“Is The Market Wrong?”: Financial Conditions Are Tightening At An Alarming Pace

As a result of the recent spike in yields, and surge in the dollar following the Trump victory, the market’s reaction has been to assume that this is a harbinger of rising inflation due to a tidal wave of “imminent” fiscal easing, and has accordingly pushed up the December rate hike odds to above 90%. After all, the logical offset of the expected easing in fiscal conditions is for the Fed to tighten monetary policy, arguably the only source of market gains (and economy support) over the past 7 years (a good read on “monetary offsets” can be found here).

But is the market wrong?

After all, just today the BIS issued a warning that the stronger dollar – far from an “all clear” signal of confidence in the economy, may simply signal far greater financial system risk as a result of a substantial global dollar funding shorage.

On the other hand, rate hikes by Yellen could precipitate the same reserve liquidation selling by China which will be forced to keep the Yuan stronger on a surge in outflows, that was observed in late 2015 and early 2016, and which sent the S&P500 into a sharp, if brief correction.

A troubling answer for the bulls emerges when looking at the latest move in Goldman’s Financial Conditions Index: as of Monday night, it has spiked above 100, the highest level since March and topping a brief spike seen in the aftermath of Brexit.

As the WSJ notes this morning, investors watch financial conditions because they show how markets are encouraging or restraining the flow of money through the economy. When conditions get too tight, they can restrict economic growth, which has been cited in the past as a reason for the Federal Reserve to hold off on lifting interest rates. In extreme cases, Goldman has ever cited the spike in the index as a catalyst for looser monetary conditions.

As the WSJ further explains, when the Fed raises rates, it seeks to tighten financial conditions gradually, but the markets sometimes do the work for them,  and more. In February, Fed Chairwoman Janet Yellen alluded to restrictive financial conditions as one factor holding back the economy. One look at the chart above shows that conditions are once again moving in the wrong direction.

It is no surprise, that the move higher in the index has largely come since the U.S. presidential election, which injected a lot of uncertainty into financial markets. A Goldman Sachs measure of policy uncertainty spiked to its highest level in records going back to 1985 on Monday.

The Economic Policy Uncertainty Index Spiked to its Highest Recorded Level

What’s causing the tightening? Much of it is due to a rise in the dollar and climbing rates, the Goldman Sachs data show. The 10-year Treasury note yield, which rises when prices fall, is up more than a third of a percentage point since the election. The ICE Dollar Index, which measures the currency against a basket of peers, is up 2.1%. This tightening has – for now – been offset by favorable moves in credit spreads and rising equity prices, which are pulling the index lower.

The index is self-referencing, which means that once it tips too far into either side, it tends to have an overriding effect on the other components, and suggests that should the recent push higher in yields and the USD persist, it will eventually drown out the favorable contribution from its other constituents, all else equal.

This is precisely what Ray Dalio referred to in his Op-Ed earlier, in which when referring to precisely this tightening of conditions, said that “the question will be when will this move short-circuit itself—i.e., when will the rise in nominal (and, more importantly, real) bond yields and risk premiums start hurting other asset prices.”

 His answer: “that will depend on a number of things, most importantly how the rise in inflation and growth will be accommodated.”

So while the jury may still be out, should the “Trump Reflation Rally” continue, and push both bonds lower and the dollar higher, the “tipping point” will arrive sooner rather than later. Ironically, that in itself may force the Fed to not only delay a December rate hike, but to actively consider further easing measures in the coming months should the move fail to “short-circuit” on its own.

Which in turn, goes back to Goldman’s warning from yesterday, in which the farm forecast that under any combination of Trump policies, the impact on global growth will be uniformly negative.

 

 

If that is the case, any Fed rate hike into this sharp tightening of financial conditions will be merely the latest monetary policy mistake. Ironically, it just may turn out that what Trump’s fiscal expansion needs, is a Fed that is far more accomodative when it comes to not only rates but also to deficit monetization.

So will Trump be the catalyst that ultimately launches QE4? That has been our thesis since election night. If so, the market is indeed “wrong”, and will be forced to undergo a sharp repricing in asset values in the near future to escape its “error.”

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