One
stronger-than-expected payroll report, and short-rate markets are focused on
the prospect of a Fed tightening. A
few thoughts:
First, short-end rates remain at very low
levels, despite the post-payroll jump. The two-year note, for example, lifted
from under 1% to over 1.4% by Monday's close (Exhibit 1). Jim Caron, our head
of rates strategy, believes that the spike has been exacerbated by
profit-taking on curve steepening positions: the 2-10 year spread reached a record
earlier last week.
Second, a rise in short-end yields was to be
expected as markets normalize: just as long-end yields were unlikely to remain
too far under 3% once there was a sniff of recovery, likewise, short rates were
going to speculate when policy-makers would temper the current extraordinarily
loose policy. In other words, the key question for rates, as for equities, is
no longer when the recession ends, but the nature of the recovery.
Our US team's view is that the market is
already too hawkish on the likely turn to tighter Fed policy. Admittedly, there
are many uncertainties. Markets, like policy-makers, have little or no
experience judging the effectiveness of the non-conventional policy tools used
in this cycle - or judging the impact of their removal. Even if it were totally
clear how the recovery would progress, the pace and sequence of removing or
tightening these policies is not clear.
The more important call, however, is on the
nature of the recovery. Dick Berner and Dave Greenlaw expect that the recession
will end by mid-to-late (northern) summer, but the recovery will be gradual.
Our team has nudged its near-term GDP numbers higher (expecting GDP will fall
by 1 1/2% through this year, versus -1.9% previously), but full-year
growth of 2 1/4% in 2010 is an anemic bounce given the depth of the
downturn. (See Recession Ending But Recovery Will Still Be Gradual, June
8.)
Given that outlook, we think markets are
pricing in tighter policy too soon (Exhibit 2). Dick and Dave don't expect the
Fed to lift its funds rate target until the September 2010 quarter. In
contrast, the futures market is pricing in a rate hike this year, with a move
to around 1 1/4% by mid-2010, and almost 2% by end-2010.
Third, the market is not a perfect seer.
Exhibit 3 shows the forecast error on the six-month-ahead Fed funds target
(that is, the gap between the funds rate priced in six months beforehand
compared to the actual target rate). To be fair, short-rate markets are worse
at forecasting easing cycles than tightening cycles. (I haven't adjusted for
carry costs, so I'm being marginally harsh, but the errors are so large that
that adjustment wouldn't significantly change the picture.) The error in the
last cycle was fairly small - no doubt due to the Fed's clear signaling of
imminent change. In prior cycles, however, short-rate futures got too hawkish,
too soon.
Fourth, regardless of whether the market is
right or wrong, it's clear that uncertainty is rising. Jim Caron has noted that
the effect of the non-conventional policy measures was to limit the range of
rate outcomes, therefore damping volatility. As those measures are relaxed,
volatility will increase. This is now happening in the rates space. Exhibit 4
shows the sharp rise in the Move index, which is the Treasury counterpart to
the Vix index. (For more details, see Jim Caron, Bonds: A Bursting Bubble? June
2.)
Fifth, while other developed-economy rates
are correlated with US rates, the rise has been much less pronounced. Our
European rates team thinks the market is right to price in the end of easing -
but does not think that tightening is imminent. See Laurence Mutkin, End of
Easing: Implications, June 5.
Finally, for equity investors, the rise in
Treasury yields combined with expectations of tighter Fed policy bring to an
end the uber-sweet spot enjoyed over the past three months: less bad macro
data, a reversal of extreme positioning, low rates, and the expectation that
policy would remain ultra-accommodative. Equities usually do cope well through
the early stage of a tightening cycle: both policy-makers and equity markets
are responding to the burgeoning economic recovery.
But this is not a normal cycle. Markets have
run hard and are now, by my reckoning, increasingly priced for a sharp macro
and profit recovery. Such a recovery still seems unlikely, at least within
developed economies. The change in the rate environment may not singlehandedly
stall the rally in equities, but in my view it is another indication that the
risk-reward on equities is again tipping. I've nominated 950-1000 SPX as a
likely region for the rally to peter out, with a stretch target of 1100. With
rate markets now starting to shift, this still seems a reasonable upper bound
for how far the current rally will travel.
Back
to Top
END OF RESEARCH ABSTRACT
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|
Coverage
Universe
|
Investment
Banking Clients (IBC)
|
|
Stock
Rating Category
|
Count
|
%
of Total
|
Count
|
%
of Total IBC
|
%
of Rating Category
|
|
Overweight/Buy
|
690
|
31%
|
214
|
35%
|
31%
|
|
Equal-weight/Hold
|
1022
|
45%
|
288
|
47%
|
28%
|
|
Not-Rated/Hold
|
32
|
1%
|
7
|
1%
|
22%
|
|
Underweight/Sell
|
510
|
23%
|
99
|
16%
|
19%
|
|
Total
|
2,254
| |
608
| | |
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