It may come as a surprise to you, but quants like bedtime stories. Our favorites include “Mary had a lamb whose size did not imply higher expected returns,” and “the little risk premium that could.” We build our signals with economic intuition, which is very much akin to storytelling, but we’re aware that stories about markets can be taken too far. When someone tells us what the market is thinking or saying, it just sounds silly. Markets don’t think! They exist solely to connect sellers and buyers. This philosophy saves us the headache of trying to make sense of random short-term market moves, but sometimes even the most scientific and dispassionate of us can’t help but try to read the market’s mind. Right now markets seem to be asking us to put aside the equations for a minute and just listen.
At the end of last year, markets were very cranky. Stocks had just put in their worst year since the financial crisis and bonds were strong. Short-term interest rate markets had gone from pricing in rate hikes to expecting rate cuts. The dollar and some of the other safe-haven currencies had been outperforming. It was a classic “risk-off” move. An observer could easily conclude that the market was worried about the prospect of a recession and the trade conflict between the U.S. and China. The market seemed to be saying that the Fed was in the process of making a policy error, which would result in a bad economic outcome.
This year markets are in a better mood. Stocks are up sharply while credit spreads have narrowed and volatility is low. Recession fears have subsided but markets are not in full risk-on mode. In fact, bond yields are lower than they were at the end of December. This is unusual, because bond yields usually rise when other markets price in a strong economy. It’s difficult to imagine the Fed cutting rates with stocks near all-time highs and growth around 3%. 1 1 Close As of Q1 2019, U.S. GDP grew 3.2% YoY. Source: Bureau of Economic Analysis. It seems like fixed income markets aren’t thinking very clearly. 2 2 Close Meanwhile, currency markets have had very low volatility this year and few sustained trends. They are saying “we have no idea what’s going on.”
A closer look at the bond market reveals that low yields may not indicate a high probability of a recession. Fed funds futures are pricing almost a full cut by the end of 2019 and then at least another in 2020, but not much after that. 3 3 Close Source: Bloomberg. , 4 4 Close Markets tend to price rate stability two years out – it’s very difficult to know when cycles will turn, so they just kind of price a long-term average. Currently the market expects a very low long-term average. Markets are saying that a few rate cuts will solve whatever problems exist. Unlike in many past cycles, the Fed did not raise rates too much and has the tools to prevent a material slowdown. Fixed income is expressing a lot of confidence in the Fed. The Fed should be flattered by what the market currently thinks of it.
On the other hand, inflation should be offended by the market. TIPS breakevens are pricing inflation to average below 2% for the next 10 years. 5 5 Close As of the close on May 1, 2019, TIPS breakevens were pricing inflation to average 1.91% over the next 10 years. Worth noting, TIPS breakevens are benchmarked to CPI, which tends to be higher than PCE (the Fed’s target). Source: Bloomberg. That is the equivalent of calling inflation a feeble shadow of what it once was. This helps explain why the Fed may have room to cut rates. The Fed targets 2% inflation in the long run, and if Fed members think there is a risk of falling too far below that level, they might consider easing policy. 6 6 Close The Fed has a dual mandate, targeting 2% PCE inflation and maximum employment. The Fed could act, even if the economy is growing at a decent pace. Long term, low inflation may also explain why the yield curve is so flat while some other markets seem unconcerned about recession. The low 10-year Treasury yield may simply reflect less compensation for inflation risk than in past cycles rather than saying anything about future growth.
This soft-landing scenario of rate cuts without recession is not unprecedented, and some investors may be reminded of the mid-1990s. 7 7 Close Fed Chairman Powell was even asked about it in the press conference on Wednesday. The Fed also cut in the mid 1980s without threat of recession, but conditions were very different. In 1994, the Fed hiked aggressively into a booming economy. Stocks bounced up and down; growth slowed, but there was no recession. Many economists had feared inflation would get out of control, but it stayed at levels that, at the time, were considered moderate. 8 8 Close What passed for moderate inflation back then was much higher than today. Sort of like civil discourse. In 1995, influenced by difficulties in Mexico, the Fed reversed course and cut rates. 9 9 Close The Fed has always been influenced by global or regional events. Stocks reacted with one of their strongest runs of the past hundred years. In retrospect, some people have even gone so far as to call what followed a “tech bubble.”
While the current situation has some obvious similarities to that period, there are also differences. The recession was not nearly as deep in 1992 as it was in 2008, and the Fed started hiking much earlier in the cycle in 1994 than it has this time. Growth in the economy was much stronger then and rates were nowhere near the zero lower bound. There was no talk of secular stagnation or a falling neutral rate. Market multiples in late 1994 would look quite attractive by current standards.
To sum up, the market may be saying that the economy is doing fine, but because inflation is low the Fed may cut rates a couple of times. This can be good for equities and credit because the combination of low rates and solid growth can help earnings. Before you get too excited, there are many ways that things could get in the way of a happily ever after. Inflation could go up. Investors could suddenly realize that it’s not 1995. More importantly, we quants are required to remind you that stories about markets are only stories. 10 10 Close If we didn’t, we’d have to change the A in our name from “Applied” to “Almost.” Market prices reflect probabilities of multiple events and not any one outcome. Markets are mechanisms for displacing risk and allocating capital, not for weaving narratives. Ok, we’ll stop the quantsplaining and tell another one of our bedtime stories: stay diversified. The end.
There will be no Wrap-Up next week. We'll be back the week after. The end (again).
What We Are Watching
Australia Central Bank Meeting (Tuesday) and New Zealand Central Bank Meeting (Wednesday) Both Australia and New Zealand will feature potentially eventful central bank meetings this week. In both countries, inflation has been low in recent years, but policymakers have kept interest rates steady due to strong labor market conditions and positive growth. 11 11 Close Of course, it is not a coincidence that the two countries are in a similar economic situation. Not only are there strong direct trade linkages between them, but both countries are also large natural resource exporters that have grown increasingly sensitive to Chinese commodity demand in the last decade. However, growth data in both economies has been softer lately, and central bankers are contemplating rate cuts. In Australia, recently released CPI data for the first quarter came in well below consensus forecasts, and the domestic housing market is cooling. Short-term interest rate futures now price a greater-than-even chance of a rate cut when the RBA meets on Tuesday. Markets also price high odds of a cut in New Zealand. The last RBNZ statement was clearly dovish, declaring that “the more likely direction of our next OCR move is down.” 12 12 Close RBNZ Statement, 3/27/2019. Since that time, CPI and employment data have both delivered negative surprises, seemingly cementing the case for easing. Complicating matters somewhat, this will be the first RBNZ meeting at which policy is set by a newly-formed Monetary Policy Committee (MPC) and the new appointees may not be in a rush to shift policy at their first meeting. 13 13 Close Prior to this, policy decisions in New Zealand were entirely up to the RBNZ Governor, an unusual arrangement by international standards.
China Trade (Wednesday)
Chinese growth has slowed over the last year, but a number of data series showed improvement in March. However, it can be difficult to separate signal from noise in Chinese data releases in the first quarter, as year to year changes in the timing of the Lunar New Year can have a large impact on monthly figures. Discouragingly, PMI data for April reversed some of the bound seen in March. Trade data for April will be watched closely to see whether the economy has truly begun to improve. In particular, market participants will be looking for a rebound in import growth, as weakness in this area has painted a troubling picture of Chinese demand.
U.S. CPI (Friday) Core CPI inflation, which excludes the direct impact of changes in food and energy prices, accelerated in early 2018, rising from 1.8% at the start of the year to a peak of 2.4% in July. The possibility that a tighter labor market was finally generating inflationary pressure contributed to the hawkish tone of Fed policy last year. In recent months, however, inflation readings have cooled down once again, with Core CPI up only 2% YoY in March. Some of the slowdown has been driven by volatile components, such as financial services and apparel (where there has also been a recent methodological change), so could reverse in the months ahead. However, if inflation continues to decelerate, it could convince the Fed to consider lowering interest rates. Consequently, lower than expected CPI data could be positive for equities and bonds and negative for the U.S. dollar.