The events of the past week have made me think that the markets are severely underpricing the risk of additional tightening in the coming ~18 months, regardless of who the President is.
- People saw the Brexit spike was to be faded. It’s the age of the stop-inducing algo. We got another taste of it in GBP just last month. If you can’t hold on to it (and add) in thin markets, it will be taken away. But markets adjust. So part of the recent move lower in equities and yields is in anticipation of an extreme move that needs to be added to. I do not think we see a similar move this time around because there should be more ammo on the sidelines.
- The hurdle for two hikes next year is very low. I realize after the Dec 2015 hike, where the Fed predicted 4 hikes in the following year, their credibility is shot. But the Fed has also learned from their mistakes. The Fed also adjusts. The thing with economists is that they always tweak their models to fit the past data. They know they predicted 4 hikes and only got 1. Two hikes to seems like a reasonable hurdle (my over/under is 1.5 hikes).
- The growth and inflation data are better. The hurdle for additional hikes is not very high: 2% GDP and 2% inflation. Q4 GDP is starting to look firm, or at least not as bad as a month ago.
- The wage data is better. We are starting to get wage inflation, which is what the FOMC have been looking for. We have additional increases in the minimum wage on several state ballots this year. Furman and Kreuger had an interesting WSJ op-ed on how the non-complete clauses could be depressing wages. The authors have the ear of the White House, and the current status quo on wage restraint may not hold.
- I think we could get a post-election bounce in activity. Since the candidates are so different, companies (and people) may have been holding off on investments until the future was clear. We may have seen this in the UK post-the-Brexit-vote, and that may have been one of the reasons the UK data has improved.
- Article 50 next year is not going to be the panic fixed income buy that everyone thinks it is. We all saw that the intraday spike in rates was a great spike to sell into. The UK has actually done better since the vote. The gods surely are smiling on Carney as they have everything a central bank could want – growth, inflation and lower exchange rate (for now). Having to go through Parliament probably is going to require a softer Brexit.
- China looks better. Lost in the US headlines was the fact that China looks to be emerging from its slumber. If you need evidence, just look at commodity prices. I’m not saying there isn’t downside (well, okay… I have been saying for a while now that the China downside is overstated), but if that engine gets picked up again, the US downside to growth and inflation starts fading.
I’m not saying that everything is rosy – I’m just saying Z6Z7 < 15 (traded down to 14 Friday) could offer good value on a dip. My only “concern” would be an equity meltdown. FANG stocks are looking a little more toothless recently and there may be something more to the equity selloff than the elections. But after having the fixed income bulls run wild for most of the year, there could be some reasons for cautious (front-end) bearishness from the current levels. And this is the reason for Trade F33. Watch for it shortly.