Morgan Stanley: What's Going on in the Markets - A Bond's Eye View

On October 3 U.S. Federal Reserve (Fed) Chairman Jerome Powell’s comments indicated for the first time that they may tighten their monetary policy. Equity markets have traded lower every day since that statement. It is important to note that U.S. Treasury yields moved first, followed by equity/risky assets. I’ll explain why this is important, but first let’s discuss what is going on in the markets.

An important distinction

The Fed has been raising rates since December 2015 to remove excess accommodation. The goal has been to “normalize” policy rate levels to neutral. Moving to neutral IS NOT the same as tightening. Powell on October 3 announced he may tighten the Fed’s monetary policy, and this set in motion the events of higher rates and falling risky asset prices.

Based on Fed models, a 3.00% fed funds rate is widely viewed as the neutral rate (real fed funds rate (r*) of approximately 1% + 2% inflation target = 3%). This is approximately what the market is pricing for the terminal fed funds rate.

What changed?

Powell’s comments indicated that the Fed may increase rates toward 3.50%, reinforcing the Fed’s “dot plot” prescription, which is 50 basis points higher than the 3.00% market consensus policy rate—meaning a tightening of 50 basis points for which asset prices need to reconcile.

Assessing the risks

Much of the adjustment in asset prices has come not from U.S. Treasuries but from riskier assets, namely equities that are adjusting to a higher discount rate (interest rate) for cashflows (earnings).

Mathematically, this has mechanical consequences, some of which are:

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