The dovish course correction (ish)
Frequent readers may recall that I’ve been using a Three Phases model to guide macro views and positioning for most of 2018, and that is continuing now. However, I’ve made a significant change to my expected price action in the later stages of this macro evolution, specifically in Phase 3. A few weeks ago, I suggested that the events of October kicked off a Three Phases cycle in miniature, which would culminate in Phase 3-type price action once the Fed responded to tighter financial conditions with a “dovish course correction.” Well, what has transpired since then should constitute such a shift. Now that it’s happened though, I found myself modifying the expected Phase 3 price action for reasons I’ll discuss. The change partially reflects some lingering uncertainty about whether the rhetorical shift in the Fed’s language is actually “enough” of a dovish lean to truly open up Phase 3. According to the roadmap I’ve described all year, such a dovish lean into tight financial conditions should be cause for a significant relief rally in risk assets, and a material rise in long term interest rates as risk aversion abates. At this point though, I no longer think Phase 3 results in much of a rise in rates.
First, the course correction: in the week of November 12th, Richard Clarida, Raphael Bostic, Patrick Harker, and Chairman Jerome Powell all had on-the-record comments which signaled a pause or take-it-slow approach to further rate hikes, and that the committee was shifting to data dependency for further tightening. The various comments also re-injected some precision to their estimates of the neutral rate, in contrast to October’s speeches which effectively blurred the committee’s estimates. Then of course, last Wednesday Chairman Powell said the policy rate was currently “just below the broad range of estimates of the level that would be neutral for the economy.” That comment was pretty clearly intended to walk back his “we’re a long way from neutral” soundbite from October 3rd.
If following the Three Phases playbook, which has served as a reliable anchor for our macro-driven views all year, one should respond to dovishness by keeping or adding to risk assets, and reducing duration exposure. I felt compelled to call a bit of an audible though, and continue to favor duration. My reasoning was as follows:
- The October comments which kicked off the Three Phases in miniature did the most harm by raising and obfuscating the Fed’s estimates of the neutral rate – and by extension, the terminal rate on this tightening cycle. Reversing this, through acknowledging the impact on the economy of the policy tightening which has already occurred, should lower the expected neutral rate and terminal rate, which in turn should put downward pressure on long term yields.
- I believe the appropriate neutral rate (especially in the near-term) ought to be conditional on continued Quantitative Tightening, which should result in a neutral rate that is lower than it otherwise would be without QT. The dovish course correction represents a Fed acknowledgement of this idea, while at the same time suggesting nothing about slowing down QT.
- In a regime where Fed officials do not react to negative market developments, and instead telegraph an intent to press ahead on a rigid tightening path, yields can’t decline that much in the long end in the absence of clear policy-error evidence (which was absent). But once the Fed shifts to data dependency and away from policy rigidity, this allows yields to decline and for duration to once again function well as a risk-reducing diversifier in a portfolio. Additionally, the dovish shift was not so dramatic or ill-timed as to look inappropriate from a policy perspective, which kept breakeven inflation rates from exploding higher (in fact they shrank).
- Perhaps most importantly, I’m not convinced that the rhetorical shift is truly sufficient to result in a durable risk-on. I continue to believe that liquidity drain is the most important medium-term driver of markets from here, and there is still no hint in the Fed’s communications that they acknowledge this particular angle. So, in other words, there’s a risk that markets are still in Phase 2, in which duration is helpful to portfolios.
For these reasons, I have cautiously continued to hold duration and to deviate from the Three Phases model’s original prescription for Phase 3 positioning. A bit of a hedge though: very recent price action in rates looks grabby, as if a capitulation is occurring toward the ideas I’ve presented here or something similar. That’s a reason to be patient on entry level, even though I think generally these ideas still apply.