What's Going on in the Markets: A Bond's Eye View
October 11, 2018
On October 3 U.S. Federal Reserve (Fed) Chairman Jerome Powell’s comments indicated for the first time that they may tighten their monetary policy. Equity markets have traded lower every day since that statement. It is important to note that U.S. Treasury yields moved first, followed by equity/risky assets. I’ll explain why this is important, but first let’s discuss what is going on in the markets.
The Fed has been raising rates since December 2015 to remove excess accommodation. The goal has been to “normalize” policy rate levels to neutral. Moving to neutral IS NOT the same as tightening. Powell on October 3 announced he may tighten the Fed’s monetary policy, and this set in motion the events of higher rates and falling risky asset prices.
Based on Fed models, a 3.00% fed funds rate is widely viewed as the neutral rate (real fed funds rate (r*) of approximately 1% + 2% inflation target = 3%). This is approximately what the market is pricing for the terminal fed funds rate.
Powell’s comments indicated that the Fed may increase rates toward 3.50%, reinforcing the Fed’s “dot plot” prescription, which is 50 basis points higher than the 3.00% market consensus policy rate—meaning a tightening of 50 basis points for which asset prices need to reconcile.
Much of the adjustment in asset prices has come not from U.S. Treasuries but from riskier assets, namely equities that are adjusting to a higher discount rate (interest rate) for cashflows (earnings).
Mathematically, this has mechanical consequences, some of which are:
A rise in risk-free rate sets in motion this mechanical repricing of risky asset valuations.
Market price action today can be explained mathematically through the mechanics set in motion by a rise in risk-free rate expectations. Of course, this could trigger knock-on effects and an overshoot under the mechanical fair value—perhaps this is what we are seeing today. We are not diminishing this risk, but we see it as a temporary correction. Why? Because economic fundamentals remain strong, which to us are more important for medium- and long-term investment horizons.
An important observation to make is that U.S. Treasury yields barely moved as risky asset prices fell. It is the classic case of the U.S. Treasury market adjusting first, to be followed several days later by riskier assets. This is the cornerstone of our thesis behind this move in risky asset prices, which is that it is a rational and mechanical adjustment to higher risk free rate expectations.
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