Macro and Credit - The Clemency of Titus

"Clemency is the noblest trait which can reveal a true monarch to the world." - Pierre Corneille

Watching with interest France getting a onetime exemption for its swelling budget deficit for 2019 with France now expecting a budget deficit of 3.2% of GDP (it will be higher rest assured...), whereas Italy in recent days has offered to target a budget deficit of 2%, when it came to selecting our title analogy for our first post for 2019, we decided to go for a musical one, Mozart's 1791 opera entitled "The Clemency of Titus". 

In 1791, the last year of his life, Mozart was already well advanced in writing Die Zauberflöte by July when he was asked to compose an opera seria. The commission came from the impresario Domenico Guardasoni, who lived in Prague and who had been charged by the Estates of Bohemia with providing a new work to celebrate the coronation of Leopold II, Holy Roman Emperor, as King of Bohemia. The coronation had been planned by the Estates in order to ratify a political agreement between Leopold and the nobility of Bohemia (it had rescinded efforts of Leopold's brother Joseph II to initiate a program to free the serfs of Bohemia and increase the tax burden of aristocratic landholders). Leopold desired to pacify the Bohemian nobility in order to forestall revolt and strengthen his empire in the face of political challenges engendered by the French Revolution. No opera of Mozart was more clearly pressed into the service of a political agenda than "La clemenza di Tito" (The Clemency of Titus), in this case to promote the reactionary political and social policies of an aristocratic elite. No evidence exists to evaluate Mozart's attitude toward this, or even whether he was aware of the internal political conflicts raging in the kingdom of Bohemia in 1791. 

In similar fashion, we think that the European Commission's one off "clemency" in relation to France's budget deficit trajectory comes from a desire to "pacify" and "forestall" revolt and maintain the European "empire" in the face of upcoming European elections and political challenges. These challenges have been increasing at a rapid pace in 2018 with the rise of their nemesis aka "populism" but, we ramble again...

In this first post of the year, we would like to look at the continuation of "risk-off" and what it entails. We have been pretty clear about the need to reduce your high beta exposure credit wise in the light of additional weakness in oil prices affecting dearly the US High Yield CCC bucket. Also, we did advise you to raise your cash levels to start playing defense and we were lucky enough to spot the peak in US equities in our first October conversation "The Armstrong limit". The rest, as we say, is history...But, as 2019 is already showing, volatility is very strong. 

Synopsis:

• Macro and Credit - Looking for "safe havens"
• Final chart  -   Confidence has taken a knock

• Macro and Credit - Looking for "safe havens"

As we pointed out in our November conversation "Zollverein", when it comes to credit and macro, we tend to act like any behavioral psychologist, namely that we would rather focus on the "flows" than on the "stock". The S&P/LSTA US Leveraged Loan 100, which tracks the 100 largest loans in the broader Index managed to lose 2.54% over the month of December, still managing to post a positive return of 0.44% whereas US High Yield was down 2.26% for the year, close to US Investment Grade losses at 2.25%. Flow wise, U.S. High Yield funds ended up a bloody 2018 with a $3.94 billion withdrawal for the week ending on December 26. The full-year outflow amounts to a cool $35.3 billion, according to Lipper weekly reporters.

Back in September in our conversation "The Korsakoff syndrome", we pointed out towards a Wharton paper written by Azi Ben-Rephael, Jaewon Choi and Itay Goldstein published in September and entitled "Mutual Fund Flows and Fluctuations in Credit and Business Cycles" (h/t Tracy Alloway for pointing this very interesting research paper on Twitter).

This paper points to using flows into junk bond mutual funds as a gauge of an overheated credit market to tell where we are in the credit cycle. In their paper they pointed out that investor portfolio choice towards high-yield corporate bond mutual funds is a strong predictor of all previously identified indicators of credit booms.

Why do we look at fund flows? There is as well another reason to our focus.

We like to look at fund flows from a total return perspective. This is a subject we also discussed in our January 2018 conversation "The Lindemann criterion":

"Fund flows have a tendency to follow total returns

Fund flows have a tendency to follow total returns, both on the way up and on the way down. When risk assets are performing well, investors do most of their saving in risky assets, and keep relatively little in cash. As the cycle matures, risk assets become more expensive and deposit rates rise, they do steadily more of their saving in safe assets. Finally as risk assets start to wobble they try and withdraw some money and do all of their saving in cash, precipitating a sell-off." - source Macronomics, January 2018

Of course, retail investors, being more feebler when it comes to their holding, no wonder they have been recently fleeing leveraged loans ETFs given the "liquidity" focus and attention it has been given by many pundits including former central bankers. As indicated by LeveragedLoan.com on the 1st of January, outflows in leveraged loans have been significant in recent weeks:

U.S loan funds saw yet another record outflow during the week ended Dec. 26, as retail investors withdrew $3.53 billion, according to Lipper weekly reporters. 

That’s the sixth straight substantial outflow, totaling a massive $13.5 billion, punctuating a staggering turnaround for the asset class. Before that withdrawal streak, U.S. loan funds and ETFs had seen some $10.3 billion of net inflows. For 2018, then, the final figure will be a net outflow of $3.1 billion, according to Lipper. 

The most recent activity brings the four-week trailing average to a $2.6 billion outflow. 

Loan funds accounted for $2.9 billion of this week’s outflow, while ETFs accounted for a $626 million outflow. The change due to market value was negative $746 million. 

With the withdrawal, loan fund assets have dropped to $90.7 billion, including $9.8 billion from ETFs, says Lipper. — Tim Cross" - source LeveragedLoans.com

When the trend is not your friend...The pressure on funds has been relentless and outflows significant in various asset classes as indicated by Bank of America Merrill Lynch in there Follow The Flow report from the 28th of December entitled "The worst year since the ’08 crisis":

"Closing the worst year since ’08 

Only a few days to go before the end of the year, and 2018 will be remembered as the worst year since 2008. Outflows dominated this year across high-yield, high-grade, equities and EM debt funds. The lack of yield across European fixed income assets and the lack of catalysts to reverse the outflows we have seen this year are painting a dim picture for 2019. With macro indicators continuing to point to more downside, we expect further widening in credit land. We also expect further beta underperformance amid challenging liquidity backdrop and rising idiosyncratic risks as the ECB QE is now over. 

Over the past week… 

High grade funds suffered another outflow, making this one the 20th week of outflows over the past 21 weeks. High yield funds recorded another outflow, the 13th in a row. Looking into the domicile breakdown, US-focused funds led the outflow trend, while Euro and Global-focused funds were slightly less impacted. 

Government bond funds recorded an inflow this week, the fourth in a row. Meanwhile,

Money Market funds recorded another large outflow. 

All in all, Fixed Income funds recorded another outflow, bringing this year’s outflow to

$102bn, a negative record for the asset class. 

European equity funds also continued to record outflows, making this week the 16th

consecutive week of outflows. During the past 42 weeks, European equity funds

experienced 41 weeks of outflows.

Global EM debt recorded another large outflow this week, the 12th in a row.
Commodity funds recorded another inflow. 

On the duration front, short-term and mid-term IG funds led the negative trend by far, while the long-end of the curve recorded another small inflow." - source Bank of America Merrill Lynch

We agree with Bank of America Merrill Lynch, cracks in credit markets have been significant and unless there is some stabilization, there will be additional pain inflicted to the high beta crowd hence the need to reach for quality.

As well throughout 2018, we mentioned rising dispersion in credit markets with investors becoming more discerning when it comes to selecting issuer profiles. We also touched on the increasing trend in large standard deviation moves in various asset classes typical in the late stage of an extended credit cycle which has been plagued by years of repressed volatility thanks to central banks meddling.

For instance, the latest Japanese yen's flash crash/rally highlighted how Mrs Watanabe aka Japanese retail investors, through Uridashi funds are still heavily invested in carry trades for extra yield such as the Turkish Lira, though in recent years they have drastically increased their allocation to the US dollar it seems as indicated by Bloomberg on the 3rd of January in their articled entitled "Flash-Crash’ Moves Hit Currency Markets":

"With Japan on a four-day holiday this week, traders said they struggled to handle a flood of sell orders with pricing erratic. Once the yen strengthened past 105.50 against the dollar, others were forced to cover their short yen positions, said traders who asked not to be identified as they aren’t permitted to speak publicly.

“It looks more like a liquidity event with the move happening in the gap between the New York handover to Asia,” said Damien Loh, chief investment officer of hedge fund Ensemble Capital Pte., in Singapore. “It was exacerbated by a Japan holiday and retail stops getting filled on the way down especially in yen crosses.”

As a result, the yen surged against every currency tracked by Bloomberg, and was up 1 percent against the dollar at 107.78 by 9:30 a.m. in London.

The haven asset has strengthened against all its major counterparts over the past 12 months as concerns over global economic growth mounted and stocks tumbled. It rose 2.7 percent against the dollar last year, the only G-10 currency to gain versus the greenback." - source Bloomberg

Given the intensity of the selling in December, with credit spread widening and gold surging as well in conjunction with the Japanese yen, no wonder investors are trigger happy when it comes to seeking refuge from the indiscriminate selling we have seen over the last quarter and in particular during the last month of the year.

The search for safe havens is well described also in Bloomberg's article from the 3rd of January entitled "In This Mess of a Market, Safe Havens Are Making a Comeback":

"The remarkable thing about recent yen performance may not be its almost 4 percent surge against the dollar on Thursday, but the fact the currency just clocked its best month in about two years.

That exact statistic also applies to gold, which in December notched the largest jump since January 2017. Both assets have continued to climb this year. Meanwhile, bonds of G-7 governments had their best December in a decade, according to a Bank of America Merrill Lynch index.

Put simply, traditional havens are back.

The same myriad of drivers bedeviling equity investors in 2019 is also sending them to safety. While the trade war is showing up in real-world data, it’s cropping up in company earnings too, as evidenced by Apple Inc.’s guidance cut on Wednesday. At the same time, Federal Reserve tightening is sapping liquidity and in the process reigniting volatility in markets. Idiosyncratic risks from the likes of Brexit and Italy’s budget squabble with the European Union are merely compounding the risk-off mood -- and adding fuel to the haven trade." - source Bloomberg

With earnings disappointment leading to more large standard deviations move in equities as indicated by Apple but by also Delta Airlines, with no real clear resolution as of yet in the trade war narrative between China and the United States, 2019 has started with even more volatility to say the least.

No wonder as indicated by Bloomberg's article above that the shiny little metal aka "gold" has been seen as well as a "safe haven" in times of acute turmoil:

"Going for Gold

Sentiment toward gold also brightened in mid-October, when money managers abandoned their record net-short position against the metal as the outlook for the dollar deteriorated.

Since then, investors have piled into exchange-traded funds backed by bullion, which have amassed 126 tons of metal worth $5.2 billion in 60 sessions -- the biggest increase over a comparable period in more than 18 months.

A paring of expectations for rate hikes has also contributed to demand, as gold typically falls during periods of monetary tightening because it’s a non-interest bearing asset.

“Gold is bid due to multiple headwinds” for the world economy, said Ole Hansen, the head of commodity strategy at Saxo Bank A/S by email. “Stocks, the dollar and bond yields are all down while the risk of further U.S. rate hikes has almost been removed.” - source Bloomberg

This is as all to do with investors looking at the flattening of the yield curve, weaker macro data and deceleration in global trade in conjunction with weaker earnings than expected and trying to figure out if the Fed will show some "Clemency" in similar fashion as Titus did in Mozart's opera.

We hinted a "put-call parity" strategy early 2014, eg long Gold/long US Treasuries as we argued in our conversation "The Departed", it has been working again nicely in December:

"If the policy compass is spinning and there’s no way to predict how governments will react, you don’t know whether to hedge for inflation or deflation, so you hedge for both. Buy put-call parity, if there is huge volatility in the policy responses of governments, the option-value of both gold and bonds goes up."

Of course given the uncertainty surrounding the number of hikes and additional tightening from the Fed with the acute weakness in US equities, no wonder some pundits have been resorting to this "put-call parity" strategy.

Obviously, the sudden rise in US wages to 3.2% YoY in December, the fastest pace since April 2009 and with Nonfarm payrolls coming at 312K versus 177K expected, with a more dovish Fed on the wire as we type this very post, it seems that Fed chairman Jerome Powell has been listening to Stanley Druckenmiller and Kevin Warsh's take on the Fed's policy in the Wall Street Journal, hence the strong rebound seen in equities markets today. Not only have we seen the return of a Fed put, hence our "clemency" title analogy, but China has well has come to the rescue of decelerating growth with its cut of the required reserve ratio by 1% to release cash into the economy and support rapidly stalling growth. The RRR for banks will drop by 0.5% on January 15 and a further 0.5% on January 25, the PBOC said. Here comes the central banking "cavalry".

For credit markets, at least on the US side damages have already been done as seen in large outflows seen in recent weeks. What would clearly stabilize the situation we think, at least for US High Yield, would be a bounce in oil prices which would probably lessen the velocity in credit spread widening particularly in the high beta space of the CCCs bucket highly exposed to the energy sector.

Can the Fed restore "goldilocks"? A not too hot and not too cold economy? We wonder again, how much damage has been inflicted to US earnings due to the long lasting trade war narrative. Was the Apple large standard deviation move a wake-up call for the Fed?

One thing for sure is that the Huawei fight with the US administration is not about trade war, but mostly about "tech" war (and 5G). On that subject, we recently used the following chart in relation to the quantity of jobs created versus the quality as per the data from the BLS, this doesn't comprise the latest data release:

- graph source BLS - Macronomics

Back in January 2017 in our conversation "The Ultimatum game" we argued:

"The United States needs to resolve the lag in its productivity growth. It isn't only a wage issues to make "America great again". But if Japan is a good illustration for what needs to be done in the United States and therefore avoiding the same pitfalls, then again, it is not the "quantity of jobs" that matters in the United States and as shown in Japan and its fall in productivity, but, the quality of the jobs created. If indeed the new Trump administration wants to make America great again, as we have recently said, they need to ensure Americans are great again." - source Macronomics, January 2017 

Once again it isn't the quantity of job that matters, it's the quality of jobs. No matter how the Trump administration would like to play it, but productivity matters more than trade deficits. The lackluster most recent Purchasing Managers Index showed a fall in the reading from new orders in the US from 61 to 51, and China as well has been decelerating with its export orders falling below the 47 mark. This clearly shows that there is no clear winner from a trade war. 

Sure talks are about to start again between China and the United States but at this stage, as we stated above, it is all about damage assessment on earnings. 

Given the Fed has been on a hiking path in conjunction with its QT, as we stated in our conversation "Ballyhoo" in October 2018,  using a more real-time look at financial conditions points towards a higher velocity in the tightening trend of financial conditions, a case of "Reflexivity", being the theory that a two-way feedback loop exists in which investors' perceptions affect that environment, which in turn changes investor perceptions. On the subject of financial conditions we read with interest Nomura Special Report from the 28th of December entitled "Financial conditions turned restrictive for growth":

"Key Developments

• Our revised US financial conditions index (FCI) suggests financial conditions are now restrictive for growth (Figure 1).

•  Since the end of September our FCI has declined almost a full percentage point – from +0.7% to roughly -0.3% currently. The units of our FCI are the contribution of financial factors to growth over the next six months (see Refreshing US Financial Conditions Index for a complete explanation).

• After heightened volatility in October and November, US equity markets sold off sharply in December. So far this month the S&P 500 index is down 10.8% (through 27-Dec). Implied equity volatility remains high. The VIX index jumped sharply in December and remains elevated.
• Corporate spreads have widened notably since end-September. Investment grade options-adjusted spreads are now roughly at their long-term median, but they remain well below levels reached in late 2015 and early 2016.
• Business surveys suggest that credit is only modestly harder to get, at least for smaller businesses.
• The recent tightening of financial conditions is notable, in both equity and credit markets, and will probably affect how the FOMC sees the risks around its forecast.
• Potential external risks, such as Brexit, US-China trade negotiations and US fiscal policy debates in Congress, raise economic uncertainty and have a potential to tighten financial conditions further.
• At the margin, the recent tightening of financial conditions reduces the probability that FOMC will raise short-term interest rates again soon." - graph source Nomura.

This explains probably the "reflexivity" issue seen in the markets given the flattening of the yield curve with weaker macro data and decelerating global growth which created anxiety relating to the double impact of both rate hikes and QT on financial conditions.

As pointed out by Andreas Steno Larsen from Nordea on his twitter feed there is a direct relationship between US Financial Conditions and ISM Manufacturing PMI:

"We have been pretty explicit recently that ISM would drop FAST! ISM dropped from 59.3 to 54.1 in Dec.
Unfortunately more of the same is in store over the coming 3-4 months. Below 50 readings could be on the cards." - source Nordea, twitter

Obviously the recent dovish tone taken by Fed chairman Jerome Powell seems to have had the desired effect of tampering the velocity in the tightening.  

As pointed by Bloomberg in their article from the 3rd of January entitled "Jerome Powell Pledged Allegiance to Data and Some of It Looks Grim", the Fed is clearly in damage assessment mode when it comes to the data, regardless of the strong Nonfarm payroll print:

"Factory PainIf there’s one place where the data are souring decisively, it’s manufacturing. The Institute for Supply Management’s factory index dropped by the most since 2008 last month and touched a two-year low. While the ISM gauge remains in expansionary territory at 54.1, just 11 of 18 industries reported growth in December. That’s the fewest in two years.

Production problems are far-reaching. JPMorgan Chase &Co. and IHS Markit’s global manufacturing index fell in December to the lowest level since September 2016 as measures of orders and hiring weakened, data showed this week.

Trade uncertainty and concerns about global growth seem to be an important factor in the recent U.S. weakness: tariff worries have surfaced repeatedly in Fed surveys. Apple Inc. cut its revenue outlook this week for the first time in nearly two decades thanks to weaker demand in China.

Housing Wobbles 

Fed officials watch the housing market because it’s an interest-rate sensitive sector, and it’s been showing signs of cooling for months. That hasn’t abated since the Fed last met: the pending home sales index dropped 0.7 percent on a monthly basis in November, compared to an analyst expectation for a 1 percent gain. Home prices are still rising, but the latest S&P CoreLogic Case-Shiller index showed that gains continue to moderate.

Market Souring

While it’s not a real-economy measure, the Fed closely watches market volatility because it can feed through to consumer and business sentiment and the real economy. Stocks saw the worst December rout since the Great Depression and a few near-term Treasury security yields have crept above their longer-term counterparts since Powell’s December press conference, a sign that investors were pessimistic about the outlook for growth.

That’s enough to make Powell’s colleague in Texas, Dallas Fed President Robert Kaplan, argue for putting rate increases on hold for the first couple of quarters of 2019.

“This is a very critical time. We need to be very vigilant. We need to be on our toes. And I think patience is a critical tool we should be using during this period. We can get this right,’’ Kaplan told Bloomberg Television in an interview on Thursday." - source Bloomberg

The big question is, will this be enough to initiate a strong rebound in equities and a rally in all things "high beta" such as leveraged loans? 

When it comes to leveraged loans, as pointed out by Lisa Abramowicz from Bloomberg on her twitter feed, there has been already some "short covering" happening:

"BKLN, the biggest leveraged-loan ETF, is posting its best one-day rally in its eight-year history. Loans are suddenly benefiting from both a more positive outlook on the U.S. economy paired with benchmark rates that are rising again." - source Lisa Abramowicz - Bloomberg - twitter

Again what could cause a sustained rally? Clearly the "Clemency" of both the Fed and the PBOC can trigger some significant "short covering" also a positive agreement between the United States and China would alleviate some concerns, yet when it comes to the forward EPS optimism we criticized back in 2018 as not being warranted, it is all about how much "reflexivity" has been triggered and how much "confidence" has been shattered by the recent violent gyrations in various asset classes we think.

"The Clemency of Titus" aka Fed Chairman Jerome Powell is linked to the transmission mechanism between FOMC policy and the real economy. On this very subject we read with interest Wells Fargo's take from their note from the 3rd of January entitled "Time to Press Pause? Financial Conditions & the FOMC":

"Financial Conditions Have Tightened

Financial markets deteriorated sharply at the end of 2018. The S&P 500 fell more than 10% in the fourth quarter, while the yield on the 10-year Treasury security slid about 30 bps as investors flocked to safer assets. Given the forward-looking nature of markets, the tumult raised concerns about growth in the new year and was even seen as a reason the FOMC might hold off on its widely telegraphed rate hike in December. Chairman Powell stated numerous times in his post-meeting press conference that the Committee was not looking solely at financial markets, but broad financial conditions. So how have financial conditions—not just markets—evolved recently, and what does it mean for economic growth and the future path of FOMC policy?

For a wide-ranging view of financial conditions, we turn to the Chicago Fed’s National Financial Conditions Index (NFCI). The index includes 105 variables, capturing leverage, risk and credit conditions. Since the index is constructed to average zero over time (with a standard deviation of one), negative readings indicate historically loose financial conditions, while positive readings indicate historically tight conditions. Therefore, higher values of the index are indicative of tighter financial conditions.

The NFCI rose 14 bps over the fourth quarter of 2018 (Figure 1).

 - Source: Bloomberg LP, Federal Reserve Bank of Chicago and Wells Fargo Securities

The move was the largest quarterly increase since the start of 2016—a point at which the FOMC hit pause on rate hikes. Specifically, risk-related measures, like the VIX index and TED spread, have risen over the past few months. At the same time, indications of leverage, like weakening corporate debt issuance, have pointed to more restrictive financial conditions (Figure 2).

- Source: Bloomberg LP, Federal Reserve Bank of Chicago and Wells Fargo Securities

Credit conditions, which reflect the willingness to borrow and lend at prevailing prices, have been little changed. But the overall NFCI generally remains at a low level, indicating that general financial conditions are not overly restrictive at present.

Financial Conditions: The Transmission Channel between FOMC Policy and the Real Economy

Financial conditions per se are not an objective for the FOMC, but they are taken into account due to their indirect effects on the Fed’s two policy goals: “price stability” and “maximum employment.” The committee’s aim in tightening policy is to prevent the economy from overheating to the point that it risks significantly overshooting its inflation target, which it defines as PCE inflation of 2%. However, the FOMC’s primary policy tools, the fed funds rate and the balance sheet, have little direct effect on the Fed’s two policy objectives.

Instead, the FOMC’s tools affect the economy by influencing other interest rates and risk taking. In that way, financial conditions capture the transmission of FOMC policy to the real economy. Businesses and households will modify investment and saving plans depending on the relative ease or tightness of financial conditions. Tighter conditions, reflecting the availability and cost of credit, may reduce the ability and/or willingness to take on debt, which, all else equal, could weigh on growth in investment and consumption and thereby on the overall rate of real GDP growth. In contrast, easier conditions could stoke up growth in consumption and investment.

Behind the Starting Line after Three Years of FOMC Tightening

Given that financial conditions are influenced by FOMC policy, it is not unexpected to see broader financial conditions tighten as the Fed normalizes policy. In other words, tighter financial conditions are an anticipated byproduct of FOMC rate hikes. But monetary policy decisions and broad financial conditions do not always move in tandem. Despite the FOMC raising its target range for the fed funds rate 225 bps since late 2015, financial conditions as measured by the NFCI have eased on net over the period (Figure 3).

 - Source: Federal Reserve Bank of Chicago, Federal Reserve Board and Wells Fargo Securities

The easing has primarily come in terms of credit, with, for example, corporate bond spreads narrower and bank lending standards looser. The overall easing in financial conditions since late 2015 stands in contrast to the previous two tightening cycles in which the FOMC raised rates by the same amount. As noted previously, general financial conditions do not appear to be overly restrictive at present.

With financial conditions still easy relative to when the Fed first began to normalize policy, does that mean there is more tightening in store? In each of the previous six rate-hiking cycles, the FOMC did not stop until financial conditions had tightened on net (Figure 4).

  - Source: Federal Reserve Bank of Chicago, Federal Reserve Board and Wells Fargo Securities

This historical record suggests that the FOMC may very well have a few more rate hikes to go in this cycle, at least at first glance.

Does the FOMC Need to See Financial Conditions Tighten Further?

The traditional NFCI does not take into account underlying economic conditions. All else equal, it makes sense for investors to take on more risk, for households to take on more debt and for lenders to ease standards in an improving economic environment. As a result, financial conditions and economic conditions are often closely correlated. Therefore, it is not unusual to see financial conditions ease, at least for a time being, at the same time the FOMC is raising rates—both are responding to a stronger economy.

To isolate financial conditions only, the Chicago Fed also calculates an Adjusted National Financial Conditions Index (ANFCI). The ANFCI controls for the macroeconomic environment, and thus it is more telling in regard to how underlying financial conditions have evolved. By this measure, financial conditions have tightened more in recent months than implied by the NFCI alone (Figure 5).

  - Source: Federal Reserve Bank of Chicago, Federal Reserve Board and Wells Fargo Securities

Specifically, the ANFCI has increased about 20 bps since late September, which is about twice as much as the increase in the NCFI. Although the ANFCI remains low in a historic context, the rise in the index implies that financial conditions are a bit tighter in total than when the Fed first began raising rates in late 2015 (Figure 6).

 - Source: Federal Reserve Bank of Chicago, Federal Reserve Board and Wells Fargo Securities

The degree to which financial conditions have tightened over a rate-hike cycle helps quantify how far—or short—the FOMC has come. Yet there is no set amount by which financial conditions need  to tighten, or a threshold to cross, before the FOMC stops raising rates. If the economy is showing few signs of overheating, looser financial conditions relative to the start of a tightening cycle are not necessarily a problem. The same can be said for an economy where growth is slowing back toward its longer-run trend, as is the case today.

How financial conditions impact the stability of the overall financial system may, however, be of concern. If a prolonged period of loose financial conditions stokes instability via greater risk taking, more leverage and questionable credit, then those factors may affect policymaking. That said, the primary means of addressing financial instability are likely to be targeted regulatory (macro-prudential) policies by the Federal Reserve and other federal banking agencies rather than the blunter tool of changes in interest rates by the FOMC. At present, the Fed generally does not seem to be unduly concerned with financial stability. The Federal Reserve Board’s inaugural Financial Stability Report released in November found that while valuations are elevated, private sector credit risks are moderate and leverage and funding risks are low.

Moreover, the cumulative amount of tightening in financial conditions may not be as much of an issue as the speed. Over the past month, the financial conditions indices rose faster than at any time since the start of 2016 (Figure 7).

Given that it takes time for financial conditions to effect the real economy, the FOMC could perceivably hold off on subsequent rate hikes in the near term as it waits to see how financial conditions have affected growth prospects.

Conclusion: The FOMC Might Revisit the Pause Button

The last time financial conditions tightened as sharply as this past December was at the start of 2016. Back then, the FOMC had just raised the fed funds target rate for the first time since the crisis. However, signs of slower growth in China caused volatility in financial markets to spike and overall financial conditions tightened. Following its initial rate hike in December 2015, the FOMC subsequently remained on hold until December 2016.

Our most recent forecast, which was compiled in early December, looks for two 25 bps rate hikes in 2019, first in March and again in September. But we readily acknowledge that the risks are skewed to a longer pause in the first half of the year than we thought just a month ago. Overall financial conditions do not appear to be overly restrictive at present, but they clearly have tightened in recent weeks. Consequently, the FOMC may decide that a period of wait-and-see is again appropriate, especially with the fed funds target rate already close to many committee members’ estimates of “neutral” and with inflation showing few signs of significantly exceeding the Fed’s target of 2%. We will be watching incoming data and making changes to our Fed call, as appropriate." - source Wells Fargo

Sure "Titus" might have shown some "late" clemency and maybe just re-initiated the infamous/famous "put" given the recent rout in various asset classes, but it remain to be seen if it too late to re-ignite the "animal spirits" and trigger a sustained rally given that a lot of damages have already been inflicted on the back as well of more surprises to be seen on more "earnings surprises à la Apple or Delta Airlines. We continue to advocate playing defense and use the rally to reduce your beta exposure in search of quality. It doesn't matter how long the Fed's clemency is going to last, we think we are clearly in the final innings of this extended credit cycle and you probably should focus more your attention on capital preservation than capital appreciation. 

If indeed the Fed is data dependent (or more likely S&P dependent...), then obviously, the "Clemency of Titus" is somewhat warranted as per our final chart below showing that for global CFOs, they have been less optimistic thanks to trade war fatigue obviously. 

• Final chart  -   Confidence has taken a knock

If success is a mind game, so is confidence and in the case of CFOs as per our final chart from Bank of America Merrill Lynch's The Inquirer note from the 31st of December entitled "Planet Earth to Policymakers - Please Reflate", then there is more downside to come when it comes to Global PMIs:

The view of asset markets and global CFOs is in sync – global growth is now in a broad, deep and persistent slowdown. The IMF, however, sees global real GDP growth going from 3.73% in 2018 to 3.65% in 2019, a second decimal slowdown. Policymakers are in the same stable boat, which is vulnerable to capsizing. The breadth of OECD leading indicators, which was near historical highs at the start of the year, has weakened considerably. In October 2018, only 10% of countries saw YoY rises in the OECD leading indicator vs. 71% in January 2018. In January 2018, 46 of 47 global equity markets were above their 200-day moving averages, now only 7 of 47 are. The world monetary base is contracting 0.5% YoY, and likely to shrink 4.6% by December 2019, unprecedented in 37 years.

The bottom line: Financial markets and CFOs think the world economy is in real trouble. Policymakers are oblivious to this scenario. One of them is going to be wrong. Past history suggests, the policymakers. The science experiment of Quantitative Tightening might be halted, the Chinese credit impulse is still in free-fall and might need to be revived a lot more dramatically, and global fiscal easing could be a lot more muscular. Those are 2019’s likely surprises. If this happens, Asia and EM equities could be in for massive gains. Stay tuned." - source Bank of America Merrill Lynch

Could the central bank cavalry come to the rescue of global equities? Or is too little too late? We wonder....

"If there is something to pardon in everything, there is also something to condemn." -  Friedrich Nietzsche

Stay tuned!