Here we go again. While most investors last week were focused on the ex-post better-than-expected company earnings and manufacturing data, I was focused on the ex-ante developments in stock market discounts for inflation premiums. To understand how sensitive US markets are to the slightest hint of uneasiness from the Fed, you only have to look at how inflation premiums in various asset prices responded in the wake of the latest FOMC statement. Wednesday, the FOMC meeting yielded very little “forward guidance” from the committee as it merely stated that it would continue to watch the data to determine the pace of asset purchases. The following is from the FOMC statement
"Taking into account the extent of federal fiscal retrenchment over the past year, the Committee sees the improvement in economic activity and labor market conditions since it began its asset purchase program as consistent with growing underlying strength in the broader economy. However, the Committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases."
I don’t know what data they are looking at that is showing improvement in economic activity, nevertheless the announcement looked to be a big non-event. Markets, however, reacted in a big way, and the bias was undoubtedly tighter.
It’s important to realize how the Fed impacts market prices via the inflation premium. There is a pervasive misconception about how quantitative easing works in markets. Most market participants believe QE lowers interest rates via the flow of purchases. The Fed believes QE lowers interest rates by removing the available stock of securities. I believe QE lowers interest rates by raising the inflation premium embedded in the curve, thereby lowering real interest rates which push down nominal yields.
When the Fed initially floated the tapering idea, markets got the message loud and clear; the Fed was no longer committed to its inflation target. As a result the inflation premium collapsed, real rates exploded, and nominal yields were forced higher. The market was commanded by real rates, and this could be seen in the spread between nominal and TIPS yields that fell as rates rose.
10-Year Vs. 10-Year TIPS
It’s happening again. Friday I counted six different asset markets that all reflected a lower inflation premium and tightening of financial conditions. The USD rallied hard against the euro, gold and oil were falling apart, interest rates were rising with reals pushing up nominal, the eurodollar curve (3M LIBOR futures) steepened, and volatility of volatility that was spiking just two weeks prior collapsed to the lowest level in years. This is all the same trade, and it is extremely important to understand the implications.
Real 10-Year Vs. Eurodollar Curve
Crude Vs. Gold
Thus far these moves are not garnering any attention from the financial media, Wall Street analysts, or the blogosphere, but it could very well be the biggest development since the Fed decided to forego tapering in September. That decision was 100% due to falling inflation expectations with the goal of reigniting them. After the meeting, I wrote the following in The Fed Is Data-Dependent, Depending on What Data It Chooses
The decision not to taper is a re-engagement of its defense of the inflation target. In fact since the weak August employment report, falling real rates and the steeper curve was reflecting this inflation target commitment ex ante. It seems the market already had a sense that the Fed wasn't going to taper. The question for participants going forward is whether this extension of QE will re-raise inflation expectations in order to lower real rates.
Between meetings, inflation premiums failed to get any traction. Inflation breakevens in the curve trended sideways as yields fell while gold had trouble sustaining rallies and the USDJPY was confined to a tight range. Data has been weak with employment registering one of the worst gains all year and inflation readings were very benign with YoY PPI hitting the lowest levels of the cycle. Going into last week’s meeting, there were expectations the Fed may provide hints it would be easier longer, lower the unemployment threshold, and attach a GDP stipulation to its forward guidance; there were some outlier suggestions it might even increase asset purchases. It did nothing, and "nothing" in the market’s view was tighter. This is a critical distinction.
The first reaction to a mere mentioning of tapering purchases was met with a fierce unwinding of positions that had been predicated on higher inflation premiums. Carry trades that were short dollars, either implicitly or outright, exploded in epic fashion. Now we are seeing similar price action on the heels of the Fed’s confirmation of the status quo. First it was less stimulus
is tighter, now it’s no further stimulus
is tighter. It’s as if the diminishing return of QE has now approached zero.
To the extent that QE and lower real interest rates are responsible for the rally in risk multiples, this has major implications. While stocks ended the week relatively unscathed, there were signs of increased sensitivity to the reduction in inflation premiums in other asset prices. The most glaring example among stock market charts was the relative performance of beta in the price action on Friday. The Dow Jones Industrial Average
(INDEXDJX:.DJI) was outperforming (+.49%) the S&P 500
(INDEXSP:.INX) (+.29%) with the high-beta Russell 2000
(INDEXRUSSELL:RUT) (-.42%) seeing significant selling pressure.
Stock Market Indices: Russell 1000 Index Vs. Russell 2000
Volatility of Volatility
The collapse in vol of vol is also noteworthy as it suggests protection buyers have capitulated in the face of what could be an extremely volatile environment. As we witnessed in the spring, falling inflation premiums and rising real interest rates will put leveraged positions at risk. When leverage is under stress, implied volatility tends to rise as buyers seek to reduce exposure to a rise in realized volatility.
It seems as if the market is now highly exposed to a volatile environment, yet implied volatility is for sale. Should the rise in real rates persist, you could see a negative feedback where implied volatility lifts, putting pressure on short dollar leveraged positions which would strengthen the dollar further, thus lowering inflation premiums and pushing real rates even higher.
VIX Vs.10-Year Inflation Premium (Inverted)
It’s time to buckle up. The markets have fired a shot across the bow, and investors need to realize what is happening under the surface. The entire QE regime has benefitted both economic and market activity predicated on high inflation premiums and low (negative) real interest rates. If last week’s price action is a harbinger of a regime shift, then markets and the economy are going to be under pressure. This is a time to leave your position’s confirmation bias at the door and heed the message of the market. If the past is any indication, this low-volatility environment is about to get volatile. If you are prepared and liquid, volatility can be your friend. If you are exposed and illiquid, volatility can be your worst nightmare.
No positions in stocks mentioned.