On the QT

When a subject is touchy, people will cautiously discuss it quietly -or on the 'q.t.'. Our friends at the U.S. Federal Reserve have been using a version of this strategy to silently paint the picture for a return to normal for the U.S. economy- whatever 'normal' means. Thankfully they have moved away from the rearview mirror approach exemplified by their now-defunct "transitory inflation" fairy tale. Powell and Co. have been badgered into reducing monetary accommodation more quickly by a chorus of voices led by Mohammed El Erian and others. It appears they got the message.

In past tightening cycles, upon realizing this change of policy, yield curves would steepen into the implications of such tightening. Not this time. The bond market seems to be marching to the beat of a different drummer. The Fed's intentions - which will be revealed more fully tomorrow, are seemingly being ignored by the long end of the Treasury market. A faster pace for the removal of asset purchases - tapering of QE - is likely to be unveiled after tomorrow's meeting. But the pandemic has thrown a major monkey wrench into the typical policy normalization scenario. In the chart below we see that the onset of the Omicron variant has coincided with a sudden drop in the ten-year yield. That has put up a serious roadblock to the path to a 'normal' yield curve.

U.S Ten Year Yield

The combination of a weakening global growth picture and highly desynchronized policy is now driving the bus on long rates. China is quickly easing monetary policy in response to its destabilizing real estate blow-up. Lockdowns and continuing QE policy support have depressed rates in the Eurozone. Japan is bumbling along as always as it continues its demographic death spiral. Non-China Asia has slowed, caught in the supply-chain cross-currents. The Fed's effort to steepen the curve has been thwarted by forces out of their control. Long U.S. rates, especially due to the rising currency, look increasingly appetizing to the huge global pool of yield-starved savers - thus tamping their normal path higher at this point in the cycle.

The secondary effect of this confounding situation is that it is helping to sustain asset prices. As a result of the low opportunity cost to risk-taking, the TINA bid to U.S. stocks is still in full swing, perversely keeping the illusion of calm. This despite transitioning to a rising rate environment and coming under counterattack by a pernicious new viral variant. Meantime, bonds also continue to keep their bid, despite the eroding effect of the highest inflation levels in 30 years. So what can the Fed do?

A different type of QT may perhaps apply here. 'Quantitative Tightening' is now looking like a viable policy option for the Fed, especially given the long end of the bond market is starving for yield. With a $4+ Trillion balance sheet, they have the flexibility not just to cease their QE purchases over the next year, but to actually sell down their position. While unprecedented, it is more likely now that their rate-hiking 'wiggle room' has quickly evaporated due to the overwhelming global demand for safe assets that have any kind of yield. And with bonds 'expensive' relative to inflation, it would be only prudent to help normalize rates at the long end of the curve in that same fashion as they artificially lowered them during the height of the pandemic.

Will they do it? Hard to say with any conviction. This morning there is an op-ed penned by a former uber-dove at the Fed, Narayana Kocherlakota, who is arguing that current Fed policy risks a '70s style' inflationary spiral. He is arguing for a stronger response to the still-nascent inflationary forces. Talk about a turnaround! Is this a trial balloon from the Fed? Could it be 2018 all over again? The market won't like that.

And it would seem, at least in the short run, that this 'come to Jesus' moment is both overwrought and ill-timed given the growth-sapping effects of Omicron and a suddenly sharp deceleration in the commodity boom. Both oil and copper peaked six weeks ago and I take their 'leading indicator' status quite seriously as to growth forecasts. Other leading indicators (ECRI) have come down sharply as well. The renewed supremacy of Growth over Value stocks since October would seem to argue for a weakening cyclical impulse. Airline stocks - always a real-time cyclical indicator - have been viciously grounded this month. The risk of a dangerously flat or inverted curve next year is much higher than many investors want to believe.

Maybe the market has it right at the long end, that quickening the pace of taper and advancing the schedule of short rate hikes will short circuit the inflation spiral, quelling long-term inflationary expectations. I see the more likely risk that they are tightening into an already peaking global economy fraught with downside risks, potentially causing a growth slowdown in the back-end of 2022. Maybe that's the message of the long end. Have we seen the peak reopening trade already?

Whatever the message, this tightening cycle will challenge the Fed more than any other prior episode. Their mandate focussing solely on the U.S. economy is increasingly at odds with the reality of their status as the de facto global reserve currency. As I have argued before, simultaneously managing domestic policy imperatives in an increasingly complex global context is a fool's errand. They have lost control of the yield curve. They may have to resort to selling bonds in order to regain it.

I'll bet Powell is saying the same thing - on the q.t.

Risk Model: 2/5 - Risk Off

The model's reluctance to chase this market is notable. The elevated volatility - VXV - combined with a weak Cu/Au reading reflects the current angst over the morphing pandemic and its effect on growth expectations. Short of a surprise dovish pivot by the Fed or really good news on the pandemic, I don't see that narrative changing. The S&P 500 has been advancing on the back of fewer stocks as Apple dominated the news by approaching $3Tn in market cap. The general seems to have left his troops behind given the chart below of the 6 week average of advances minus declines. Not a healthy market as we head into the tax-loss selling season. For those expecting a year-end rally, Santa may be stuck in quarantine this year.

NYSE Advance-Decline Line