Fed rates - Where are we now?

Chad Slater

Ellerston Capital

There was a brief period when “Faded (Where are we now)” topped the charts recently and we thought it would be an apt title for this week’s blog.

Late last year, our Head of Macro and Risk did an excellent piece looking at how markets behave once the Federal Reserve goes on pause after a rate hiking cycle, the key findings being the equity market usually rallies, interest rates fall, and economic data slows.

Figure 1 – S&P Performance after Fed Pauses

Source: Bloomberg, Team Analysis

So far, about right ... that is up to about late April. That playbook worked – indeed it worked far better than we even thought it would, with Morphic throwing in its bullishness earlier than we should have.

But May has seen a marked change of sentiment. US 10-year yields have plunged to lows and markets are now pricing in a rate cut by year end, with a 30-40% chance of two cuts (Figure 2) or more.

Figure 2 – Market-implied probability of FED Funds rate cuts

Source: Bloomberg, Team Analysis

Emerging Markets have started to underperform dramatically, having largely tracked developed markets during the first quarter.

The other somewhat alarming anomaly of note is the persistent strength of the US dollar. With the US being the only strong economy last year raising rates, USD strength could be explained by interest rate differentials. The “Fed Pivot” and removal of rate hikes to be replaced by cuts has done nothing to slow “King Dollar”. A strong dollar makes it harder for liquidity conditions outside the US, putting pressure on everything from industrial commodities to equities.

So what to make out of all this?

Returning to last year’s playbook, the weakness in data was to be expected to some degree. What is disconcerting is that forward indicators such as the Purchasing Managers Index (PMI) for May continues to decelerate.

Figure 3 – Manufacturing Purchasing Manager Indices

Source: Minack Advisors

How much is due to tariffs impacting confidence is hard to know because at the moment there is a spread between what companies are saying – the PMI – and what they are doing – jobs data, as they continue to hire staff, pay more and with no job layoffs.

Secondly, Non-Executive Director of Morphic and strategist Gerard Minack, points out that the US has never been pulled into a recession by falling exports since the US usually runs a trade deficit (they import more than they export) and also a relatively small portion of the economy is based on external trade compared to other countries.

Figure 4 – Net export contribution to GDP Growth

Source: Minack Advisors

As such, with people getting jobs and pay increases, it is hard for the US economy to “spontaneously combust”.

From here we see two playbooks:

  • 2007/1999/1990 scenario: This is somewhat straightforward. The Federal Reserve has overtightened; the yield curve inverting was the signal and by 2020 the US will be in recession. Sell equities, sell credit, buy bonds and bunker down.
  • 1995 scenario: There is a less common outcome after the Federal Reserve pauses, they pull off a “soft landing”. In this case, interest rates were cut a little and the economy stayed on track for another four years before the dot com collapse of 2000. Those years were feast and famine – the mother of all equity bubbles in the USA whilst also blowing apart Asian economies in the Asian Crisis.

So, if we assume the market is correct and the Federal Reserve does cut rates this year or early next year, that is a pretty large range of outcomes.

What should we watch to know which way things go? We would nominate three things:

  1. The aforementioned PMIs: if the US PMIs show no sign of bottoming by September and print around 47, the recession outcome is the most likely.
  2. Initial claims data: the US releases weekly data on newly laid-off workers. Whilst on any given week the signal is weak, if the average over a month starts to rise, it is a good indicator that jobs data will slow next.
  3. Credit Spreads: it is often said that “bonds lead you into recession and equities lead you out”. Widening credit spread data would contradict rallying equities and should be watched in conjunction with the above hard data.

These are all conditions to watch – but having said that, early 2016 had a lot in common with the above and the markets recovered.

For now, Morphic has been building individual short positions in stocks to the point where we have more short stocks than longs for the first time since we launched, rather than a dramatic raising of cash levels which were raised modestly over the month.

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Chad Slater
Chad Slater
Co Head Global Equities (ex-Asia)
Ellerston Capital

Chad co-founded Morphic Asset Management in 2012. As a stock picker Chad is also a generalist but has strong regional knowledge of Europe and the Americas. He has also been awarded the CFA Charter.

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