The Answer To El-Erian’s Quandary: It’s “A Perfect Storm” Melt Up

On Friday, Pimco’s Mohamed El-Erian referenced one of our recent charts showing the dramatic divergence between Treasury yields and stocks, which he said “this (simple yet powerful) chart from @zerohedge warrants a PhD thesis in Finance.”

This (simple yet powerful) chart from @zerohedge warrants a PhD thesis in #Finance #stocks #bonds #markets pic.twitter.com/w61rDBFkPT

— Mohamed A. El-Erian (@elerianm) June 2, 2017

Roughly at the same time not one but two banks offered their own “dissertations” on El-Erian’s thesis, first Deutsche Bank, then Bank of America.

As DB’s Dominic Konstam wrote in response to the ongoing paradoxical divergence, saying “we think equities continue to move higher and bond yields lower. 10s haven’t yet convincingly broken below 2.15 percent but we stick with the success so far in the excess liquidity-yield momentum model that suggests they will and they ought to move to 2 percent or below.”

According to Konstam there “seems to be a perfect storm of so so growth and falling inflation, enough for the Fed to tighten modestly but being at risk of over doing it. The net impact is for financial conditions to ease via the soft dollar as term premium is tied down. And it is hard to see the Fed either taking a time out or accelerating tightening for fear of same said error.”

Echoing something Goldman said several months ago when Jan Hatzius pointed out that the Fed’s rate hike led to the biggest easing in financial conditions on record, DB also noted that “the easing in our financial conditions index is one of the most extremes on record, thanks to Fed tightening!”  And, as DB adds, the softer dollar “should give Draghi sufficient cover to remain dovish”, not to mention keep pressure on the PBOC to raise the Yuan against the declining dollar, something which sparked tremendous FX fireworks over the past week.

Some more details:

We think equities continue to move higher and bond yields lower. Financial conditions continue to soften. Our index was at peak tightening in January 2016, the index level was at -1.53 with the previous peak tightness -1.73 in February 2011, before twist and -3.29 October 2008. The recent local peak softness was November 2016 (-0.71). Since then the softening has been driven mainly by dollar weakness, contributing 47 percent of the easing in financial conditions. Mortgage spread narrowing and some recovery in FX reserves have each contributed another 20 percent or so in softer conditions1 while equities 7 percent. The irony is that faster Fed tightening has neatly coincided with an easing of financial conditions. One might be tempted to suggest that if the Fed wants to tighten financial conditions for fear of overheating the economy, it is going about it the wrong way. The logic here is that the (rates) market remains fearful that the Fed’s push for normalization runs the risk of lower inflation and weaker real growth that will undermine equity valuations. The self-inoculating response is therefore lower rates (5 years and out) and as we wrote last week, bonds act as a crutch to equities – equities are anyway cheap and whatever is good for the bond market at least since 2008 has never been sustainably bad for the equity market

Konstam follow up with a critical discussion of what it would take for the Fed to burst the equity bubble, but has so far refrained from doing so, which in turn prompted Goldman one month ago to ask if Yellen has lost control of the market (and warned of “policy shock”), to wit:

Ironically, if the Fed wants to tighten financial conditions two possibilities would be an overt policy error to be much more aggressive and short circuit the mild expansion but without the smoking gun of inflation – that should see equity declines despite lower long dated yields with spread widening. Ironically the dollar might weaken as an offset. Or go the other extreme and take a time out to be more overtly behind the curve and allow higher inflation expectations via a steeper curve that might raise the dollar, soften equities and spreads (hunt for yield dissipates). Neither of these directions is necessarily guaranteed to succeed nor appear particularly appealing – and arguably the recent faster pace of tightening was supposed to look a bit like the former but is clearly back firing. The conclusion is that the Fed can’t do a lot that appears credible to the market. The path of least resistance is therefore a soggy dollar, low yields and robust equities.

In a tangential discussion of why the Fed may be trapped this time around, over the weekend One River CIO Eric Peter brought up a different issue, one which suggests that the Fed is terrified of an aggressive tightening cycle for one reason: China.

“Classic late-cycle action,” said the CIO. “Vol-compression, loosening financial conditions, and a pain-trade that tilts forever higher,” he continued. “Normally the Fed ends it. Hiking aggressively, flattening the curve, widening credit spreads, and then the economy rolls.”

But this cycle is not quite like the others. “The real credit excesses haven’t been created here, they’ve formed in China, which leaves the Fed in a quandary.”

Much as the Fed would like to have jurisdiction over every corner of global finance, they no longer control China. 

Finally, in a note on Friday after the payrolls report which sent yields tumbling and stocks to new all time highs, BofA’s Hans Mikkelsen had the simplest possible explanation: “All news is [again] good news”

This is what the BofA credit strategist said: “May’s jobs report – with lower than expected headline jobs growth of 147K, negative revisions of -66K and downward revisions to wages – represents another piece in a string of disappointing hard economic data. Impressively, even though stocks initially struggled and declined with rates, eventually they turned around and closed up 0.37% on the day (Figure 1).”

It got better with BofA noting the patently obvious, namely that “Clearly, equities continue to respond well to both positive and negative economic data, as the latter leads to a more dovish monetary policy stance.

While the Fed appears determined to hike in two weeks (Figure 2), it appears that the relevant risk is they do not – or more likely deliver a dovish hike by using language in the statement/talking dovishly at the press conference. For next week, our European economists are looking for the ECB to downplay downside risks and give a slightly more balanced assessment. However, also there the risks are skewed toward a more dovish outcome (see: ECB: baby steps towards normalization). Remain bullish on HG spreads.

In short, the “PhD thesis” answer Mohamed appears to be looking for is that the record liquidity glut continues to push risk higher, with the result that whether good or bad news, stocks continues to make all time highs even as the divergence between bonds and stocks grows to unprecedented levels. Perhaps a far better finance thesis is how much longer will the Fed allow this particular divergence to continue, although our advice is not to seek an answer from the FOMC committee, whose actions have allowed this financial paradox to emerge in the first place.