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Vince Foster: Under Quantitative Tightening the Market May Command a Lower Price and a Flatter Curve


A quantitative tightening is much different from a price tightening.

This past week was full of event risk and all asset markets reacted in kind. The general spin out of Wall Street was that stronger data is bringing closer the timing of Fed tightening  In response I commented on twitter: to recap; Fed about to attempt something that's never been done before and they are going to do it sooner than the market expects.

There is a pervasive misunderstanding for how the Fed is going to exit an interest rate policy stuck at the zero bound. The risk is not when they begin raising rates; the risk is how they raise rates.

A month ago I noted the S&P 500's recognition of various Fibonacci levels and that the consequential 1.618 extension at 1969 should be recognized and that investors need to be cognizant that risk of a pullback was elevated. On June 30 in Welcome to Sarajevo I wrote:

Because this is such a huge level with cyclical consequences I will allow it to wiggle on both sides before drawing any conclusions. The previous 618 extension in 2011 essentially vibrated for six months before turning the market lower. This is a larger degree wave and thus could be in place much longer.

The market has been on a mission and Fibonacci has made his presence known. Is the 1.618 extension a stopping point? I don't know, but this is a natural place to stop and I would say the market is vulnerable to shock. The market often makes the news, and if it wants to make this level resistance then it may find the black swan to fulfill its objective.

The following month the S&P 500 (SPX) would chop around in a large range on top of this 1969 level. On last Wednesday, the market was hit with a blowout Q2 GDP report and bonds were under some serious pressure. Stocks were unable to capitalize on the better economic data, and were clearly bothered by the move in interest rates, and ended up closing relatively unchanged at 1970.

On Thursday the bond market remained under pressure and stocks were gapping lower. The pressure persisted and when it was all said and done the major indices closed down 2%. Friday's employment report was pretty much status quo with 200k job gains and subdued wage growth. Nevertheless, stocks remained under pressure and finished one of the worst weeks in months.

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Turning away at the 1.618 is a major statement by the market and this level is now a formidable line in the sand for the future direction. This rally from the 2011 lows needs to get consolidated, and if the market is making the news, then the Fed's exit from the zero bound is an obvious narrative. However I think the narrative is being misapplied.

As I noted above Wall Street keeps focusing on the timing of the first rate hike being brought forward and that the yield curve is mispriced for this reality. This week I want to offer a possible reason why the curve is not mispriced and why the strategists are missing the critical distinction of this pending tightening cycle.

Last week I recapped the Minyanville interest rate conference call whereby Kevin Ferry broke down the most important concept facing the future of monetary policy. This week I want to drill down into one specific comment he made on the call regarding the age old debate in monetary policy whether it is targeting the price of money (level of interest rates) or the quantity of money (the supply).

They are basically admitting that they can't control the supply and the price of money, the quantity and the price at the same time. And so they are offering to create a spread between those two things. With the reverse repo facility that has affectionately been called the Death Star and the funds rate...

The distinction between targeting price and/or quantity cannot be understated. I think something to keep in mind or at least consider when thinking in terms of how much or when the market is discounting tightening is whether it is price tightening or quantity tightening.

Under quantitative easing the curve traded at the steepest levels in history. In other words, because quantity easing is easier than price easing the market commanded a higher price. It stands to reason the opposite is also true. Quantitative tightening is tighter than price tightening therefore the market may require a flatter curve and lower price. Make no mistake about it we are still in quantitative regime and what the curve could be saying is that under quantity tightening, the price of money should be lower.

So to say that the market is not prepared for the Fed's tightening cycle is incorrect. The market is focused on quantitative tightening and the curve started discounting quantitative tightening in June 2013. Contrary to the growing consensus, I believe the market isn't behind the Fed and I think you could argue it's in front of the Fed by six months.

The fear is of a 1994 surprise tightening that spooks the market, but it's not 1994. It's not even 2004 when the Fed gradually increased 25bps at a time. In fact I think this cycle is more akin to 1998, which ironically is largely responsible for the following years of monetary malaise.

Recall in 1998, when the Fed feared the contagion risk presented by the failure of Long-Term Capital Management, it eased aggressively to cushion the blow. This introduced the market to the Greenspan put and moral hazard. The stock market went parabolic out of the 1998 hole and never looked back. The Fed quickly responded and six months after easing 75 basis points began tightening until finally inverting the curve and pricking the stock market bubble in 2000.

It wasn't necessarily the tightening of policy per se but rather the policy volatility. In other words, the Fed jammed the market higher and then tried to cool it off in a very short period of time. This is very similar to policy in 2012 that accelerated stimulus, first via extending forward guidance of zero percent interest rates from 2013 to 2015, and then launching QE III in September; first targeting the mortgage market and then expanding it to Treasuries. Not six months later the Fed slammed on the brakes by introducing the concept of tapering.

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The similarity is eerily uncanny. The Fed eases aggressively, stocks go parabolic and then the Fed quickly reverses policy. I charted the 30YR MBS yield from 2012 to the present over the 1998 cycle, and the yield demonstrates a similar trajectory with the then fed funds rate. The only difference is 1998 was a rates regime and 2013 is a quantitative regime. Under this quantitative regime the market has already delivered intense tightening.

Last Tuesday mortgage REIT American Capital Agency (AGNC) held their Q2 conference call and President Gary Kain made a similar point when asked about their portfolio positioning in front of pending Fed rate hikes.

I think you got to be a little careful with looking at those as examples, because in the past, when the Fed has tightened, it has never just gone through a tapering process. And the tapering process still created a more than 100 basis point increase in rates. It's already done things like crush the supply of mortgages, and have people kind of go through a complete hedging process. And all of that occurred, like, a year ago, and maybe potentially a year and a half, before kind of an actual tightening process occurred.

So, I think that there are lot of dynamics here that, we feel that have to be taken into account, and just clear, just looking back to 2004 and 1994 is very short-sighted, given what we've already gone through, and the fact that we've never had a situation where the Fed had already tapered.

Translation; this is a quantitative regime and the market has already tightened. Everybody is looking in the rearview mirror, but the yield curve has already passed them by. Wall Street thinks the market is six months behind, but it looks to me like it is six months ahead. When the Fed finally does get to reducing the quantity of money the big trick will be if that environment commands a lower price.  The big trick may be on all the strategists who think curve is mispriced because they are applying price metrics to a quantitative regime.

Twitter: @exantefactor
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