Valuation Comeuppance
QT credibility, goods, house prices and wages peaking, valuation comeuppance
Quantitative Tightening Credibility
After some reflection on the whirlwind events of last week, we are most surprised, but probably shouldn’t be, by market participants’ underappreciation of the impact of quantitative tightening evident in the 23bp steepening of the 2s10s Treasury curve following the Fed meeting. When we wrote Returnless Risk two weeks ago and Relief Rally last week, we made our case that the Fed policy path was fairly priced in both the front-end of the Treasury and equities market, but that long term Treasury yields were still too low given a negative term premium and zero real rates (TIPS yields). On the day of the meeting, the balance sheet contraction plan was more tentative than we expected, however, like the reaction to the soft release of the plan in the March meeting minutes three weeks ago, long term Treasury prices plunged as investors began to seriously consider just how far those prices were from fundamental fair value due primarily to the massive Fed pandemic purchases. As much credit as Chairman Powell gets for his anti-Greenspan obfuscation communication, when he says things like “we don’t really know balance-sheet shrinkage effects”, if you consider that the pandemic response was 150bp of rate cuts and $5 trillion of balance sheet the expansion, the rate equivalent of ~250bp, their credibility is questionable at best, at least in our view. Consequently, our explanation for the quick reversal of the relief rally following the as expected policy steps and removal of 75bp rate hike optionality, was the sharp move in longer-term rates attributable to investor concerns about the implications of QT exacerbated by the Fed’s lack of confidence in the implications of balance sheet contraction. Even after the 134bp increase in 10-year real rates and 50bp increase in the 10-year term premium (see definition and link below), those rates remain well below our assessment of fundamental fair value given the longer-term outlook for inflation, growth, demand for capital and monetary policy.
On the plus side, our outlook for inflation is improving, goods prices and wages appear to have peaked and in this note we will make a case for how house prices, the source of inflation the Fed has the most control over, are also likely to slow considerably. The implications of peak inflation are that the Fed is likely to be able to slow the rate hike process in the fall. At that point QT will be the primary source of policy tightening and while we think longer term yields are headed higher, the private sector is well positioned to absorb those hikes. Additionally, as we explain later in the report, the implications for the equity market are smaller than Thursday and Friday’s price action implies. Given the 15% decline in the S&P 500, any further drop would approach the scale of the 2011 and 4Q18 Fed policy corrections, in both of those cases the markets were also absorbing significant policy shocks. In 2011, the markets had to deal with the possibility of a US sovereign default during the debt ceiling and budget showdown on Capitol Hill that led to a US ratings downgrade. In 2018, the trade war was in the early stages of triggering a global manufacturing and export recession. No such shock exists today. We expect the equity market to stabilize and recover in the coming weeks.
“The term premium is the compensation that investors require for bearing the risk that short-term Treasury yields do not evolve as they expected.”
Treasury Term Premia: 1961-Present NY Federal Reserve Liberty Street Blog