Fra BNP Paribas analyse.
Last week our Interest Rate strategists examined three previous Fed tightening cycles (1994, 1999 and 2004) to gauge when the market begins to anticipate (price in) higher interest rates. https://globalmarkets.cib.echonet/fiweb/myportal/DocumentViewServlet/05_US_Outlook_04_Ju ne_Overview_.pdf?docType=pdf&docId=150230&source=Source%2BWeb&viewSource=latest Research&stream=true)
They found that front end volatility began to tick up approximately 6-8 weeks in advance of recent inaugural rate hike meetings. If one believes the FOMC will lift off at its September 2015 meeting, history suggests that this anticipation will commence in/around the July FOMC meeting (indicated by middle blue vertical line, Chart 1). In the more extreme case of 2004, current period rate volatility could spike in line with the June FOMC meeting (left blue vertical line, Chart 1).
Post Friday’s strong nonfarm payrolls print, the market-implied probability of a September hike moved from 50/50 to 62% hike/38% no hike. Today’s upside surprises in ‘control group’ retail sales should further this move. BNP Paribas’s economists also believe that June’s FOMC meeting may be perceived as being more hawkish than the market expects, particularly with respect to the press conference. Thus, we would not be surprised to see an increase in front-end volatility as soon as next week.
As with any derivative action, the reaction function in the Equity and Credit markets has been less clear historically. On the Credit side, spreads tightened until approximately 4-6 weeks before the meeting before widening from the tights 15-30bp over the course of the next two months. Still, in 2004 spreads largely stabilised, whereas by early 2000 Credit was pricing in the shift in risk appetites around the run-up to the dot-com bubble. US Equities showed little reaction to the Fed in 1994 or 2004, while in 1999 the market was still discounting exorbitant technology multiples.
Conversely, in 2015 Credit has already experienced several periods of Fed-related fear, while a large swath of the US Equity market appears relatively unperturbed by the prospect of higher rates. We believe that one underappreciated risk to Credit valuations during Q3-15 is a 5-10% US Equity correction.
