aftermath of the decision yields not only repriced across the curve in Canada but risk assets caught a bid in the United States on the theory that this was yet another signal of central banks getting ready to slow or pivot their hiking cycle.
Note: In a prior Market Making newsletter I detailed how uniquely rate-sensitive Australia, Canada, and the United Kingdom are and that it’s not at all clear their over levered households - with their large number of floating rate mortgages - can absorb a terminal rate even close to approximating that priced into the US.
With that said, Goldman is still anticipating the BoC to do a 50bps move in December and 25bps in January for a terminal rate of 4.50%. However, the market is already pricing in that the BoC will cut more than it hikes next year…
The day after the BoC announced their more dovish tilt, the ECB fully met market expectations by raising 75bps. It would have been truly shocking if this didn’t occur as it’s hard to imagine a rate hike decision that was more thoroughly telegraphed by a central bank than this one.
However, it was the language that President Lagarde used around the ECB having made “substantial progress” in removing monetary accommodation that caught the eye of market participants.
This was followed up with Lagarde stating that the inflation outlook needed to be linked to the rising risk of recession in Europe and that future rate hike actions needed to be taken in light of the “substantial progress” that’s allegedly already been made.
Here was Goldman’s view…
Though the ECB also reiterated that the pace of hikes is tied to inflation pressures, we interpret the overall communication as the ECB preparing the ground for a slowdown to 50bp in December.
President Lagarde also confirmed the ECB is moving forward on QT, with an agreement on guiding principles likely at the December meeting, for a subsequent announcement and implementation that we expect in Q1 and Q2 23 respectively.
Note: The ECB did end the TLTRO arbitrage though, as was expected and forecast.
If you read between the lines it appears that the ECB thinks that raising rates - even to the modest levels they have - will be sufficient to slow inflationary pressures in light of the recession that is almost inevitably going to occur.
This is a gamble — especially in the face of the inflationary readings out of Europe we got on Friday that blew away all expectations in Italy, France, and Germany.
Italian headline beat by 2.9% coming in at 12.8% YoY vs. 9.8% YoY consensus.
French headline beat by 0.6% coming in at 7.1% YoY vs. 6.5% YoY consensus.
German headline beat by 0.7% coming in at 11.6% YoY vs. 10.9% consensus.
Given these readings, GS updated their EuroArea headline inflation forecast that’ll be coming out tomorrow to 10.87% vs their previous estimate of 10.19%. Further, they’ve updated their core estimate to 4.91% which is a worrying level as it suggests headline inflation being so elevated it’s beginning to bleed back into core.
As if this weren’t enough, on Friday the Q3 GDP numbers released were higher than anticipated in France, Spain, and Germany — suggesting that these economies may be able to absorb higher rates relatively well and that a large enough recession to wash away inflation may not be coming.
Here’s how one note from Goldman summarized it all…
Putting it all together, the growth data looks better than feared and inflation is running away. Would the ECB have been so dovish if they knew how strong the inflation data was going to be? My guess is probably not. On balance they will likely still do 50 in Dec, but it feels like we may end up with a more protracted cycle than the market currently prices..
To put this all into context, here’s how the terminal rates gyrated after the decisions coming out of the BoC and ECB and then how they evolved over the week. As you’d expect, the data we got Friday out of Europe put terminal rate expectations right where they were before the dovish rhetoric from Lagarde…
When it comes to domestic equities, the hot inflation prints and strong GDP growth out of Europe didn’t matter much. What mattered was the perceived sentiment from Lagarde: that what the ECB clearly wants to do - whether they can get away with it or not - is to step-down future rate hikes to protect what they perceive to be an overly fragile economy based on forward looking indicators like PMIs.
Increasingly I’m becoming partial to the theory that many within the ECB believe that a recession is an inevitably. As a result, they may be trying to walk a fine line between retaining market confidence by doing the bare minimum of hikes, but actually hoping to keep significant rate divergence with the US so that economic adjustment comes through the FX channel (i.e., currency depreciation).
In other words, since they can’t credibly begin loosening monetary policy during periods of excessively high inflation, what the ECB is hoping is that the depreciation of the Euro can help facilitate a less severe recession next year through higher exports, more tourism, etc.
To this end, a phrase increasingly being thrown around is “inflation tolerance”. This jives entirely with what I’ve been thinking regarding the increasing appetite of rate-sensitive countries (i.e., almost all of those outside the United States) to allow economic adjustment to come through the FX channel.
Factor 4: Dollar Weakness…
While there was a lot that happened this week, something that shouldn’t be lost is that while yields compressed across the curve the dollar also descended from its previously loft heights…
This is an unmitigated good for equities given how much the strong dollar has dragged on earnings. As a general rule of thumb, each 10% increase in the dollar index translates into around a 1% EPS decline across the S&P 500.
However, JPM isn’t fully buying the dollar weakness trend persisting…
This move feels much less organic given its antecedents: the initial trigger was muscular MoF intervention in USD/JPY last Friday, which was then followed by an early-week Sunak bounce in GBP that carried the rest of the embattled European FX bloc with it, and topped off with the largest one-day drop in USD/CNH in the history of the pair on reported Chinese intervention. The checkered history of FX intervention suggests that central bank smoothing in JPY and CNY has limits and is unlikely to reverse pre-existing trends, and political risk premium cannot keep leaking out of the pound indefinitely, hence the durability of the current dollar sell-off is open to question.
In other words, it’s the view of JPM that the dollar weakness we’ve been observing is more about risk premium dislodging from other G10 currencies then something more intrinsic to the US.
Although if the market gets even a sliver of dovish rhetoric after the FOMC meeting this Wednesday then it’s almost assured we’ll have further USD drawdowns which will be an additional positive driver of equities.
Factor 5: Data That Didn’t Surprise…
Last week I flagged the economic data that would most move markets this week. Since it all came in roughly inline with expectations, it’s fair to say that the data just acted as a slight tailwind to risk assets as the week came to a close.
PCE increased 0.33% MoM vs. estimates of 0.3%.
Personal Spending came in at 0.6% in September vs. estimates of 0.4% while Personal Income came in at 0.4% in September, exactly inline with estimates.
Employment Cost Index came in at 1.2% QoQ, exactly inline with estimates.
What I watched most closely was ECI and it was hard to get too excited either way about it. It shows, as most thought, that wage pressures have cooled ever so slightly but are still far too high to be conducive with inflation returning to target.
The other major piece of data that came out last week was Q3 GDP which came in above expectations at an annualized rate of 2.6% in the third quarter.
But the GDP print is a bit of Rorschach test for how you’re currently thinking about the economy as most of the snapback was due to a dramatic swing in trade, inventories, and government spending. Indeed, trade boosted GDP growth by 2.8% alone.
Alternatively, the private domestic side of the economy continued its gradual but unmistakable slide downwards primarily due to the decline in residential investment given that it’s the most rate-sensitive component of GDP.
Factor 6: The Technical Side of Things…
The way that I’d frame the remarkable risk-on sentiment that has powered markets over the past week - culminating in the sharp equity gains we saw Friday - is that we had dovish sentiment as the base with supportive flow dynamics overlaying it. The combination of these have led to what some are now calling an equity “melt up”.
Last week we began exiting the corporate buyback blackout window for this quarter and are now - according to Goldman - looking at an average of $5b in buybacks occurring per day over the next two months.
Given how relatively strong corporate balance sheets are, we’re setting buyback records this year…
Further, given the position asymmetry right now (i.e., almost everyone having a significant short book) that provides for significant upside risk, as Goldman explains:
Fund positioning is getting cleaner, with gross leverage down to 41st 5y%ile, although long/short ratios remain close to 5y lows, in a sign that the pain trade remains to the upside despite de-grossing.
As systematic CTAs remain close to their max equity short levels that means a flat tape still requires significant buying to hedge exposure or extreme buying if we get steep moves up. Again, here’s Goldman…
CTAs are forecasted to buy $50bn next week in a flat tape and up to$160bn over the next month in a 2std up scenario. They remain close to max equity short,-$72bn , suggesting asymmetry remains to the upside.
On top of all of this, we’re finally seeing significant equity inflows with some technical levels being reached that could trigger more systematic re-positioning. Just this past week we saw $23b in global equity inflows as we inch closer to the much looked at 200dma — we’re already well past the 20 day moving average on most indices.
The Fed’s Quandary…
Here are some trading desk note quotes from Goldman on Friday and Saturday…
Whether coordinated or not, there has been a global tap of the breaks from central banks around the world. Don't kiss the freight train.
With the central bank induced rally this week, this puts us firmly back in CTA buy territory. This is as violent a set-up we have had all year.
The focus now shifts firmly to Powell. Is he ok with this easing of financial conditions? That is the only question you need to ask yourself this weekend.
To say that the Fed has put itself in a quandary would be an understatement. If there hadn’t been the soft intervention last Friday, October 21, and yields had been allowed to stay elevated into early this week then we still would have almost certainly still seen treasuries rally, the dollar weaken, and equities spike due to the dovish central bank actions and rhetoric we got.
However, by talking down yields on October 21 it sparked a rally that was then only exacerbated by what we saw through the week — leading markets, who don’t handle nuance well, to believe that we’re entering the final innings of this rate hike cycle.
What makes this all the more difficult for the Fed is that we are, objectively, in the final innings of this rate hike cycle. There should likely be a step down in the magnitude of rate hikes moving forward.
But it’s difficult to believe that if the Fed does nod toward lowering the pace of hikes moving forward at this meeting that we won’t see a material loosening of final conditions. Thus undoing partially (or even entirely!) the rate hike delivered.
It’s flabbergasting that the Fed has put itself in this quandary again after the nearly identical script played out over the summer.
This week Goldman posed the question of whether Powell is fine with financial conditions having eased so significantly since the soft intervention of just last Friday. This is a bit of a rhetorical question - as the answer is obviously that he’s not fine with it - so let me sharpen the question up a bit…
The real question is whether Powell fully appreciates how much more financial conditions will loosen in coming weeks if he gives any credence to the idea of stepping down rates, normalizing rate hikes, etc.
This is something that Powell undoubtably didn’t appreciate in late-July when he delivered his comments on reaching the neutral rate. By the time Jackson Hole came around financial conditions had loosened so materially that it was inescapable that he needed to talk tough — which is exactly what he did.
Given that we’ve only had a week of significant loosening in financial conditions the question is now whether Powell can see that the market is poised for, as Goldman said, the most violent (upwards, risk-on) set-up we’ve had all year.
The market is ready to materially lower credit spreads, pummel the dollar, beat down treasury yields, and make equities fly — it’s just waiting for permission from Powell to do so.
It’s a foregone conclusion that we’ll have 75bps of tightening at this meeting and I don’t think there’s any real chance of Powell trying to shock markets by going 100bps — he likely doesn’t have the votes to do so, even if he wanted to.
My personal view is that Powell will now have to use his statement after the meeting to try to move the December rate hike expectations well above 50bps. I’m not overly confident this will dissuade the market too much from pressing higher — the market knows that a step-down is coming whether it’s at this meeting or next.
But given that the Fed believes that tightening financial conditions is required to avoid inflation becoming sticker than it already is, then this is their most viable path moving forward. It’s hard to overstate just how much of a self-inflicted wound the actions of October 21 were — although maybe they just like a challenge…
Part 2: Closing this Chapter of the Gilt Crisis
Every edition of the Market Making newsletter has contained a section covering the gilt crisis — it’s been the singular dominate story of markets over the past month as the sixth largest economy in the world saw it’s currency and rates markets whipsaw as if it were a fledgling emerging market.