Get Out Now: SocGen Predicts Market Crash, Bear Market For The S&P

While the charade of sellside analysts releasing optimistic, and in the case of Barclays and Goldman "rationally exuberant"previews of the year ahead...

... is a familiar, long-running tradition on Wall Street, rarely has the intellectual dishonesty and cognitive dissonance been quite so glaring: take Goldman, which while admitting that valuations have never been higher, and the upside case never more reliant on just one piece of legislation which has a significant chance of not passing (GOP tax reform for those unaware), Goldman still has to temerity to predict not only no bear market in the next three years, but goes so far as to suggest an "irrationally exuberant" target of 5,300 in three years.

And as of this morning, the penguins are on full parade, with virtually not a single big bank predicting the market will drop in the coming year. Here are the latest S&P price targets, EPS forecasts and implied PE multiples, for the year ahead:

• Bank of Montreal, Brian Belski, 2,950, EPS $145.00, P/E 20.3x


• UBS, Keith Parker, 2,900, EPS $141.00, P/E  20.6x


• Canaccord, Tony Dwyer, 2,800, EPS $140.00, P/E 20.0x


• Credit Suisse, Jonathan Golub, 2,875, EPS $139.00, P/E 20.7x


• Deutsche Bank, Binky Chadha, 2,850, EPS $140.00, P/E 20.4x


• Goldman Sachs, David Kostin, 2,850, EPS $150.00, P/E 19x


• Citigroup, Tobias Levkovich, 2,675, EPS $141.00, P/E 19.0x


• HSBC, Ben Laidler, 2,650, EPS $142.00, P/E 18.7x

Good luck with all those 20x P/Es in a world in which rates are rising and central bank balance sheets will start contracting in one year.

Luckily, there is the occasional honest bank, like Macquarie (whose Viktor Shvets has become one of our favorite commentators for his objective, no nonsence analysis) and - as of this morning - SocGen, whose strategist Roland Kaloyan has written a note which warns that with bond yields rising (see the crash in China overnight, where the Shanghai Composite tumbled the most in 17 months on the realization that rising rates is bad for stocks), there is effectively no upside left in stocks, which coupled with the prospect of a US economy recession in 2020 will "crimp returns in 2019" Furthermore, in light of the record vol shorts, SocGen jumps on the VIX-squeeze crash bandwaon, warning vol positioning could "strongly deteriorate the risk reward profile of equity markets."

In not so many words: with little stock upside left, with the threat of rising interest rates slamming P/E multiples, with the economy in deep in late cycle, with equities trading at record valuations, with everyone short vol and just begging for a vol short squeeze, SocGen"s advice is simple: get out now.

Here is SocGen:

We are less enthusiastic about equities heading into 2018 – We do not see much upside on our major equity targets for the next 12 months. We expect stretched valuations and rising bond  yields to limit equity index performances in 2018 and the prospect of a US economic slowdown in 2020 to further cramp returns in 2019. We also raise some concerns about the quantity of shorts on volatility, which could potentially strongly deteriorate the risk reward profile of equity markets.

Specifically, with regards to the S&P, SocGen reports that US equities are now at - or rather about 100 points above - their fair value:

The S&P 500 has reached our target for the end of this cycle (2,500pts) and is now entering expensive territory. Indeed, on all the metrics, US equities are trading at levels only seen during the late-90s bubble. Since Trump’s election, the US equity market has risen 24%, but only half of this came from earnings growth. The other half has been driven by P/E expansion. According to our calculations, the US equity market is already pricing in potential tax reform. The rise in bond yields and Fed repricing should be headwinds against further US equity rerating.

If that wasn"t enough, SocGen also notes that its valuation model suggests "that upside on the S&P 500 is limited: the US equity market is already pricing in a rebound in growth and inflation. The rise in bond yields and Fed repricing should be a headwind against further US equity rerating."

In practical terms, this means that SocGen is predicting that the S&P, which is already 100 points above the bank"s year end target of 2,500, will tumble to 2,000, or more than 20%, before rebounding modestly to 2,200 just as the US economy succumbs to a recession, at which point all bets are off. And not just the S&P, but virtually all major European bourses are due for a bear market in the coming 12 months.

Here are some of the key arguments behind SocGen"s bearish outlook, first a familiar discussion of the risk posted by the biggest vol short ever observed.

Equity volatility, both realised and implied, has been edging ever lower for quite some time now. Being invested in a simple systematic short VIX future volatility has been strongly rewarding: +290% over the last two years. However, when the tide turns (i.e. VIX spikes), the drawdown can be significant. The quantity of short positioning on VIX open in the market (see right chart) would potentially amplify any spike of the VIX.

The risk of a VIX surge ties into the question of how the market"s risk/return profile will be shaped in the coming year based on what the prevalent VIX level is:

The risk /reward ratio as measured by the Sharpe ratio has been very attractive for US equities: good expected return supported by reasonable valuation and EPS growth, a very low Fed fund rate and an ultra-low volatility regime. At the current 12-month forward P/E, we factor in our Fed Fund scenario (2.25% by end-2018) and a different volatility regime. A change of VIX regime from 10% to 15% would push the US equity Sharpe ratio back to its historical average.

Then there is the already record stretched valuations, something even Goldman admitted earlier this week, with "US equities trading above their long-term average and at a level only seen during the dotcom bubble."

US equities have not been in attractive territory valuation-wise for a while. Indeed, on all the main valuation metrics, US equities are trading above their long-term average and at a level only seen during the dotcom bubble. However, expected earnings growth for the next 12 months (12%) is below the 20y annual earnings growth average (14%).

The last risk is that bond yields are going higher, forcing a contraction to PE multiples, as investors shift away from equities into bonds, as the dividend yield on US stocks at 2.0%, is now lower than the 10Y yield  of 2.3%.

Under our scenario, US Treasures will reach 2.70% at the end of 2018. This should be a headwind for equity markets. Indeed, our US equity risk premium is at 2.9%, one standard deviation below the long-term average . Any increase in bond yields would push the equity market further into expensive territory relative to bonds The dividend yield offered by US equities (2.0%) is already lower than the current US longterm bond yield (2.3%).

Finally, SocGen points out something that few other analysts  have admitted: half the S&P rally since the Trump election has been on the back of multiple expansion, with just 48% the result of earnings growth. Furthermore, as SocGen calculates, assuming tax reform passes, a decrease in the US tax from 35% to 20% as planned by Trump’s tax reform would theoretically boost earnings by 8.5%. The 12-month forward P/E has risen 12% over the last 12 months. In other words, contrary to conventional wisdom, more than 100% of Trump"s tax reform is already priced in.

Since Trump’s election, the S&P 500 has risen 24%. Only half of this performance has been driven by earnings growth; the other half is from P/E expansion. Assuming that analysts have not factored tax reform into their earnings forecasts, tax reform expectations have been the driver of P/E expansion. The S&P 500 index tax rate is currently 26.6%. Assuming that US companies generate 43% of their profits abroad (here) and pay 35% of their US profits on taxes (i.e. with no loopholes for US profits), the average tax rate outside the US would be 15.5%. A decrease in the US tax from 35% to 20% as planned by Trump’s tax reform would thus theoretically boost earnings by 8.5%. The 12-month forward P/E has risen 12% over the last 12 months.

Separately, turning to Europe, Socgen acknowledges the euro zone"s economic recovery is in full swing but - in yet another bearish thesis - argues that the current valuations don"t leave "much meat on the bone" and that the expected rise in the Euro could also weigh on exporters in particular, and European stocks in general. Additionally, with the European Central Bank set to progressively unwind its stimulus package, investors are increasingly wary of the amount of debt some companies have accumulated thanks to historically low interest rates.

Cable group Altice, whose shares have collapsed more than 50% in the last 30 days due to concerns on its €50 billion euros pile of debt, and whose debt plunge has been seen by some as the catalyst for the recent junk bond swoon, is an example of what is likely to come, Societe Generale said.

And while the French bank saw pockets of growth in Germany, France and in sectors such as financials, but warned that political risks are still present, notably in Spain with the Catalonia crisis and Italy which faces general elections in 2018. Oh, and the UK too: "We also recommend staying away from the UK as Brexit negotiations are accelerating and several scenarios are possible: only a soft Brexit would be supportive for the FTSE 100.

And yet, after all that, not even Socgen is willing to bite the bullet, and warn that ahead of what clearly is "a bear market is coming" call, investors should dump risk: so ingrained is the desire to run with the penguin herd, that even the most contrarian calls are doused in such a big layer of caveats, Arnold could easily driver his hummer on top of.

To wit: "But then again, should we be outright bears? After all, we do see some value pockets in the market and some specific themes (M&A, consumer in the eurozone)."

Which almost explains the report"s cover page...

April Payrolls Preview: "It Better Be Good"

After the abysmal March labor report, all we - and the Fed - can say is that April better be good, or else Yellen"s claim of "transitory weakness" will simply be the latest nail in the coffin of Fed credibility. Here is the consensus for the key numbers the BLS will report at 8:30am ET on Friday morning.

• March Nonfarm Payrolls Exp. 185K, (Prey. 98K, Feb. 235K) US Unemployment Rate (Mar) M/M Exp. 4.6% (Prey. 4.5%, Feb. 4.7%)


• Average Hourly Earnings Exp. 0.30% (Prey. 0.20%, Feb. 0.20%)

Payrolls Expectation by Bank:

• Barclays: +225K,


• Bank of America: +170K,


• Goldman Sachs: +200K,


• SocGen: 165K,


• UBS: +210K,


• Wells Fargo:+178K,

Big Picture: Friday’s non-farm payrolls release follows Wednesday’s FOMC meeting where the Fed, as expected, kept rates on hold with all eyes now on June’s decision. One key takeaway from this week’s decision was the Fed noting the labour market conditions continuing to strengthen as growth slowed, as it deemed that job gains had been solid despite March’s softer than expected labor market report and quasi-recessionary Q1 GDP. The Fed’s statement was devoid of any real negatives and has led to Fed Fund futures pricing in a near 80% chance of a 25bps hike at its June meeting.

As RanSquawk notes, the expectation for a headline print of 185K points to a solid bounce-back from last month’s 98K, with the possibility of an upward revision to last month’s release as many analysts have attributed the weakness to negative payback following a late Easter holiday and an unusually warm winter in the US. However, the unemployment rate is expected to tick up to 4.6% from 4.5%, with many suggesting that last month’s fall was a result of sampling noise.

Goldman is even more optimistic than the consensus, and estimates payrolls increased by 200k in April, a sharp acceleration from March’s +98k pace and above the three-month moving average of +178k. It sees labor market fundamentals remaining encouraging on the whole, as April exhibited a further decline in initial jobless claims, improvement in regional service sector employment surveys, and an elevated labor market differential reported by the Conference Board. Continuing claims also fell sharply from survey week to survey week, dropping at their fastest pace in two years (-64k). Additionally, Goldman believes a favorable swing in the weather –reflecting mainly the timing of Winter Storm Stella during the March survey week – is likely to boost April job growth by roughly 25-40k relative to trend.

On the negative side, the bank believes the trend in retail employment growth is now slowing, reflecting the weaker brick-and-mortar sales trends and a continued shift towards less labor-intensive e-commerce firms. We also expect minor drags on job growth from the tail end of the federal hiring freeze and from a telecom strike that continued into the survey week (a -2k impact).

Goldman"s summary:

We estimate the unemployment rate remained stable at 4.5% in April following the one tenth drop in March (to 4.496% unrounded). The pace of employment growth picked up sharply in the household survey to start the year, with 1.4 million cumulative jobs added over the past three months (adjusted for the impact of the January population controls). Offsetting this improvement, the participation rate also moved higher, rising three tenths over the same period to 63.0%. While the risks to our unemployment rate forecast are likely skewed to the upside (given the possibility of mean-reversion), our base case expectation is that the rate continues to round to 4.5%.

Finally, we expect average hourly earnings to increase 0.3% month over month and 2.7% year over year, reflecting the interaction of firming wage growth with positive calendar effects. The April payroll period ended on the 15th, which in our model, is associated with above-average wage growth. Additionally, we believe the acceleration in the employment cost index to a cycle-high pace in Q1 provides additional evidence of firming underlying wage growth.

Recent Data: Wednesday’s ADP employment report showed another sign of steady growth, coming in at 177K vs. the expected
175K. Despite last month’s lack of correlation, the private employment figures tend to give an indication of the
headline figure when viewed over a longer horizon. April’s soft data (The Markit and ISM PMIs) point to a slowing in
hiring, although all the surveys’ employment sub-indices remained in expansionary territory, with all the headline
releases strong.

Factors arguing for a stronger report (per Goldman):

Weather rebound. We believe the winter storms in early March likely exerted a meaningful drag on payroll growth in the last report, as Winter Storm Stella hit the Midwest and East Coast at the beginning of the March survey week. The level of population-weighted snowfall during a March survey week was at its highest since at least 2005, and similarly, the month-to-month drop in April survey week snowfall is also the largest over that period. Accordingly, we expect April payrolls growth to benefit, as swings of this magnitude have historically been associated with meaningful acceleration in weather-sensitive payroll categories, such as construction, retail, and leisure and hospitality (Exhibit 1).

Exhibit 1: Weather Likely Shifting from a Drag on March Payroll Growth to a Boost in April

Source: National Centers for Environmental Information, National Oceanic and Atmospheric Administration, Bureau of Labor Statistics, Goldman Sachs Global Investment Research

Regional granularity also suggests a meaningful drag from weather in the March employment report. Overall payroll growth in New England, Mid-Atlantic, and East North Central regions swung from +102k in February to -52k in March (compared to a 2016 average pace of +47k), likely reflecting unusually snowy March weather and some payback from the relatively warm February. Weather-sensitive industries in the regions contributed the majority of the March deceleration. One additional consideration is that the effects of Winter Storm Stella appear to have lingered throughout the March survey week in many populated areas. As a point of comparison, the snow produced by the January storms in the South – which did not appear to materially affect payrolls – had largely melted away by the Tuesday of that survey week. This suggests scope for the April employment report to benefit from workers in the establishment survey returning to their jobs. Taken together, our base case expectations assume that weather will boost April payrolls growth relative to the underlying trend by between 25k and 40k.

Jobless claims. Initial claims for unemployment insurance benefits declined, averaging 243k during the four weeks between the March and April payroll survey periods, a new cycle low. Additionally, continuing claims dropped by 65k from survey week to survey week, their largest decline over such a period since April 2015.

Service sector surveys. Despite declines in some of the service-sector employment surveys, our overall non-manufacturing employment tracker improved in April (to 54.5 from 53.7), and all of its components remained in expansionary territory. The ISM non-manufacturing (-0.2pt to 51.4), New York Fed (-5.2pt to +8.5, SA by GS), Dallas Fed (-3.6pt to +4.5), and Markit PMI Services employment components softened. However, this was more than offset by a sharp rise in the Philly Fed subindex (+9.2pt to +26.4) and further improvement in the Richmond Fed employment component (+4pt to +21). The key labor market subcomponent of the Consumer Confidence report also remained strong, edging down by 1.1 from the cycle-high reading in March to 11.7. Service sector payroll employment grew 61k in March and has increased 121k on average over the last six months.

Job cuts. Announced layoffs reported by Challenger, Gray & Christmas after our seasonal adjustment fell by 15k to 31k in April, a six-month low.

Arguing for a weaker report:

Continued retail weakness. Retail employment growth has fallen from its historical trend of 15-20k per month to -5k on average over the past six months. While some of the March weakness was likely weather-related, we expect the structural shift of retail sales from brick and mortar stores toward less labor-intensive e-commerce firms will continue to weigh on payroll growth in that industry, with the impact on the order of 10k per month relative to its previous trend. This drag on retail employment has appeared particularly pronounced recently – with a 61k cumulative drop in retail payrolls over the last two months – and we note the possibility that weak brick and mortar sales trends in Q1 may be accelerating the pace of this structural shift.

Exhibit 2: Shift Towards Online Retail Could Reduce Overall Job Growth by Roughly 10k per Month

Source: Bureau of Labor Statistics, Goldman Sachs Global Investment Research

Federal hiring freeze. The administration’s hiring freeze for federal workers (excluding defense and public safety) went into effect on January 23 and concluded on April 11 – the Tuesday of the April survey week. So far, its impact appears quite limited, with federal payrolls down negligibly in February and March (mom sa). As shown in Exhibit 3, the impact also seems minor in the context of federal job growth during the 1981 federal hiring freeze at the start of the Reagan administration (Exhibit 3). Thus far, government departments may have been able to offset the hiring freeze through reduced attrition or increased contracted hiring. Accordingly, we expect a minimal drag from the final month of the freeze and are assuming a flat reading for total government payrolls in tomorrow’s report.

Exhibit 3: Federal Hiring Freeze Exerting Minimal Impact on Payrolls So Far

Source: Bureau of Labor Statistics, Goldman Sachs Global Investment Research

Telecom strike. The April employment report coincided with a strike of 2k workers in the wired telecom subindustry, which is set to reduce payroll growth in the information sector by 2k this month.

Neutral Factors:

Manufacturing sector surveys. Employment components of manufacturing sector surveys were mixed in April but all remained in expansion territory. The ISM manufacturing employment component fell 6.9 points to 52.0 after reaching its highest level since mid-2011 in the March report. The Richmond Fed (-15pt to +5) and Kansas City Fed (-4pt to +9) employment subindices also declined. In contrast, the Empire State (+5.1 to +13.9), Philly Fed (+2.4pt to +19.9), Dallas Fed (+0.1pt to +8.5) and Chicago PMI employment components all improved. Manufacturing payroll employment rose 11k in April, its fourth consecutive increase, and has increased 10k on average over the last six months.

ADP. The payroll processing firm ADP reported a 177k increase in private payroll employment in April – about as expected – suggesting a stable underlying pace of job growth. The ADP measure overshot considerably to the upside relative to BLS private payroll growth in March (+255k vs. +89k), making the task of teasing out the underlying signal from the report more difficult. We believe the 177k pace of private job gains was encouraging on the whole, and we also expect the rebound from Winter Storm Stella to show up more visibly in Friday’s employment report.

Job availability. The Conference Board’s Help Wanted Online (HWOL) report showed a modest decrease in April online job postings (-1%) following February’s uptick (+2%). However, we continue to place limited weight on this indicator at the moment, in light of research by Fed economists that suggests the HWOL ad count has been depressed by higher prices for online job ads.

Some other observations:

Fed Impact: The impact on the Fed’s thinking could be slightly more in focus following last month’s headline 98K. Despite the employment growth average still sitting well above the Fed’s threshold for moving towards full employment, another big miss could begin to throw up some questions for the central bank. At present the rate path and the Fed’s message remain clear, and as a result it would seemingly take a string of poor labour market reports to derail the Fed’s plans to deliver two more 25bps hikes this year.

There are also wider factors in play within the Fed’s thought process, such as an inflated stock market, its large balance sheet and the Trump administration’s proposed fiscal stimulus.

Market Reaction: As ever, fast money moves will surround the initial headline. A stronger than expected number historically sends the USD higher and Treasuries lower with the opposite tending to be the case for a weaker number, before markets digest some of the other details of the report.

H/t: @RanSquawk

FOMC Preview: Here Are The Possible Surprises In Today's Statement

Today"s FOMC announcement at 2:00pm is expected to be mostly a non-event, and the only incremental information will be what is contained in the updated statement, which comes one month ahead of the Fed"s next expected rate hike in June. There will be no press conference and no update to the summary of economic projections. The statement is expected to incorporate modest changes to reflect recent (mixed) data but see the risks around the meeting are low.

Here is what Wall Street consensus looks like ahead of 2pm:

• The market expect no rate hike at the May meeting; Fed Fund futures are currently pricing in a 65% probability of a June rate hike.


• There is a risk of a small hawkish surprise if the committee indicates they are "looking through" Q1 weakness in growth and inflation.


• A less likely dovish surprise could come from the FOMC emphasizing the decline in inflation.


• It is likely too soon for the committee to update language related to reinvesting balance sheet securities.


• Subsequent Fed speeches by Yellen, Fischer, Williams and Rosengren on Friday will likely provide additional color

Continuing the trend from recent weeks, most Wall Street firms expect the Fed to hike twice more this year despite the recent slowdown in US economic indicators and the near record collapse in the Citi eco surprise index, in June and September and announce balance sheet reduction in December.

With that in mind, below are some observations from Citigroup on the few surprises in the "wording" contained in today"s statement:

FOMC “looking through” weak Q1 may read slightly hawkish

The statement will need to update language regarding inflation, consumption, and job growth – all of which have slowed since the March meeting. The relative hawkishness depends on the extent to which Fed officials attribute the softness to transitory factors.

Consumer spending – Spending slowed significantly in January and February. The consensus view (reflected in March FOMC minutes) is that much of the weakness is transitory owing to (1) less utilities usage due to warm weather and (2) delayed tax refunds.

March: "Household spending has continued to rise moderately"

• Dovish: Household spending moderated.


• Neutral: Household spending moderated but consumer sentiment remains high and real income growth has been robust.


• Hawkish: Household spending moderated largely due to transitory factors

* * *

Inflation – A surprise decline in core prices in March led core PCE to print 1.6% year-on-year undoing most of the progress since 2016. Some update of the inflation language is in order.

March: "Inflation has increased in recent quarters, moving close to the Committee’s 2 percent longer-run objective; excluding energy and food prices, inflation was little changed and continued to run somewhat below 2 percent."

• Dovish: Inflation is running below the committee’s longer term objective


• Neutral: Inflation has edged lower


• Hawkish: Inflation edged lower in part due to large declines in certain categories.

* * *

Labor market – Going into the March FOMC meeting the economy had added over 200k jobs in each of the previous two months. The last job print of 98K was widely attributed to payback from previously warm weather.

March: "Job gains remained solid and the unemployment rate was little changed in recent months."

• Neutral: Job gains slowed but the unemployment rate fell further.


• Hawkish: Job gains were solid over the last quarter and the unemployment rate fell further.

* * *

Balance Sheet – Discussion of the timing and details of tapering of reinvestments will likely continue at the May meeting. Assuming tapering is announced in December, the committee may wait until at least June and more likely September before adjusting language in the statement regarding the balance sheet. The minutes to be released on May 24 will likely be more informative on this point.

* * *

And here is Goldman"s full list of exepctations for today"s statement:

1. Constructive comments on full-year growth. Despite the 0.7% increase reported in this morning’s Q1 GDP report, we expect the FOMC statement will continue to sound constructive on growth trends, repeating that “economic activity has been expanding at a moderate pace”, or simply saying that activity “continued to expand.” Underlying growth in the first quarter appears firmer than headline GDP would suggest, and Fed officials including Vice Chair Fischer have argued that growth is likely to be stronger during the remainder of the year. Exhibit 1 summarizes this mixed but generally positive message from growth indicators, which featured some sequential slowing in payrolls growth and our Current Activity Indicator (CAI) but also a drop in the U3 and U6 unemployment rates as well as positive data surprises on net. Relatedly, we expect an adjustment to the statement’s labor market characterization that acknowledges the pronounced drop in the unemployment rate, yet also softens the language around “solid” recent job gains (reflecting the slowdown in March headline payroll growth). We also expect the committee to downgrade its assessment of household spending (from “rise moderately” to “rise modestly”) and for the committee to remove the word “somewhat” in its characterization of firming business investment (i.e. “business investment appears to have firmed.”)

2. Few changes to description of inflation-related data. The previous statement distinguished between headline- and core inflation, a distinction we expect the committee will retain. However, given the pronounced softness in the March core inflation report, the previous statement’s “little changed” characterization of core inflation would seem out of place. Indeed, this morning"s GDP report was consistent with core PCE inflation at 1.6% in March (yoy), down from 1.7% in February. Accordingly, we expect a brief acknowledgement of this softness (i.e. “core inflation slowed somewhat in March”). However, we expect the statement will retain the “continued to run somewhat below 2 percent” wording. Also, the mid-April drop in market-based measures of inflation expectations largely reversed in the final week of the month, with 5Y/5Y breakeven inflation now back at the March levels (2.1%). As a result, we expect no changes to the inflation expectations wording.

3. And unchanged inflation outlook. Despite the March setback, the drop in the March unemployment rate coupled with the committee’s apparent growth optimism suggest little need to modify the inflation outlook. We currently forecast core PCE inflation to reach 2.0% in early 2018, which seems broadly consistent with the March statement’s expectation that “inflation will stabilize around 2 percent over the medium term.” Accordingly, we expect no changes to the inflation outlook paragraph.

4. Unchanged balance of risks and “accommodative” policy description. At its June 2016 meeting, after concerns about the spillovers from Brexit had faded, the FOMC said in its statement: “Near-term risks to the economic outlook have diminished.” The committee upgraded this language again at the September meeting, saying: “Near-term risks to the economic outlook appear roughly balanced.” The qualifiers “near-term” and “roughly” suggest Fed officials are less than fully confident about the outlook. However, we do not expect any changes to this section of the statement, as improving international growth trends are likely weighed against continued geopolitical risks and today’s softer 1Q GDP data. A meaningful upgrade to the balance of risks should be taken as a hawkish signal for the near-term policy outlook, in our view. In terms of the assessment of the stance of current policy, committee members appear to use “accommodative” interchangeably with “modestly” or “moderately accommodative,” and we see little reason to qualify the “accommodative” characterization in next week’s statement – particularly because doing so would likely be interpreted as a dovish shift. 

5. Subtle reference to eventual balance sheet adjustment. We expect a minor change to the balance sheet paragraph, with some sort of allusion to possible eventual reductions. Given the extent of the discussion in the minutes to the March FOMC meeting – as well as several comments by Fed officials over the last month about the Fed’s plans for ending reinvestment – it would seem odd for the statement to omit any reference to the topic. At the same time, committee members will likely want to avoid signaling an imminent policy change. If the committee does edit this section, we expect the wording to be fairly vague and noncommittal. One possibility is that the committee adopts the “gradual and predictable” language from the March minutes as a description of its overarching balance sheet policy. 

6. No explicit mention of fiscal policy. Notwithstanding the Wednesday tax announcement, the committee has gained little incremental clarity on the legislative outlook since the March meeting. Furthermore, the FOMC does not explicitly include the issue in the list of factors it will use to assess appropriate monetary policy (even though fiscal stimulus may be the single most important source of uncertainty for the economic outlook this year and next year.) The committee has mentioned fiscal policy in past statements, but only after-the-fact in recent years. For example, statements in 2009 referred to “fiscal and monetary stimulus”, while those in 2013 said that “fiscal policy is restraining economic growth”. A similar approach seems likely this time around, with fiscal policy only discussed in the statement after legislation begins to affect the economy. 

7. No dissents. Minneapolis Fed President Neel Kashkari dissented against the March hike, but dovish dissents seem very unlikely given our expectation that rates will be left unchanged. We also do not expect any hawkish dissents, in part because a pause at this meeting would still be consistent with as many as four hikes over the course of 2017 that could be achieved in the three remaining press conference meetings.

It's 1994 Again: Why Albert Edwards Expects An Imminent "Bond Market Bloodbath"

Following the Trump presidential victory, two prominent macro strategists have undergone a significant change in their outlook: while David Rosenberg, who started off with a deflationary, and bearish outlook, then flipped to inflationary (and bullish), has recently once more "mean-reverted" and expects a further drop in yields as deflationary forces return, his SocGen peer, Albert Edwards - while still expecting a deflationary "ice age" in the longer-run (in case there is any confusion, he expressly states "make no mistake. Unlike most in the markets, I remain a secular bond bull and do not think this 35 year long bull bond market is over") now expects an imminent "bond rout" in the coming weeks as the Fed"s rate hike cycle leads to an aggressive selloff in short- as well as long-term rates. The result will be another "central bank-inspired recession", which will lead to the convergence of yields on the 10Y US Treasury with Japanese and European bonds below zero, as the global deflationary ice age enters the final round.

Edwards" summary of his current state of mind, just as the Fed is about to make (yet another) historic mistake, is - as usual - rather picturesque:

Make no mistake. Unlike most in the markets, I remain a secular bond bull and do not think this 35 year long bull bond market is over. I believe the US Fed has created another massive credit bubble that will, when it bursts, lay the global economy very low indeed. Combine this with the problems of a Chinese economy dependent on increasingly ineffective injections of credit to produce increasingly pedestrian GDP growth and you have a right global mess. The 2007/8 Global Financial Crisis will look like a soft-landing when the Fed blows this sucker sky high. The seeds for that debacle have already been sown with the Fed having presided over one of the biggest corporate credit bubbles in US history. All that is needed now is for the Fed to sprinkle life-giving rate hikes onto these, as yet dormant, seeds of destruction. Accelerated Fed rate hikes will cause tremors in the Treasury bond markets, forcing rates up, most especially in the 2 year – just like 1994. But as yet another central bank-inspired global recession unfolds, I  believe US 10y bond yields will ultimately converge with Japanese and European yields well below zero – in other words, buy 10y bonds on weakness!

And speaking of 1994, and the reason why Edwards is confident that despite the market "pricing in" the Fed"s upcoming rate hikes, nobody has any clue what is about to be unleashed, the SocGen strategist reminds his clients of the Orange County "havoc" unleashed with the 1994 rate hike cycles.

For those few of us in the markets of a certain age, Orange County conjures up only one thing: 1994 goes down in infamy as one of the biggest ever bond market bloodbaths in history culminating at the end of the year with Orange County in California going bankrupt (younger clients in their late 20s will only know the OC as the mid-2000s teen programme based in Newport Beach, which I watched religiously with my then teenage son and daughter).

I remember the 1994 period as if it were yesterday (unlike yesterday itself). Despite the Fed telegraphing the series of rate hikes and market participants forecasting multiple hikes, it was most curious how the market went into total convulsion. I was chatting to my ?similarly young? colleague Kit Juckes about this and he reminded me that the whole yield curve gapped up some 50bp immediately! It was a bloodbath, especially for 2y paper.

For the benefit of readers who may have missed this particular episode in bond market history, Edwards here are some more details of how the 1993/1995 rate hike cycle flowed through to the bond market, and then promptly resulted in an inverted curve.

You really had to be there at the end of 1993 to understand just how widely expected the 4 February 25bp Fed rate hike was. I was at Kleinwort Benson back then and I remember articulating that rates could rise somewhat more than the market expected on our December 1993 macro European tour. There was no real pushback. I have managed to lose my Global Strategy Weekly files from that time to see exactly what I was saying then, but I have my yellowing press cuttings file! From the FT on 8 Feb 1994 I find this, “on Thursday (the day before the Fed’s first hike), Mr Albert Edwards of Kleinwort Benson  wrote: In the US, Alan Greenspan could not have been clearer. He regards 3% as an excessively low rate which has served its purpose to eliminate the banking crisis and alleviate the credit crunch. The Fed does not care what headline inflation is, rates are heading higher. The risk is that the markets do not view a ¼% rate increase in isolation but the first in a series of tightenings, which it will be”. I was not alone in that view. It was quite common on the sell-side. What though we could not anticipate was quite how savage the bond sell-off would be.

Additionally, Edwards also shares two articles from that year, first from Fortune entitled “The Great Bond Massacre of 1994” see link, and also from December, when The New York Times analysed events surrounding the most high profile casualty of that year, namely Orange County, link. In a word the problem was leverage.

Fortune Magazine wrote in 1994, “Just as in the U.S., European bond investors were operating on lots of leverage. That made them just as vulnerable when the margin calls started to come. The result: "You had a snowballing liquidation completely out of proportion to the (economic) fundamentals," says Gilbert de Botton, chairman of Global Asset Management in London. "Both the U.S. and Europe had been overexploited by investors on margin."

“Back in New York, the report of extremely strong 6.3% real growth in the fourth quarter of last year, combined with Greenspan"s well-publicized fears about incipient inflation, struck new fear into bondholders. The Clinton Administration didn"t help matters. "The saber rattling over Japanese trade hurt a lot," says de Botton. "(U.S. Trade Representative) Mickey Kantor"s allusions to the effect that the U.S. was not in favor of a strong dollar was an indirect source of forced selling (of U.S. bonds) by European investors." Fearing currency losses and declining bond values, foreign holders of U.S. bonds began to pull out.

“Given all the leverage in the market, it shouldn"t have been surprising that long rates moved up sharply when the Fed finally began boosting short-term rates. Indeed, some members of the Open Market Committee voiced fears at the February 4 meeting that even a small increase in the Federal Funds rate could rattle the bond market. Rattle it did. The initial rise in long rates brought forth a flood of margin calls. Rather than put up more money, which many of them didn"t have anyway, speculators liquidated their holdings. With individuals bailing out of bond mutual funds as well, and little or no new money  coming into the market, bond prices had nowhere to go but down."

Edwards" rhetorical question, here: "Does that snippet not sound eerily reminiscent of current events?"

He also points out that while the Fed has so far hiked rates twice in the current tightening cycle, "these have become such isolated hikes that the market (Fed Fund futures strip) has lost confidence that the Fed will ever deliver their promises as represented by the Fed dots." With next week"s rate hike, however, all this will change.

There is another key similarity between 2017 and 1994:

The top chart shows that back in 1994, just before the Feb 4 rate hike, 2y yields were trading some 100bp above Fed funds. That one 25bp rate hike prompted the 2y-Fed Funds spread to soar from 100bp to 250bp within the space of three months while the 10y-2y curve flattened rapidly, destroying carry-trade bets along the curve. The key similarity with 1994 is that currently US 2y yields at 1.35% still trade tightly to the current Fed Funds rate of 0.75% (see left-hand chart below). If the market really takes on board Janet Yellen?s much more aggressive rhetoric, then we could easily see 2y yields rise towards the 10y as we did in 1994. If that happens and the US 2y spread with German and Japan continues to soar (see righthand chart below), this will be like rocket fuel strengthening the US dollar

Finally, while Edwards is hardly a technician, he provides two charts to substantiate his claim that a historic bond rout may be imminent: while the right-hand chart shows that US yields have now broken out and are heading to 2.65% and then 2.85% in the short term, it is the left-hand chart that is most interesting, "showing that US 10y yields can rise all the way to 3¼% and beyond and the secular Ice Age bull market in government bonds would still be intact."

Edward"s conculsion: "In 1994, it was excess leverage that broke the market, culminating in December 1994?s bankruptcy of Orange Country and also the Mexican Peso crisis in that same month (due to dollar strength). I?m going to look harder for my 1994 Global Strategy Weekly file, for despite remaining a secular bond bull, I think we are in for a rough ride - especially with equity markets at record highs."