US Rates Strategy: The Canary in the Coal Mine?

Research evidence excerpt

US Rates Strategy: The Canary in the Coal Mine?

IdeaMThese are aggregated based on their estimated growth elasticities relative to the federal

funds rate, using the Federal Reserve’s FRB/US model.

As a result, the index can be interpreted as the equivalent change in the federal funds rate,

expressed in basis points, required to generate a similar effect on economic activity.

• Since the onset of the Iran conflict, through June 11, financial conditions have

tightened in a manner that is equivalent to a 31bp rise in the federal funds rate.

A decomposition of the five variables shows that the net tightening in financial conditions

has mainly been driven by higher 10-year US yields and appreciation in the USD.

• This should be of little surprise to most investors with the repricing in the market-

implied path of Fed policy (for more, see Beware of the Sirens' Song).

Despite the fact that financial conditions have already tightened in a manner equivalent to

more than a 25bp hike in the fed funds rate, most investors continue to see risky asset

appreciation as an indication that financial conditions are still too "easy."

• Indeed, since the onset of the Iran conflict, the contribution of S&P 500 returns

has, on net, eased financial conditions by 21bp, as of June 11 (see Exhibit 12 ).

Index level advances – albeit from concentrated sectors – have been a powerful

temptation for investors to avoid looking at the technicals propelling the market under

the surface.

• The squeeze in financing costs, increased reliance on leverage, and narrow market

leadership could be ingredients for a rude awakening from the Siren's song.

Investors may then conceivably lose conviction in the consensus optimistic outlook for the

US economy as well as their expectations for growth.