Friday 9 August 2019

Drug Addiction & the Stock-Bond Feedback Loop

Over the past month, the bond market has seesawed between paroxysmal rallies & emetic sell-offs. In between, however, an overall placid composure has taken hold: arguably due less to complacence & more to trauma as investors prepare for the next bout of volatility. While there's little disagreement about the role that policymakers have played, what's fascinating is the degree to which so much of the recovery in risk assets is due solely to the promise of more imminent easing, as opposed to any improving fundamental picture. It's an addiction - and the time for intervention is long gone.

Let's be clear on one thing: the equity market has only managed meaningful recoveries when the odds of Fed easing are on the rise. Not the other way around. 

Drug addiction teaches us that, particularly in cases involving an excessive amount of stimulant, the brain releases dopamine in excess. That, in turn, causes a feedback loop to develop: mu receptors (a class of opioid receptors) are over-excited, causing them to shut down dopamine production. The physical response is withdrawal, leading to more & more stimulus required for a release of dopamine. This dysphoria is what causes addicts to seek out more of the drug, in a vain search for that initial "high".

Here's a chart showing the percentage of time we've spent at various degrees of additional implied easing for the September FOMC, over the last month - once a full cut was priced for the July FOMC.

% of time spent at various degrees of easing expected at the September FOMC
Note that the shape of the distribution shows really 2 key "humps". One small hump between 30-35bps (i.e. slightly more than one 25bp cut), and one much larger hump between 20-25bps (i.e. slightly less than one 25bp cut). Currently, we're sitting at 32bps, meaning that the market is pricing in a little more than one 25bp cut in September.

Meanwhile, the December FOMC doesn't look too dissimilar. We've spent the majority of the time pricing two outcomes for the Fed: one where they ease by just under 50bps, one where they ease just under 75bps. 

% of time spent at various degrees of easing expected at the December FOMC
What's concerning, however, is what these charts look like when you overlay the distribution of "what's priced in" for the FOMC & equity market returns. 

See below: cumulative SPX returns vs "what's priced in" for the September FOMC.

Histogram of cumulative SPX returns over the last month at various degrees of easing expected at the Sep FOMC.
In other words, the majority of positive SPX returns have taken place when the promise of central bank easing is on the rise. Not the reverse. In fact, since we're now priced for MORE than 25bps of easing at the September FOMC, this means that the Fed is being pushed towards an outcome where they have to deliver 50bps - in order to keep equity markets on the rise. 

If not, then the realistic best case scenario is that stocks sell-off & then the Fed is pushed again towards promising more easing (one can easily envision a scenario where QE4 is unveiled as a response) in December. In that sense, equity markets are rooting for yields to continue to head lower. When they stop heading lower or reverse altogether as investors contemplate the reality of what negative yields mean, that's the proverbial Minsky moment for equities. 

Bottom line: without another "hit", the equity market doesn't have a lot of positive news to look forward to. And that's a bad thing for independent central banks. 

Sources: Bloomberg. Pricing uses active Federal Funds futures contracts, as of 8/8/19.