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Sorry to all the stonkheads: Bonds are still boss. From Morgan Stanley’s equity team on Tuesday:
Bond Market Still in Charge . . . Over the past 6 months, interest rates have been the most important determinant of equity index performance, in our view. We see this continuing in the near term, and believe interest rate volatility is an important consideration for equity investors, particularly as economic forecasts have centered around a narrow range of outcomes. We also think it’s worth exploring the differences between how the bond market and the equity market price the future path of the fed funds rate.
This is, uh, not surprising, given all the inflation and the fast rate hikes and now the impending cuts and whatnot.
But this makes it important to dig into what exactly it means that fed funds futures are pricing in 150 basis points of cuts this year, and why fund managers surveyed by BofA are more convinced about imminent easing than they were in, uh, March 2020 and November 2008 . . .
For example, when Goldman Sachs said late last year that the amount of rate cuts priced into the fed funds futures market were unlikely to show up outside of a recession, does that mean the average bond fund manager or rates trader believes that a recession is coming in 2024?
No, the consensus really does seem to be that the US economy will have a “soft landing” with slowing growth and no economic downturn. Here’s a slide from a poll Goldman did of clients in London earlier this month, versus what they said last year.
But remember, if you’re managing exposure to global interest rates — whether as a giant corporation or a fund/wealth manager — you probably aren’t just picking your favoured scenario and putting a bunch of directional bets on it. (And hey, even if you’re a macro-hedge-fund punter, maybe you don’t feel alive unless you’re betting against the consensus.)
Morgan Stanley explains:
With the tight relationship between yields and valuations having been established over the past few years and having strengthened more recently, we think it’s worth considering the breadth of assumptions the bond market is making in terms of its forward pricing of rate cuts. While this aggregate pricing is easily observable, it tells us little about the probabilistic assumptions that underpin it.
In talking with bond investors about what’s priced, there appears to be a wide range of potential outcomes for this year rather than a narrow consensus view (as one might assume by looking at the Fed Funds futures curve). In other words, the forward curve reflects a more nuanced view of the future rather than a singular defined outcome.
It’s more a function of a probabilistic distribution of outcomes that have different implications for stocks. In contrast to bond market pricing, many forecasters appear to have centered around a more narrow outlook on GDP growth, inflation and unemployment for this year (see last week’s note for more). That forecast is also largely in line with what the Fed is expecting according to its economic projections.
Consensus has generally settled on the “soft landing” scenario: The labour market will cool down enough to slow inflation, but not enough to tip the US economy into recession, and as a result the Fed will only cautiously trim rates.
After all, the central bank focuses on real, inflation-adjusted rates and how restrictive they are. With inflation having cooled significantly over the past year, monetary policy has in practice tightened even with the Fed sitting on its hands. So they could cut rates just to “rightsize” the degree of tightness.
But there are also two other scenarios. If there’s a proper scary recession, the Fed will probably cut rates quickly, and by more than 150bp. And if inflation picks up significantly, investors might start to worry the Fed will keep tightening policy, or just keep it too tight for too long.
Markets aren’t pricing in any chance of higher rates, of course. This is because:
1) it seems unlikely that inflation will heat up enough to spur more hikes. Interest rates are now restrictive in real terms, and even a renewed uptick won’t change that.
2) if more hikes do start to look possible, investors are probably going to freak out and tighten financial conditions on the Fed’s behalf, the way they did during the sell-off in long-dated Treasuries last year, and
3) if companies and investors don’t tighten financial conditions for the Fed, the Fed has made it pretty clear it’ll raise rates until inflation is completely under control.
The latter two options, of course, lead to recession. And then steep rate cuts.
There’s no clear problem with the bond market pricing reflecting all of these potential outcomes.
In fact, options pricing indicates that bond investors are still prepared for volatility. While the go-to index measuring US interest-rate volatility (the MOVE Index) isn’t all that high compared to 2022 and 2023, it has settled at a higher baseline than we saw for most of the ZIRP era. So rates traders seem decently prepared for a bumpy ride:
For stocks, however, there could be a problem if investors are betting on a soft landing and 150bp of rate cuts this year. From Morgan Stanley again:
We wonder whether equities may be attributing too much weight to the aggregate pricing that the Fed Funds futures curve presents as opposed to thinking about the underlying set of probabilistic outcomes.
In other words, if there’s a full 150bp of cuts, there are probably going to be more than 150bp of cuts. And that’ll in be a recession, when investors in equities will have bigger problems than their faulty assumptions about rates.
