When it comes to Wednesday's rate hike, the opinion of Deutsche Bank, which has openly called such a move a "policy error" in the past, is quite clear: "the Fed’s objective is to slow credit. With deficient market liquidity that is easier done and said. In doing so it appears they also may help tidy up outstanding FX issues around RMB. Neither are good for risk on now and both favor curve flattening."
To be sure, DB does not want to come out sounding like a tinfoil hat blog by telling the whole truth without spinning it at least a little bit, which is why it adds that "Doom and gloom is not the official call on either the US economy, the Fed nor China. But it is our rates view that doom and gloom should be hedged. Do not underestimate how far rates can fall or the curve can flatten depending on the extent to which the Fed insists on tightening and the sensitivity of credit creation and EM/China fall out."
That is about as close as DB's Dominic Konstam will come to saying "doom and gloom" is now the base case.
But that's in the medium-term. How to trade the short-term which even a resigned DB believes means a Fed rate hike (even if it is promptly undone with a rate cut or worse as Hilsenrath hinted yesterday)? Here are Konstam's two core trade recos for the next few days... which some may say is really one trade.
It’ll take some deep dives in SPX to stop the Fed from tightening. Possible but even we cannot be that pessimistic. So they hike. Then what? How many can they really manage. Less rather than more. And it all depends on how quickly they achieve their real goal. The real goal is not managing inflation higher, otherwise they wouldn’t hike at all. Nor is it managing unemployment higher. That’s not the mandate. The real goal is to cut credit – the evil eye of leverage that threatens longer term sustainable growth. Partly thanks to an already over extended credit cycle and super deficient liquidity, they probably don’t need to hike very much at all. For safety we’ll assume they might try to get to 1 percent. That’s still plenty good enough to expect the curve to flatten and bullishly from the long end. Don’t under estimate how far rates can fall in this scenario. 5y5y easily can trade to old lows and 2s-bonds can flatten to 150 bps. China, like credit should also “get resolved” in Fed tightening. A golden opportunity to have more extensive depreciation.
Here DB makes an amusing detour between what it "really" thinks, and its "official" bullish, optimistic position which is spun by the cheerleaders such as LaVorgna and Bianco, whose only job is to placate bullish clients who hear what they want to hear, and spend some "soft dollars" with the German bank:
Of course to be clear our official view on China is not that. Officially, we have been optimistic on Chinese growth and limited scope for depreciation. Officially we also think the Fed has plenty of ability to raise rates without flaying the economy and credit markets.
But... "Officially though also, we think investors should use the rates market to hedge those official views."
We get it: ixnay on the Koolaid-ay.
What is more surprising is that rarely if ever have we seen a more acute example of just how profoundly one group within a bank disagrees with the bank's "official" cheerleading narrative: things must be really bad internally for the discord to be so public.
So putting all this together, what is DB's recommendation, assuming the market does not crash by over 100 points overnight and trigger a rate hike pause?
It's two fold: either buy bonds, or buy even more bonds.
Even without the profit constrained world for the dim labor market view, the Fed wants credit to slowdown. When credit slows down, buybacks slow. A roll over in the credit cycle is always associated with significant slowing in the labor market. It is true there are some metrics that suggests the corporate sector still has some juice in it, in terms of net worth, outlays to profits. It is not nearly as stretched overall as it has been on these other metrics this time around. But at this rate, it pretty much will become mid 2016. If it wasn’t the Fed wouldn’t be raising rates after all. So maybe there is an immaculate tightening but the choice seems to be either the Fed achieves its goals quickly to a very low terminal Funds rate. Buy bonds. Or they need to be even more aggressive. Buy even longer duration bonds. The choice is more about where to put the long leg of the curve flattener not about whether to steepen or flatten the curve.
And just to confirm that it is all about return of capital, not on DB also points out what has been the topic of the past week, namely the spectacular implosions in various junk bond funds, something which should not be happening if the economy and financial conditions were strong enough to handle a tiny 25 bps rate increase:
Credit stresses in the market place appear to be fast emerging. As our HY strategists have argued it is not good enough to “ignore” credit woes simply because they are concentrated in one sector. Crises are always concentrated in one sector but that then leads to contagion. Contagion occurs because of leveraged and forced selling and forced refinancing that then cannot take place.
Taking all this together, what DB's "unofficial" message is, since there is no "immaculate tightening", one which soaks up $600-800 billion in liquidity to start and goes up as much as $3 trillion at 1%, is to start frontrunning QE4 and/or NIRP by the Fed, something which the market will "force" on Yellen in two distinct ways - by causing a sell of in stocks, and by inverting the yield curve hinting a recession is imminent unless the Fed eases immediately once it begins tightening.
Just as Hilsenrath warned yesterday would happen.