Authored by Peter Tchir via Academy Securities, As we head into Wednesday’s Fed decision, I am not sure how a ‘data dependent’ Fed hikes. Or at least not one with a modicum of self-doubt about whether hiking rates AND shrinking the balance sheet might have more of a toxic effect than previously thought. When Did Balance Sheet Reduction Not Count as a Rate Hike? Before balance sheet reduction many people at the Fed and a lot of Wall Street analysts argued that $X amount of balance sheet reduction was equal to Y in terms of basis points worth of rate hikes. There wasn’t clear agreement on what Y was for any given amount of $X but there was widespread agreement that Y was greater than zero. Yet, the current Fed either forgot about it our is willfully choosing to ignore it. Mario Draghi, who has done more with less than any other central banker, seemed to admonish the Fed, when just last week, at his press conference he mentioned how helpful QE had been. If QE was helpful, then QT must be harmful. Seems like common sense. Seems like the Fed at one time believed it. Seems like Wall Street believed that too, before being cajoled by the Fed to just look at the dots (the dots, where one of the 16 esteemed people privileged to submit dots thought 2.125% by the end of 2019 was appropriate and another one of them thought 3.625% would be appropriate- hardly inspiring confidence from my perspective). Fed Balance Sheet versus S&P 500 Stocks were able to rally from 2016 to 2017 without balance sheet growth, but there certainly seems to be some indication that the S&P did well when the Fed was growing their balance sheet, stalled for a period and even had some drawdowns when the Fed was maintaining the balance sheet and seems to have had increased volatility now that the Fed is shrinking the balance sheet (they started the year reducing up to $20 billion a month, they are up to as much as $50 billion per month depending on what is maturing). Is that the most compelling chart of all time? Certainly not. Is it compelling enough to at least give some pause to shrinking the balance sheet? To make a rational person think that maybe, just maybe, QE helped on the asset inflation side of things and that it is hurting now that we have shifted to QT? You Can Boil a Frog – But Only if You Do it Slowly I’m not sure whether it is true or not, but there seem to be stories suggesting that you can boil a frog and it won’t jump out of the water, so long as the heat increases are gradual. Nothing Gradual About the Rise in 2-Year Treasury Yields For 4 years, the 2-year treasury yields went from 0.25% (virtually zero) to 0.5% (almost zero). Then it took almost 2 years for the yield to climb to 1.25% (not zero). Then it took less than a year yields to climb to 2.75% (definitely NOT zero). If even a frog is smart enough to jump out of the pot when the heat gets turned up too quickly, you would think some investors and managers would do the same thing? Rising front end yields have two impacts on markets and the economy They give investors alternatives and allow investors to de-risk to achieve similar stated returns. That is an ongoing process and one, that over time is natural, but if rushed causes problems like we see lately. They cause companies to pay more for debt as it rolls over, which hurts earnings as higher interest costs should come directly out of profit margins. It seems to be hurting auto sales and housing sales as well. Higher rates can be fine, but I think a gradual process would make more sense. Powell Might Not Have an Equity Put – But He Better Have a Credit Put I really don’t care that much what Powell lets happen to the stock market, but he better pay attention to what is going on in the credit market. In February, VIX was exploding, equities were being hit but credit markets were pretty stable. Comcast was able to price a deal on top of where they’d priced in the past 6 months. The credit markets were quite tame in February, relative to equities. Credit widened coming into June as supply took its toll (I can’t help but think that issuing more T-bills than ever before and the Fed shrinking its balance sheet also added to the pain). Credit is clearly at the forefront of concerns. LIBOR vs OIS is back above 41. The Bloomberg corporate bond OAS is at 141, a level it saw back in 2016 as it was tightening from the energy/CoCo problems of late 2015 and early 2016. The last time it hit 141 on the way up was the middle of 2015. I’m not sure it is a central banker’s role to worry about stock market valuations (though they seem to have cared since Greenspan initiated the Fed Put), but they certainly should care about credit markets and those need to be functioning smoothly and there are an increasing number of signals that the credit markets are not cohesive right now (the problems with loan only borrowers in the leveraged loan market are suddenly coming home to roost with BKLN (lev loan etf) down much more than HYG/JNK (high yield) in the past 1 month and even in the past 3 months. The leveraged loan market is something we’ve warned about and so has the Fed, so the problems are real, but let’s not force the issue too quickly. Exactly What ‘Data’ Is the Data Dependent Fed Looking At? I’ll ignore the inversion we’ve had recently and just highlight one simple chart. Inflation Expectations (which the Fed should care about) Are Plummeting The Fed’s own 5 year forward breakeven has dropped like a stone since October. After almost a year of sitting comfortably above the 2% mark, it is now below 1.95% and falling. Yes, maybe the 16 people who can’t submit dots even close to each other know better than the markets, but I think the market has analyzed the data and decided it sucks. I’m betting on the market. Rates versus Balance Sheet I have no idea why the Fed can’t just say – hey, conditions have changed, we are going to not hike and slow the balance sheet shrinkage and maintain a larger balance sheet than previously thought. The instant reaction will likely be driven by what they say and do on rates. The more important reaction could be tied to what they do and say on the balance sheet and QT. I hope the Fed doesn’t cut off its nose to spite its face because Not hiking isn’t giving into Trump, it is giving into rational thought and changes in the data and credit markets Not hiking isn’t a sign that the Fed sees something worse than what the market already sees – the market is seeing some grim stuff The Fed may want to have more room to cut rates in the future, but it might be better if they don’t push so far and so fast that we need those cuts at all Powell is not an economist, maybe he will see what so many business people see so clearly, but until then we wait on the wisdom of the 16 sages (or at least the voting members). Is this what Romans felt like waiting for the priests to determine the signs from the entrails of a lamb? Sadly, that is beginning to make as much sense to me as watching the shenanigans at the Fed.