Markets Cannot Agree To Disagree Once Warsh Stops Subsidizing Term Yields

MARKETS CANNOT AGREE TO DISAGREE ONCE WARSH STOPS SUBSIDIZING TERM YIELDS Steven Blitz

The views expressed here may not reflect the GlobalData TS Lombard House View

◼ Aumann's Agreement theorem says agreeing to disagree is impossible when base beliefs are common knowledge and then there is new evidence ◼ Absent fiscal austerity, lower inflation with low private sector leverage comes from letting real term yields rise to reprice risk markets, not hiking short-term interest rates ◼ Ending the subsidy on term yields will quickly get market participants to agreement that equities are too rich -- price correlations converge and equity markets fall ◼ Warsh's will get his way -- the vote count says so. His way is contingent on the equity market Letting interest rate markets decide where rates should be, thereby communicating to the Fed which way the economy is leaning, is laudable but unlikely. The decision-making process would iterate towards higher real term premiums because fiscal expansion and rising CAPEX increase the need for foreign capital -- capital that will want greater concessions to hold more paper (buying Yen?). Reducing the Fed’s yield subsidy consequently shifts market participants towards agreement on market valuations (too high). In turn, price correlations broaden (the hallmark of a down market). Warsh is as unwilling as any Fed Chair (save for Volcker) to kick off a bear market in equities. Equity market performance will consequently get in the way of “good” monetary policy. Inflation is a choice, but so too is growth, and everyone leans in favour of growth. What we are left with are task forces to underpin Warsh’s desire to reduce the Fed’s role and Warsh continuing his “tough guy” talk on inflation, but without the willingness to force a reset of distorted market prices.

Between now and yearend, inflation abates some, profits keep employment growth apace, and Warsh keeps the FOMC on ice. Other than the three dissenters, who exactly is going to publicly add themselves to that list? Powell? Cook? Barr? Williams? Bowman? Waller? These six plus Warsh makes it a 7-5 lock favouring Warsh. We can stop handwringing over the votes; Warsh will be in the majority for whatever he wants to do. The implication? Over time, looking past the ups and downs tied to the latest moves in the Persian Gulf, a steeper yield curve, higher inflation, and term yields eventually reaching levels that hurt the equity market because of compensatory returns. This is the lightbulb that goes on for market participants that gets enough to agreement that selling is better than buying.

The equity market, as I have written, is the critical determinant of coming Fed action and/or inaction. There is some disagreement among market participants as to whether the market is too rich, given the surge in profits. The still-room-to-run crowd has, in turn, been calling out excess CAPE yield as a false god for predicting long-term market returns. Fair enough based on the past 15 years or so. I argue, however, that QE distorted the historic relationship by pushing the equity market to higher levels than it would have otherwise reached –a critical part of my hypothesis of what changes if Warsh acts on his instincts to shrink the Fed’s role in market.

That the recent equity rally has been concentrated in fewer names trading in the S&P 500 (contact me for list, etc) keeps with history (Chart 1). Long rallies tend to have lower correlations of price changes across all categories – fear not the narrow concentration of gainers. Bear markets tend to be the opposite -- broadening correlation of price movement. Looking to Aumann’s Agreement theorem, high correlation means a lot fewer agreeing to disagree on equity market valuations. Obviously, there is always some disagreement, as sellers find buyers because buyers see value at lower prices, but there are many more sellers than buyers during a rout. The Aumann Agreement theorem essentially says that two rational people with the same assumptions about a hypothesis (e.g. what makes equity markets go up over time) that then are faced with different evidence (e.g. Fed changes its operations) but still share base beliefs…