Economics and Strategy
Expensive + Expensive = Cheap
— David Zervos, Chief Market Strategist
This past August was one of the least eventful for financial markets in modern history. The S&P went nowhere while front end rates rallied a meager 20bps. Jackson Hole was a dud. The economic data came through largely as expected. And there were no meaningful political accomplishments from the new administration.
We see two main drivers going forward for a ‘spoos and blues’ trading structure (‘Spoos + Blues’ is a long S&P position hedged with 4-year forward Eurodollar interest rate futures):
A positive supply shock induced by deregulation, which will continue to keep growth and employment strong while inflation wanes
The wind-down of a potentially Machiavellian Yellen Fed, and the rise of a market-backstopping Trump Fed
It’s the latter point which became crucial to our reengagement in ‘spoos and blues’ earlier this summer. Recall that in Janet Yellen’s June press conference, and then again in her July semiannual congressional testimony, she backed away from the word transitory when describing the consistently low inflation prints from the first half of the year. Up to that point she had tried to dismiss this weakness so as to continue with a stepped-up accommodation removal process (a posture that I have maintained had a strong political motivation). And to be sure, she was quite hawkish for the first half of 2017. Post-election Janet raised rates in December, March, and June. Further, she brought expectations for the balance sheet normalization process into 2017, when most folks had thought it would kick off in 2018. Nonetheless, by the middle of this year there was nowhere for Janet to hide – she had to give up her hawkishness given the inflation data.
Janet’s retrenchment signaled the end of political risks associated with a Machiavellian Fed – risks that had kept us out of both spoos and blues since the election. In essence our "Lil’ Janet" found herself handcuffed by the data. And that opened up a beautiful entry back into risk parity. Now you may look forward and ask why the upcoming Trump Fed will be so positive for risk parity? Some are forecasting that monetary purists such as John Taylor, Kevin Warsh, or Glen Hubbard will get the chair, and that would surely create a rocky road for spoos and blues. I however am betting against these folks. I believe Cohn was floated for a very specific reason. He is not an academic economist, and he has no strong monetary policy doctrine. If Trump and his advisors are clever, they will stick with someone just like that. They don't need a QE-hating, Taylor rule-following, rate-normalizing academic type in the seat. They need a street-smart banker who will make sure that financial markets are backstopped into the 2018 midterm elections and beyond. They need a political operative with little, or preferably no, monetary policy doctrine.
To this point it should not be lost on anyone that Trump is old enough to remember the extraordinary public battles between LBJ and Bill Martin in the 1960s. The last thing Trump wants is an independent and uncooperative FOMC like LBJ had on his hands. And while Cohn may have blown his chances at the job, there are plenty of other Cohn-like figures who fit the political parameters. Mnuchin could take it. Or any one of a number of former or current bank CEOs could be in the mix. In that sense I see no reason for folks to get bent out of shape if Cohn is discarded. The key point is that Trump will appoint someone (actually a set of people) who will help him further his political agenda. This of course requires backstopping financial markets, not ranting about monetary policy purity.
In the end this new Fed will not be fighting some ghost of inflation, nor will it whine about balance sheet size or overly accommodative monetary policy. Of course, if the economy and markets are doing well, this new guard will raise rates a few more times and wind the balance sheet down, but there will be no Bill Martin types who act preemptively against inflation risks. Further, and more importantly for risk parity trades, if markets wobble and Trump's economic record starts to erode, they will quickly backstop and juice the markets whether inflation risks are elevated or not. The Trump Fed structure, along with a strong positive supply shock from deregulation, is about as good as it gets for risk parity. It is the perfect backdrop for spoos and blues.
I must say though, I did have many folks push back on this view over the summer by claiming that both equities and bonds look expensive. They ask, how can I essentially be a buyer of both? My response to that is simple. While on their own each asset class may show some hints of expensiveness, together, with their natural dual-hedging properties you get an "expensive + expensive = cheap" outcome. Remember, spoos and blues is really just a bet on the Fed reaction function, and when Trump won, there was a real risk Janet would NOT backstop him in the event of a hiccup. There was also a material risk she would try to become a spanner in the works. The reaction function thus became blurred. But as stated above, earlier this summer Janet’s power to disrupt was usurped by the data—and now her time is up. A new set of sheriffs are coming to town, and they are not the sort to take the Jell-O shots away or act as a thorn in the administration's side. They are the ones who will be serving Billionaire Martinis upon any sign of market adversity.